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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Incorporation Breakeven Point?

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In talking with non-incorporated small business owners that are not clients of our firm, I often ask why they have not formed an S-Corporation for their business.  A common response I have been hearing is that their accountant or CPA told them that they had not reached the “breakeven point” for incorporating.  Some have even told me that their accountant or CPA actually quantified the “breakeven point” at a specific sales dollar amount.

Now, while I agree that some smaller businesses are better off as sole proprietorships, I disagree with this type of broad recommendation and concentrating too much on income as your deciding factor on whether to incorporate or not.  There are many other factors and benefits to consider…

1) Reduction of Audit Risk

Many often overlook this benefit of incorporation because they think it will never happen to them or they just don’t like thinking about it; however, it is definitely a benefit of forming a corporation and it is especially beneficial for industries with high audit risk like construction and restaurants.

Last year the IRS hired a large number of auditors in Portland and cities around the country and really ramped up compliance audits.  Having been through several audits of sole proprietorships reported on a Schedule C in the last few years, I have witnessed first hand the the inconvenience and cost related with going through an audit.  It is very “taxing” mentally, emotionally, and physically even when you have a CPA or lawyer to represent you, so I would definitely consider these costs when considering incorporation if you are in a high risk industry.

I am not suggesting that S-Corporations are free from audit risk; in fact, they have their own audit issues like reasonable compensation and excess distributions.  Rather, in general the audit risk is simply lower than with a businesses reported on Schedule C.  Also, corporations require much more detailed records and reporting, so usually the chances of errors are much lower.  I have seen some accountants make some fairly material errors simply because it was a Schedule C and a balance sheet was not required.

2) Limitation of Liability

Many business owners overlook this benefit as they believe they are protected by their insurance, or they simply think it will never happen to them.  However, in today’s litigious society with lawsuits abounding, you need to protect your personal assets and a corporation clearly separates corporate and personal assets and limits your liability in most cases to the assets of the corporation.  You should always seek the counsel of a lawyer regarding the specifics of your circumstances; however, if a business owner is in a field that has high risk of lawsuits, then an S-Corporation could really minimize that risk as opposed to staying a sole proprietor and running the risk of facing a lawsuit that can reach your personal assets.

3) Better Financial Documentation

The fact that you have to report more financial data to the IRS and keep more accurate records is often looked on as a downside to S-Corporations; however, I have seen an upside with this in the S-Corporation clients I have worked with over the years – the S-Corporation pushes you in the direction of better bookkeeping.

Sole proprietorships tend to have very poor books and records primarily because they do have to report a balance sheet.  Often, sole proprietors submit a list of expenses, a box of receipts, or even worse – an inter-mingled mess of business and personal expenses that you are magically suppose to be able to separate.  This lack of internal organization and separation of the business entity leads to poor decision making as there is nothing close to a financial statement that the business owner could review and base decisions on.  As a CPA, I see this all the time and you have to wonder how people stay in business like this.

It may take a few years after incorporation, but most small S-Corporation owners have to start keeping better records.  Loans have to be tracked and reconciled, shareholder activity has to be documented and recorded accurately, payroll has to be processed, and reimbursements have to be made for expenses paid personally.  Over time, and with the help of software, this becomes easier for the business owner and eventually they are using the internal financial statements and reports in business decisions and planning.  Yes, it is much more costly and time-consuming, but I see the S-Corporation as the much needed motivation to force us into effective business operation as financial reporting is vital to a successful business.

4) Wage & Payroll Tax Considerations

Another factor you have to look at is the industry the business owner operates in and the level of wages that would be considered “reasonable” for work that the business owner performs.  In some industries and in some positions, an average, reasonable wage that you would find in a salary guide is going to be much lower than others – which means greater tax savings with an S-Corporation since you only pay the equivalent of self-employment tax on the wages paid to the shareholder.  A dentist or doctor is going to have to have a much higher wage than a contractor or a consultant, so again – you cannot look purely at a sales volume breakeven point.

You also have to look at the number of employees that the business will have and the turnover.  With the Oregon Employment Department, if you only have minimal number of employees and low turnover, then after two years you could qualify for the lowest state unemployment rate – which is now at 0.7%.  Savings from incorporating will be much greater than a business owner with high turnover .

The Bottom Line

I admit, I am quite partial to the S-Corporation; however, it is not right for every business and situation.  However, the most important thing to remember with incorporation or any tax decision is to consider more than just the tax dollar savings.  There are always many other factors to consider and I strongly recommend talking with your accountant or CPA and have them walk through all the costs and benefits with you.  If you are looking for a CPA in the Portland area, we would be love to talk to you.  www.PandGCPA.com