In addition to being spiritually enriching, having a family business often makes good business sense. One way in which this can be true is when it comes to taxes. Entrepreneur.com brings us, as part of the End of the Year Tax Tips Series, Mark J. Kohler, CPA, attorney, radio show host and author of The Tax and Legal Playbook: Game Changing Solutions For Your Small Business Questions and What Your CPA Isn’t Telling You: Life-Changing Tax Strategies from Entrepreneur Press and partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP, who tells us why hiring your family members is one of the most powerful (and underused) tax strategies for small-business owners.
Hiring your children and family members is one of the most powerful tax strategies available to small-business owners today. Sadly, however, it’s underused.
Many people don’t realize that paying their children or grandchildren, whether they’re under 18 or adults, is an excellent strategy to minimize tax liability and enjoy a host of ancillary benefits. Before the end of the year, you should also consider whether it makes sense to put your spouse on your payroll. It’s surprising how many new clients I meet with who have their spouse on payroll without explanation. They just think that it’s “what you do.”
You can’t add the kids or your spouse to the books as an afterthought once the year has ended. You need to follow a paper trail that must be complete by Dec. 31, as well as make sure to document the work they completed this year.
So why get your children involved in the business? The days of hard work on the family farm are rapidly disappearing. More and more children are leaving home without a work ethic, money management skills or a concept of entrepreneurship. Moreover, many business owners forget that some of their most affordable labor is sitting right across from them at the dinner table.
The following are three possible scenarios for putting family members on your payroll. Here is the information you will need to determine whether this is a strategy worth pursuing.
- Paying children who are under the age of 18.
It’s important that you follow the right procedure, or this strategy could backfire. Here are the pertinent facts and rules to follow when putting your minor children to work in your business.
First, you don’t have to withhold any income taxes or payroll taxes from your own children and dependents under age 18. This also applies to workers’ comp, as well as state and federal unemployment insurance. This is because the government and insurance carriers assume your children won’t sue you if they are hurt on the job — hopefully not, at least. Your children are also probably on your health insurance plan, so you’ll end up paying the bill one way or another.
NOTE: I recommend that you review the laws in your jurisdiction to ensure you are operating legally regarding workers’ comp and other payroll taxes, as well as work permits and other regulations.
Second, realize that all of us, including our children, won’t pay taxes on the first $6,300 we earned in 2016. It’s the standard deduction, which is adjusted for inflation each year. Interestingly, you can still claim your children as dependents on your tax return and take the exemption or even the child tax credit. However, they won’t pay taxes on their earned income up to the standard deduction.
Third, make sure that your children are doing legitimate services — and keep good records. Services could include janitorial work, social media, stuffing envelopes, shredding paper, working on a rental property, etc. You might consider establishing a clear job title and description for your child and keeping track of his or her tasks.
WARNING: Hiring your children to do family chores will not qualify as a valid deduction and will certainly set you up for an audit.
Finally, you need to pay your own children under age 18 out of the correct company. Use your Sole-Prop operational business, LLC for rentals or a family management company (Sole-Prop) setup to provide support services to your S-Corp business. Most importantly, do not pay them out of an S-Corp or issue a 1099 form. A W-2 would be appropriate, but there aren’t any withholdings.
YEAR-END TIP: You need to create the system and process the payment to the child before Dec. 31 if you want the deduction in 2016.
Therefore, when you pay your children for services that they perform in your business, you can generate an expense for your income taxes by pushing income to your children. Of course, I’m not advocating that you pay your children as a “sham” operation. As I stated above, they must be legitimately involved in the business.
- Paying children who are 18 years old or older.
If you are paying children who are 18 or older, the same concept of providing legitimate services applies, and they won’t pay income tax if they make less than $6,300. This same strategy also applies to parents, nieces, nephews and grandchildren 18 and over.
First, you will have to choose between treating them as subcontractors or as employees. This means issuing either a 1099 or a W-2. Even if they make less than $6,300, they should probably file a tax return (as they may have SE tax if you give them a 1099 form). If they’re young adults, filing a tax return could be an important step in helping them get on the grid and start building a personal credit history.
EXAMPLE: If your child is going to college, do not pay his or her tuition. Give your child a legitimate role in the business as a subcontractor, pay them for their services through a 1099 and let them pay their own tuition.
YEAR-END TIP: You can issue the 1099 form in January, but you have to show payment of funds before Dec. 31 to get the write-off in 2016.
Finally, even if you pay your 18-plus child more than $6,300, that’s okay. He or she will be in a lower tax bracket than you and can establish a small business as a support company to yours — and begin the path to entrepreneurship.
Now, don’t think I forgot about you, grandparents! Certainly, we also want to teach our grandkids the importance of hard work and entrepreneurship. Why not try to integrate them into the business with legitimate services you need and were going to outsource or do yourself?
THE PROBLEM: You have to treat your grandchildren like regular employees or subcontractors and issue each of them a W-2 and withhold taxes — or issue a 1099 form. Thankfully, there is a straightforward tax strategy for paying grandchildren.
THE SOLUTION: Don’t pay your grandchildren directly. Pay and issue a 1099 form to your adult children and the support company they establish to supervise and hire their children, i.e., your grandkids. Your grandkid will legitimately work in your business under the supervision of your child and his or her “support/subcontractor” company.
YEAR-END TIP: Have a tax planning meeting with your children and your tax advisor and complete tax returns for both families in order to coordinate the strategy before Dec. 31.
This way, your kids can pay your grandkids using the strategy for children under 18 (described above) and save you from giving the grandkids a W-2 or 1099. Your children won’t pay taxes either, because on their Schedule C reporting the support company operations, they will claim the income that you 1099’d them and deduct the payments to your grandkids. This will zero out the income of their business supporting your business.
- Paying your spouse.
A lot of new clients I meet with think this is a no-brainer and that they should start paying their spouse as soon as they can afford to do so. This is not the approach they should take.
Here are a few scenarios that may lead you to consider paying your spouse.
I’ll save taxes. Wrong. If anything it will cost you taxes. First, keep in mind we are talking about paying your spouse. Thus, you will more than likely be filing a joint tax return, so if you pay your spouse, you may get a write-off in the business, but it just comes back as income when you file your personal return. You are back where you started! Moreover, if you pay your spouse with a “paycheck,” you now have to withhold payroll taxes, which only costs you more. (There may be a reason, as I will explain below, to give your spouse paycheck — but it’s not to save taxes.)
My spouse will build social security benefits. Not worth it. If you do your homework on ssa.gov, you’ll quickly learn about “spousal benefits” and future social security benefits for the “non-breadwinner” of the family. Surprisingly, spousal benefits in this situation are oftentimes much greater than your personal social security benefits. Thus, when we run the numbers for a spouse that hasn’t been on your payroll in years, to give them a significant payroll is too costly for the meager benefit. It’s more profitable to claim a spousal benefit.
I want to contribute to my spouse’s 401(k). In my view, this is an excellent reason to put your spouse on your payroll. Now with that said, there is a sweet spot to the payroll amount. If you really want to sock away some money in the 401(k), do the math and take into consideration the FICA cost of issuing the paycheck.
I have often argued that the best amount to pay in payroll is the amount that will perfectly max out the employee deferral amount. For example, a spouse could contribute $18,000 into his or her plan in 2016, and if the spouse is age 50 or over, the deferral could be as high as $26,000, but their payroll may be approximately $21,000 and $28,000 respectively.
YEAR-END TIP: Only put your spouse on payroll if you’re going to contribute to his or her 401(k) this year.
Don’t miss out on the opportunity to involve family members of all ages in your business. I have seen this strategy not only save clients thousands of dollars in taxes but also change the lives of their families.
If your children want money, tell them you need help in your business and they need to earn the money they want. They can start at any age and with any level of service. Share your passion for your business with them and help them cultivate that same passion for a business idea of their own.