Along with the holidays comes a lot of extra work for many family-run businesses, which may require putting the kids to work and having a spouse help out over the busy time. There are special tax rules when hiring your children and also for your spouse, depending on whether he or she is a business partner or an employee.
Employing Your Child
Tax reform provided a more taxpayer-friendly tax treatment for children with earned income. Generally, when a child under the age of 19 or a student under the age of 24 without any investment income is claimed as a dependent of the parents, the child can earn up to $12,200 in 2019 without incurring any tax liability.
If they earn more, then the next $9,700 is taxed at 10%.
A reasonable salary paid to a child reduces the parents’ self-employment income and tax (business owners) by shifting income to the child.
Example: You are in the 22% tax bracket and own an unincorporated business. You hire your 17-year-old child (who has no investment income) and pay the child $14,000 for 2019. You reduce your income by $14,000, which saves you $3,080 in income tax (22% of $14,000), and your child has a taxable income of $1,800 ($14,000 less the $12,200 standard deduction), on which the tax is $180 (10% of $1,800). Thus, the net income tax saved by the family is $2,900 ($3,080 − $180).
If the business is unincorporated and the wages are paid to a child under age 18, the wages will not be subject to FICA – Social Security and hospital insurance (HI, aka Medicare) – taxes since for FICA tax purposes, employment doesn’t include services performed by a child under the age of 18 while employed by a parent.
Thus, the child will not be required to pay the employee’s share of the FICA taxes, and the business won’t have to pay its half either. In addition, by paying the child and thus reducing the business’s net income, the parent’s self-employment tax payable on net self-employment income will also be reduced.
Example: Expanding on the previous example and assuming your business profits are $130,000, by paying your child $14,000, you will reduce not only your self-employment income for income tax purposes but also your self-employment tax (the HI portion) by $375 (2.9% of $14,000 times the SE factor of 92.35%). But if your net profits for the year were less than the maximum SE income ($132,900 for 2019) subject to Social Security tax, then the savings would include the 12.4% Social Security portion in addition to the 2.9% HI portion.
A similar but more liberal exemption applies for FUTA, which exempts the earnings paid to a child under age 21 while employed by his or her parent from federal unemployment tax. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting solely of his or her parents.
However, the exemptions do not apply to businesses that are incorporated or a partnership that includes non-parent partners.
Even so, there’s no extra cost to your business if you pay a child for work that you would pay someone else to do anyway.
Additional savings are possible if the child is paid more or worked part-time during the year or in the summer and deposits the extra earnings into a traditional IRA. For 2019, the child can make a tax-deductible contribution of up to $6,000 to his or her own IRA. The business may also be able to provide the child with retirement plan benefits, depending on the type of plan it uses, its terms, the child’s age, and the number of hours worked. By combining the standard deduction ($12,200) and the maximum deductible IRA contribution ($6,000) for 2019, a child could earn $18,200 in wages and pay no income tax.
Example: Referring back to the original example, making a $6,000 traditional IRA contribution will only save the child $600 in tax, so it might be appropriate to make a Roth IRA contribution instead, especially since the child has so many years before retirement and the future tax-free retirement benefits will far outweigh the current $600 savings. Contributions to Roth IRAs aren’t deductible, but distributions are generally tax-free.
A child can benefit from the standard deduction and earn $12,200 tax-free (except FICA withholding) when working for someone else and still take advantage of an IRA deduction if his or her income exceeds the standard deduction.
For 2020, the standard deduction of a single person will increase to $12,400.
Note that if the child has unearned income, such as interest, dividends, or capital gains, and is under the age of 19 or is a student under the age of 24, the child may be subject to the “kiddie tax” rules, under which the tax on the unearned income is figured using a different tax rate schedule. This situation is not covered in this article.
Husband and Wife Working in the Same Businesses
A spouse is considered an employee if there is an employer/employee type of relationship, i.e., the first spouse substantially controls the business in terms of management decisions and the second spouse is under the first spouse’s direction and control.
If such a relationship exists, then the second spouse is an employee subject to income tax and FICA (Social Security and Medicare) withholding.
However, if the second spouse has an equal say in the business’s affairs, provides substantially equal services to the business, and contributes capital to the business, then a partnership type of relationship exists and the business’s income should be reported as a partnership on IRS Form 1065 or as a qualified joint venture (see below).
While the income and expenses of a partnership activity are reported on Form 1065, the net income or loss of the business, as shown on Schedule K-1 from the 1065, will still end up on the partners’ individual 1040 return(s), to be combined with any other income the couple has for the year. Partnerships are sometimes referred to as flow-through entities.
A provision of the tax code generally permits a qualified joint venture whose only members are a husband and wife filing a joint return to not to be treated as a partnership for federal tax purposes. A qualified joint venture is a joint venture involving the conduct of a trade or business if:
(1) the only members of the joint venture are a husband and wife,
(2) both spouses materially participate in the trade or business, and
(3) both spouses elect to have the provision apply.
Under the provision, a qualified joint venture conducted by a husband and wife who file a joint return is not treated as a partnership for federal tax purposes. Instead, all income, gain, loss, deduction, and credit items are divided between the spouses in accordance with their respective interests in the venture.
Each spouse takes into account his or her respective share of these items as a sole proprietor. Thus, it is anticipated that each spouse will account for his or her respective share on the appropriate form, such as Schedule C.
When determining net earnings from self-employment for computing self-employment tax, each spouse’s share of income or loss from a qualified joint venture is taken into account, just as it is for federal income tax purposes under the provision (i.e., in accordance with their respective interests in the venture).
This generally does not increase the total tax on the return, but it does give each spouse credit for Social Security earnings, on which retirement benefits are based. However, this may not be true if either spouse exceeds the Social Security tax limitation.
If your spouse is your employee and not your partner, then you must make Social Security and Medicare tax payments to the government for him or her – half the amount comes from the employee via withholding from his or her wages, and half comes from the employer.
The wages for the services of an individual who works for his or her spouse in a trade or business are subject to income tax withholding and Social Security and Medicare taxes but not to FUTA tax.
In addition, state taxes may also have to be withheld and remitted to the state government. The employer-spouse must issue a Form W-2 for the employee-spouse.