Why Hiring Family Members Can Be Beneficial

Excerpted from Minding Her Own Business by Jan Zobel, E.A. © 2005

Hiring family members and domestic partners to work in your business can be an effective way of transferring income from one person to another. Transferring this income is perfectly legal and can result in some significant tax savings for you.

Example: Inez hires her 14-year-old daughter Corinne to clean up around her home office. She pays Corinne a salary that is comparable to what she would pay any other person or service to clean the office. She is also giving Corinne the added benefit of gaining experience by having a job. Inez benefits from the arrangement by paying less tax because she can deduct the amount she pays Corinne.

Example: Lisa owns a pet grooming business. Her life partner, Joan, has just been laid off from her job. Until Joan finds a new job, Lisa will need to pay all the household bills. Paying Joan’s share of the bills is not a deductible expense for Lisa. However, by hiring Joan to work temporarily in her business, Lisa is able to deduct 100% of the wages she pays Joan (which Joan can use to pay her share of the bills).

In general, the family member or domestic partner must be paid as an employee rather than an independent contractor, unless he or she already has her own business doing the type of work you’re hiring him or her to do. This means you need to issue W-2 forms, register as an employer, withhold taxes, pay into Social Security, and so on. (See Chapter 17 for information about your tax and withholding responsibilities as an employer.)

Hiring Your Children
A special rule applies if you hire your child. You don’t need to withhold Social Security tax as long as he or she is under age 18. Your child won’t owe any income tax until his or her total income for the year is over approximately $4,900 (the exact amount increases each year). Although you do need to issue a W-2 form, if he or she will have less than $4,900 total income, you don’t need to withhold income tax from his or her paycheck.

Inez, from the previous example, pays Corinne $3,600 during the year. Corinne also has $100 in interest income from a bank account. Her income is under $4,900, so Corinne doesn’t owe any tax. Meanwhile, Inez deducts as a business expense the $3,600 she paid Corinne, saving approximately $500 in self-employment tax and $1,000 in federal income tax.

Note: Corinne could have a total income of $7,900 and not owe any tax if she contributes (or Inez contributes for her) $3,000 to a traditional IRA retirement account. While it may be hard to imagine a 14-year-old contributing toward retirement, those who begin saving for retirement at a young age will need to contribute far less and will have more retirement money than those who start contributing later in life.

Hiring your child is a wonderful way to be able to deduct your children’s allowances or college funds. However, the child (or other family member) must actually perform the work he or she is being paid to do. His or her pay must also be commensurate with the work he or she is doing and with his or her age and abilities.

Hiring Your Spouse
Hiring your spouse to work in your business can provide benefits to both of you.

Example: Susan hires her husband, Daniel, as a sales rep for her office equipment sales company. Susan provides health insurance for all her employees, including Daniel. Daniel’s policy covers his spouse (Susan) and their children. Susan is able to deduct the full cost of the health insurance policy as a business expense.

Normally, a self-employed person can deduct 100% of the health insurance premiums she pays, but not as a business expense. (see Chapter 28.) In other words, the cost of a business owner’s health insurance provides an income tax deduction but doesn’t reduce her self-employment tax. However, in this example, Susan is able to deduct 100% of her health insurance cost as a business expense since it’s part of the policy she provides for Daniel.

Other benefits, such as reimbursement for child care expenses, can be offered to employees of your business. If your spouse is an employee, he can take advantage of the benefits, saving you both money.

Note: Any benefits you offer must be available to all employees. If your spouse is currently the only employee but you anticipate hiring additional workers in the future, consider carefully before setting up an employee benefit program.

If your business is incorporated, you are treated as an employee of the business and will be eligible for most employee benefits offered by the corporation. As a sole proprietor, however, you are not an employee of your business. This means you can take advantage of such benefits as child care or medical reimbursement programs only if you offer them to your employees and hire your spouse as an employee of your business.

Obviously, there are more than tax ramifications to be considered in deciding whether to hire a family member. You will want to seriously think and talk about the potential personal effect of being in business together. However, with proper planning, hiring family members can be an effective tax savings move.