It May be Advantageous to Employ Your Spouse, Children, & Parents in Your Family Business, But You Need to Understand the Tax Rules
Both Spouses Carrying on Trade or Business
If spouses carry on a business together and share in the profits and losses, they may be partners whether or not they have a formal partnership agreement. If so, they should report income or loss from the business on Form 1065. They should not report the income on a Schedule C (Form 1040) in the name of one spouse as a sole proprietor. But, the spouses can elect not to treat the business as a partnership by making a qualified joint venture election.
Qualified Joint Venture Election
Spouses may elect treatment as a qualified joint venture instead of a partnership. A qualified joint venture conducts a trade or business where:
- The only members are a married couple who file a joint return,
- Both spouses materially participate in the trade or business, and
- Both spouses elect not to be treated as a partnership.
Only businesses owned and operated by spouses as co-owners and not in the name of a state law entity, such as a limited partnership or limited liability company (LLC), are eligible for the qualified joint venture election. Find more information on joint ventures in Publication 541, Partnerships.
Spouses electing qualified joint venture status are sole proprietors for federal tax purposes. Each spouse must file a separate Schedule C to report their share of profits and losses. One spouse cannot continue to use the partnership’s Employer Identification Number (EIN) for the qualified joint venture. The EIN must stay with the partnership; it’s used by the partnership for any year in which the business doesn’t meet qualified joint venture requirements.
If the business has employees, either of the spouses as sole proprietors may report and pay the employment taxes. The spouse, as an employer, must have an EIN for their sole proprietorship. If the business filed or paid employment taxes for part of the year under the partnership’s EIN, the spouse may be considered the employee’s “successor employer” for purposes of figuring whether wages reached the Social Security and federal unemployment wage base limits.
One spouse employed by other spouse:
The wages for the services of an individual who works for their spouse are not subject to the Federal Unemployment Tax Act (FUTA). However, such wages are subject to income tax withholding and Social Security and Medicare taxes.
Child employed by parents:
Payments for the services of a child under age 18 aren’t subject to Social Security and Medicare taxes, if the business is a sole proprietorship or a partnership in which each partner is a parent of the child. Payments to a child under age 21 aren’t subject to FUTA. Thus, the payroll tax savings are obvious. However, payments to children are subject to income tax withholding, regardless of the child’s age. Nevertheless, total family-paid income taxes can be reduced by shifting some of the parent’s high-taxed income into the child’s lower income tax bracket. A properly executed W-4 by the child may avoid the income tax withholdings.
If the child makes an IRA contribution on his/her earned wages, additional income taxes could be saved. If the business has a retirement plan for its employees, the parents need to consult with that plan’s advisor.
Keep in mind that the IRS may disallow wages paid to a child. You need to understand the three factors that the courts look at to determine if wages paid to a child are tax deductible. The wages must be reasonable; paid for services actually rendered; and the wages are actually paid (not a journal entry) and best to be deposited into the child’s bank account. In addition to IRS scrutiny of employing children in a business, there are U.S. and state Department of Labor rules to consider.
Other considerations are (1) the impact that those wages may have on the child qualifying for education aid; (2) providing pre-tax plans for your employees; (3) health care premiums paid by the business; (4) by adding a child to the payroll and providing benefits, how are other employees affected?; and (5) if the business has no existing employees, there will be additional costs related to setting up a payroll.
Payments for the services of a child are subject to income tax withholding as well as Social Security, Medicare and FUTA taxes if they work for:
- A corporation, even if it’s controlled by the child’s parent, or
- A partnership, even if the child’s parent is a partner, unless each partner is a parent of the child.
Parent employed by child:
The wages for the services of a parent employed by their child are not subject to FUTA tax. However, such wages are subject to income tax withholding and Social Security and Medicare taxes.
Employees complete Form W-4 so that their employer can withhold the correct federal income tax from their pay. The IRS encourages everyone to use the Tax Withholding Estimator to help them make sure they have the right amount of tax withheld from their paycheck. The estimator automatically links to Form W-4, Employee’s Withholding Allowance Certificate, which they can then fill out and submit to their employer.
If you would like to discuss your business or personal tax planning, tax preparation and other financial concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
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About F. Bryan Haarlander, EA, CTRS:
Bryan Haarlander is an IRS licensed Enrolled Agent and who owns and operates a specialized tax services firm serving clients in the western suburbs of Philadelphia, PA, which includes the cities of Chester Springs, Coatesville, Collegeville, Devon, Downingtown, Exton, Frazer, King of Prussia, Paoli, Philadelphia, Phoenixville, Pottstown, Radnor, Reading, Wayne, West Chester in Berks, Chester, Delaware, Montgomery and Philadelphia Counties, as well as clients in Delaware, New Jersey, New York and throughout the continental USA.
A Certified Tax Resolution Specialist, Bryan is well-known for his IRS tax resolution expertise and his book How to Resolve Your IRS Tax Debt Problems.