Family Employee Payroll Tax Exemption Clarified

The IRS recently issued temporary and proposed regulations that extend tax savings to family-owned businesses that employ their minor children and are organized as single-member limited liability companies.  Essentially, it is nothing more than a clarification on a position that many taxpayers were already taking, but it is worth mentioning, as it is an important tax planning strategy that can produce huge tax savings with the right circumstances.

If you have a business structured as a sole proprietorship or partnership, and you have children that could work in your business, you could be eligible for some big tax savings.  For example, if you paid them up to $5,800 each (the amount of the 2011 standard deduction), they would not be subject to:

  • Federal income taxes on the income,
  • Employee social security tax (4.2% in 2011), or
  • Any Medicare tax (1.45%).

In addition, your business would not have to pay the following taxes:

  • Employer social security tax (6.2%),
  • Employer Medicare tax (1.45%),
  • Federal unemployment tax (.008% on first $7,000 of wages), and
  • Possibly state unemployment tax and other state payroll taxes.

Not only is the payment exempt from almost all employee and employer payroll taxes, it also moves income that would have been taxed at your high marginal tax rate to your children’s rate, which in this case would be zero on the federal side.  Depending on the state, there may be a small amount of state income tax involved, but overall it is going to be very minimal in comparison to the tax that you would have paid at your marginal tax rate.

Better yet, the wages can be used to fund a Roth IRA, a college savings account, or school expenses that would have been paid with or without the payment for wages, so really it is a great benefit that doesn’t necessarily affect cash flow if you plan it out ahead of time.  Lastly, don’t forget the benefit of teaching your children work ethic and getting them involved in your business at a young age.  We work with many fourth-generation family-owned businesses, so this is an important benefit even without the tax exemption.

The Fine Print

What’s the catch?  Well, to make sure the payroll paid to your children will pass IRS scrutiny, the following steps need to be taken:

  • Your child actually has to perform the work,
  • The pay rate needs to be reasonable,
  • Actual paychecks have to be given to your child from the company, and
  • You need to document the work just like you would with any other hourly employee.

As to the type of work, it just needs to be ordinary and necessary for your business and reasonable considering the age of the child.  Have them clean your office or warehouse, file paperwork, or fill in on big projects that you would normally have to hire temporary workers for.  With today’s tech savvy teenagers, you can even have them help out with IT tasks or set up computers and devices.  Whatever you have them do, make sure you treat them just like an unrelated employee if you want to avoid problems with the IRS.

To qualify for exemption from employee and employer social security and Medicare taxes, your child has to be under the age of 18.  The exemption from federal unemployment tax lasts until they reach 21.  There are also many exceptions and details that apply depending on the type of business, and payroll tax reports and W-2s will have to be filed, so it is definitely something that you will need to discuss with your tax professional before starting.

The Recent Clarification by the IRS

Single-member limited liability companies (SMLLCs) are considered disregarded entities for tax purposes and are required to be reported on the member’s 1040 tax return using Schedule C, and up until this point the rules on this payroll tax exemption explicitly included sole proprietorships and partnerships.  The new proposed regulations now specifically include SMLLCs in the list of entities that can take the family employee tax exemption.  This is good news if you have a SMLLC and have been claiming the exemption, and for those that were hesitating because of the wording of the rule.

If you have a corporation, you are not eligible for the exemption; however, in most cases there would still be a tax benefit to paying wages to your children.

If you have a family-owned business in the Portland area and would like to find out more about this tax strategy and others like it, feel free to email or call me at 503.244.8844 to set up an appointment.

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About Brian Germer, CPA

CPA with Parsons and Germer CPAs, LLP in Portland, OR

13 thoughts on “Family Employee Payroll Tax Exemption Clarified

  1. Quick question about family employees: they must be paid from payroll and not as sub-contractors to avoid paying FICA, under 18? Then as subs, they’ll need to pay FICA regardless of their age? Can you clarify please? Many thanks!

  2. I have a question about a single owner S corp. can the owner pay his children that are under 18 as employees, with no taxes taken out, federal or state? State is OR. And also no employer taxes being paid? Thanks so much!

    • The strategy unfortunately does not work for S corporations – it is only available to LLCs taxed as partnerships and sole proprietorships.

      If you pay children under 18 from a corporation, it is still subject to employee and employer Social Security and Medicare tax. However, there is still some benefit available, as you could pay your children $5k and they would not owe any income tax. Granted, it is not as good of a benefit as with the LLC, but it is still a good deal.

    • Unfortunately, Publication 15 states that the family employee exemption is only available to a “partnership in which each partner is a parent of the child”, so your scenario would not work.

      Despite having to pay FICA and Medicare taxes, you would still have the benefit of shifting income to the children.

  3. I have single member LLC in California. I have two questions:
    1. How much is non taxable standard deduction for 2014
    2. If I start with this and employ my kid should he fill separate tax return at the end of the year or he can still be y dependent on y tax return? After all, is the whole things worth because I get deduction for the kid on y tax return and will this change that status or amount how much deductions I get for my child on my tax return?

      • So it will be my child only income, he lives with us and we support him. Does it mean we can claim him like we did previous year and that he will need to file own return?

      • Yes, should be able to claim him as a dependent, as the support you provide should be more than the amount of wages you are paying your child, and yes they would need to file a tax return. Filing requirement for your child depends on the wage amount. For Fed, if under standard deduct, they shouldn’t need to file. You would have to check on the state threshold though.

  4. My husband owns a single member LLC in Colorado. We have hired our 2 sons both under the age of 18. Their wages are $8.00 an hour. They have worked 8 hours. Can I issue them a payroll check for the full $64.00 with no withholding’s and no additional payroll taxes the company needs to pay?

    • They are exempt from FICA, Medicare, and FUTA. Plus, you do not need to worry about Federal Withholding unless total wages for the year will surpass the standard deduction. You will have to check on the state payroll taxes, as there might be some employer taxes at the state level.

      In Oregon, we have some weird rules. Sole proprietorships are exempt from OR SUI, but for some reason the law is written so that LLCs are subject. Plus, we also have a transit tax that family employees under 18 are subject to.

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