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.

Single Member LLC Owner Liable for Unpaid Employer Payroll Tax

Single member limited liability companies seem to be the popular choice these days for small business owners that want limited liability protection without the extra cost  and hassle of an S-Corporation or a two-member LLC.  However, SMLLC owners need to be aware of the court case listed below regarding payroll tax liability as they are personally liable not only for trust fund withholdings taken from employee checks (Code Sec 6672), but also the employer share of payroll taxes.

Medical Practice Solutions, LLC, Carolyn Britton, Sole Member, Petitioner v. Commissioner, Docket No. 14668-07L, 132TC, No. 7 (3/31/09)

Medical Practice Solutions follows several similar rulings in the last few years regarding disregarded entities (SMLLCs) and payroll tax liability, and given the current recession it is very important the single member LLC owners understand that their limited liability protection does not extend to unpaid employer payroll tax liabilities.  In plain terms, employer payroll tax consists of the taxes not deducted from the employees check, which would be taxes like employer Social Security and Medicare tax, federal unemployment tax, and state unemployment tax.  The trust fund withholdings are the amount deducted from the employee’s gross pay that need to be paid to the respective agencies, which business owners have always been personally liable for.

On average, most employers stay current with their payroll tax liability, and most underpayments are the result of calculation errors.  However, over the years I have witnessed several employers get behind on their payroll tax liabilities due to large drops in income, embezzlement and theft, and business owners over-extending themselves in too many business ventures.  In addition, I have seen many businesses close their doors that had to deal with significant amounts of debt and/or were facing a lawsuit.  If you have a SMLLC or are thinking of starting one, you should definitely talk to your attorney about this.  If it is of significant concern, you may consider adding a spouse or friend to the LLC to take advantage of the credit ordering rules available to a two-member LLC.

I would also recommend using a payroll service provider or a CPA that will get you in the discipline of depositing your payroll tax timely.  Whether you have a SMLLC or not, the IRS is not a creditor you want to put off as the penalties involved with payroll tax payments are very substantial.

LLC vs. S-Corporation, Round 1

When setting up a business and deciding on entity type, most people are looking for 1) liability protection and 2) tax savings – specifically lowering self-employment tax liability.  For small businesses, the two best options are the LLC or the S-Corporation, and many tax or legal professionals seem to advocate for one team or the other so it is hard to know what entity is truly best for your business.  Well, I am not your advisor and I have been on both teams, so hopefully I can provide you with some balanced information and after a couple rounds, hopefully we will have a winner for your business…

Will the business own appreciating property like real estate?

If your business has anything to do with real estate rentals or owning and managing commercial or residential property, then LLC is the early winner.  This is vitally important – you should never put real estate into a corporation.  If a CPA or tax practitioner recommends this for a new small business, I would consider it malpractice.

Basically, if you put real property into an S-Corporation, then you are going to have a taxable event if you transfer it out of the corporation in the future and you will pay tax based on the fair market value of the property at that time.  I could tell you some horror stories on this issue, but trust me – if you have a residential or commercial property, put it in an LLC.
LLCs are perfect for real estate as you can move the property in and out of the entity without any taxable events.  Plus, they are much easier to setup, administer, and report for tax purposes.  Even better, if you have one owner, you can use the single-member LLC for your real estate and then the tax reporting is simplified so that you only have to complete a Schedule E as part of your personal return.

How many owners will the business have?

This is another important question to look at upfront, as it can result in a knock out in round one.  If you will be the sole owner of the business, then your options are limited to the following:

Single-member LLC (SMLLC)

The only LLC offering for the single-owner business is a great option for easy setup, administration, and tax reporting; however, it is going to cost you in the form of self-employment tax.  To the IRS, The SMLLC is no different than a sole proprietorship – in fact, the SMLLC is reported on Schedule C just like a sole proprietorship.  Unfortunately, this means that you will pay self-employment tax (15.4%) on the entire amount of your net taxable earnings.  This can really add up – especially if you are a consultant with few expenses and/or minimal capital asset needs.  After a few years of paying a hefty tax bill, most business owners are willing to put up with some extra administration and tax prep costs in exchange for a much lower tax bill via use of the S-Corporation while paying themselves a reasonable wage.

S-Corporation

The big winner for single-owner businesses is clearly the S-Corporation as most business owners can end up saving thousands.  With an S-Corporation, you do not pay self-employment tax on the earnings, BUT the owner must pay himself a “reasonable” salary, which means you are paying payroll taxes on the Federal and state level.  Usually, if you sit down with a CPA and lay this all out, they should be able to give you a ballpark of your tax savings each year; however, there are costs related with this:

  • Legal costs – it is not cheap to setup, but I would never suggest a D.I.Y for an S-Corporation.  Get it setup right and avoid legal problems later.
  • Accounting Fees – keeping your accounting data on a spreadsheet may not cut it anymore – especially if you use a lot of credit cards and loans.  Be prepared to pay a bookkeeper or an accountant to get your books setup right so that the tax preparation goes smoothly.
  • Tax Prep fees – S-Corporation returns require much more work and typically range from $750 – $2000 or higher depending on complication.  Plus, you now have to file quarterly payroll tax returns and payroll to process, which can run you about $95/quarter even with one employee using ADP, Paychex, of your CPA.

If your savings are still substantial after factoring in these costs, then you should definitely go with the S-Corporation, but make sure you have a good lawyer and a good CPA that you like as you will be talking to them frequently for the first few years.

Well, round 1 is in the bag and we are tied at 1 a piece.  In round 2 we will deal with issues for businesses with more than owner.

Just remember – never choose an entity for your business without consulting a CPA and lawyer as every situation and business is unique.  Give me a call at 503.224.8844 if you need a CPA or a lawyer to help you with your new business.