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In the ever-evolving landscape of tax regulations, business owners continually seek ways to minimize tax liabilities while maximizing the financial benefits for their families. One of the most effective strategies available, often overlooked, is employing family members in your business. Whether it’s hiring your child, spouse, or both, doing so can unlock significant tax savings and provide benefits that extend beyond the immediate financial relief.
Employing Your Child: A Win-Win Tax Strategy
The 2018 tax reform introduced changes that significantly increase the benefits of employing your child. With the elimination of personal exemptions, the standard deduction for a single taxpayer was increased to $12,550 as of 2021. This means that if you hire your child and pay them a salary up to this amount, they pay no federal income taxes. For your business, these wages are deductible, reducing your taxable income and, consequently, your tax bill.
For instance, if you run a sole proprietorship and hire your child, who is under 18, their wages are not subject to FICA (Social Security and Medicare) taxes. This creates a dual benefit: your child earns tax-free income, and your business enjoys a tax deduction, lowering your overall tax liability.
Example:
If you pay your 13-year-old child $12,550 in wages, this amount is fully deductible on your Schedule C, leading to substantial savings in both income and self-employment taxes. If your marginal tax rate is 24%, you save $3,012 in taxes, not including the reduction in self-employment taxes.
The Tax Benefits of Employing Your Spouse
Hiring your spouse can be equally beneficial, particularly if you structure the compensation as tax-free fringe benefits rather than taxable wages. By doing so, you can sidestep payroll taxes and increase your business’s deductible expenses.
One of the most powerful tools in this strategy is establishing a 105-HRA (Health Reimbursement Arrangement). If your spouse is your only employee, this arrangement allows you to reimburse medical expenses, including health insurance premiums, on a tax-free basis. The reimbursements are deductible as a business expense, further reducing your taxable income.
Example:
If your business is structured as a sole proprietorship, and you reimburse your spouse $20,000 in medical expenses, you could see a tax savings of over $7,000, assuming a 35% tax rate. This savings applies year after year, as long as the HRA is in place.
Partnership Pitfalls: Husband-Wife Businesses
If you and your spouse co-own a business, careful consideration is needed when deciding on the business’s tax structure. While a husband-wife partnership might seem straightforward, it can lead to significant self-employment tax liabilities. In many cases, restructuring as a sole proprietorship, where only one spouse is treated as the business owner for tax purposes, can mitigate this issue.
Alternatively, converting the business to an S corporation can also reduce self-employment taxes. By paying yourself and your spouse modest salaries and taking the remainder as distributions, you avoid FICA taxes on the distributions, leading to considerable tax savings.
Example:
If your business generates $250,000 in profits, splitting this 50/50 in a partnership subjects both of you to the full self-employment tax on $125,000 each, leading to a combined tax liability of $38,250. By converting to an S corporation and paying each of you a salary of $60,000, your FICA tax liability drops to $18,360, saving nearly $20,000 annually.
Conclusion
Employing family members in your business isn’t just about keeping it “all in the family”—it’s a smart tax strategy that can significantly reduce your tax burden while providing financial benefits to your loved ones. By leveraging the tax benefits of employing your child or spouse and carefully considering the best structure for your business, you can enhance your tax efficiency and keep more of your hard-earned money within your family.
