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.