Sole proprietors may be able to reduce their tax burden by hiring their children, spouse, or parents to work as bona fide employees.
There are three ways to save tax dollars for the business owner. First, sole proprietors may be able to avoid some payroll taxes on wages paid to their sons, daughters, spouses, and parents. Secondly, they are shifting income to persons who might be in a lower tax bracket. Thirdly, sole proprietors can deduct other employee benefits to amplify their tax savings.
- Reducing payroll taxes. Sole proprietors don’t have to pay federal unemployment insurance (FUTA tax) on wages paid to parents, spouses, or children under age 21. Many states also exempt family members from state-level unemployment insurance (SUTA tax). Sole proprietors don’t have to pay Social Security and Medicare tax (FICA) on wages paid to their sons and daughters under age 18. That means the child doesn’t have the 7.65% FICA tax withheld from his/her wages, and the sole proprietor doesn’t have to pay the employer’s portion of FICA either.
- Shifting income into lower tax brackets. By paying wages to family members in lower-income tax brackets, you end up deducting the wages paid on your tax return with its potentially higher tax rates, and the income gets taxed at a lower rate on your family member’s tax return.
- Deducting employee benefits. As a sole proprietor, you can offer pre-tax benefits to your employees, such as group health insurance, term life insurance, and employer contributions to their retirement plans. This opens the opportunity, for example, to deduct health insurance premiums for the family as an employee benefit on Schedule C, instead of as a deduction on Form 1040, Schedule 1. This helps reduce the sole proprietor’s self-employment tax.
Following are the do’s and don’ts of hiring family members:
- Do have them fill out Form W-4.
- Do pay a reasonable salary for services performed.
- Do report their pay on Form W-2.
- Do withhold federal and state income tax.
- Do file quarterly and annual payroll forms.
- Do provide your family members with the same benefits you offer to other employees.
- Don’t pay unreasonably high salaries.
- Don’t pay them for doing nothing.