Turn Relatives Into Employees to Reduce Taxes

March 15, 2015

march-2High-income business owners may be realizing the impact of new tax laws as they prepare their 2014 tax returns. Those laws can be especially painful if your company is structured as an S corporation or a limited liability company (LLC), with all income reported on your personal return. Besides the recently added 39.6% top income tax bracket, your income may be subject to the 3.8% Medicare surtax as well as the phaseout of itemized deductions and personal exemptions. Including state taxes, you might be in a marginal tax bracket in excess of 50%.

Savvy shifting

You may receive some tax relief by hiring relatives. The money you pay will reduce business profits, so you might have less taxable income to report. That compensation will be taxable to the relatives you hire—or it might not. The standard deduction is $6,300 in 2015, so your children can each receive up to that much, tax-free.

Example: Jennifer Boyd has a mail order clothing business that makes enough money to put her into a high tax bracket. She hires her two children and pays them $3,500 and $5,000 this year. Jennifer reduces her reported income by $8,500, saving her thousands of dollars a year in tax, while her children owe no income tax.

Jennifer also hires her widowed mother, who is in the 15% tax bracket. (That rate goes up to $37,450 of taxable income in 2015.) Again, Jennifer saves tax by reducing her income, while her mother owes relatively little in tax.

To justify the tax savings, family members on the payroll must be paid fairly for work they actually perform. Thus, tasks should be suited for each individual’s capabilities. Jennifer’s teenage son, for instance, might help with her company’s website and its IT operations; her daughter, who goes away to college, could generate market research reports that relate to Jennifer’s business and play a role in keeping the company’s social media activities up to date. Jennifer’s mother, a retired fashion designer, could provide advice on product trends and selection.

No matter what kind of work relatives perform, business owners should keep records showing their production. Compensation should be in line with the amounts paid to other employees.

Weighing the tradeoff

If your business is a partnership between spouses or a sole proprietorship or a certain type of LLC, you won’t be required to pay Social Security and Medicare taxes on the wages you pay to your children if they are under age 18. Similarly, with an unincorporated business, you won’t need to pay federal unemployment tax on wages paid to a son or daughter under age 21.

Except for those situations, the wages you pay relatives will be subject to payroll taxes. Those payments may reduce the family’s tax savings. Our office can help you calculate the net tax benefit of hiring family members and assist in setting up the required paperwork.

Beyond tax savings, hiring relatives can be rewarding. Your children may gain valuable life lessons, and your retired parents can continue to perform worthwhile tasks. Tax savings, while undoubtedly welcome, might turn out to be the icing on the cake.