Tax Strategies for Small Business Owners: How Hiring Family Members Can Save You Money
As a small business owner, you are always looking for ways to reduce expenses, improve profits, and minimize your tax liability. One often overlooked but highly effective strategy is hiring family members. While it may sound too good to be true, hiring family members can provide legitimate tax advantages, and when done correctly, it can help lower your overall tax bill.
This strategy allows you to shift income to lower tax brackets, reduce your taxable business income, and even avoid payroll taxes in some cases. In this blog post, we’ll break down how hiring family members works as a tax-saving strategy and why it might be the right choice for your business.
Shifting Income to Lower Tax Brackets
One of the primary benefits of hiring family members is the ability to shift income to lower tax brackets. As a business owner, you are likely in a higher tax bracket, but your family members might be in a lower bracket — particularly if they’re younger or just starting out in the workforce.
For instance, if you have children or other family members who work in your business, you can pay them a wage for legitimate services rendered. By paying them a reasonable salary, the income is taxed at their rate, which could be significantly lower than your own. This can result in a substantial tax savings.
Example:
Let’s say your business brings in $100,000 in income. If you hire your child and pay them $20,000, that $20,000 income is now taxed at their lower rate, reducing your overall taxable income.
By shifting this income to family members in lower tax brackets, you can reduce your tax burden while still benefiting from the work they perform in your business.
Wages as a Deductible Business Expense
When you hire a family member, the wages you pay them count as a deductible business expense. This means that the salary you pay to your family member directly reduces your business’s taxable income, which lowers your overall tax liability.
The IRS allows business owners to deduct reasonable wages paid to employees, including family members, as long as the work is legitimate and the compensation is reasonable for the role. This is a win-win — your business gets to reduce its taxable income, and your family member gets paid for their work.
Example:
If your business makes $100,000 and you pay your spouse $40,000 in wages, your business now has only $60,000 in taxable income. This $40,000 deduction can lower your tax bill significantly.
Avoiding Payroll Taxes
If your business is structured as a sole proprietorship or a partnership (including one with your spouse), there are additional tax advantages when you hire your children. For children under the age of 18 working in your business, you are exempt from paying Social Security and Medicare taxes on their wages.
This can provide significant savings, especially if you have multiple children working in your business. Additionally, if your children are under 21, you are also exempt from paying federal unemployment taxes (FUTA) on their wages.
This exemption doesn’t just apply to your children — you may also avoid payroll taxes when hiring your spouse, depending on how your business is structured. These tax savings can add up quickly, so it’s important to consider the potential benefits when employing family members.
Example:
If you hire your child and pay them $10,000 in wages, you would normally be required to pay 15.3% in Social Security and Medicare taxes (that’s $1,530). However, because your child is under 18, you don’t owe those taxes, saving you that amount.
Funding Retirement and Education
Hiring family members doesn’t just save on taxes; it also opens doors for helping them build wealth. Family members who are employed in your business can use their earned income to contribute to retirement accounts, like a Roth IRA, or save for education expenses.
Retirement Accounts: If your children are earning a wage, they can contribute to a Roth IRA and benefit from tax-free growth. This can set them up for a comfortable future while allowing you to shift income away from your higher tax bracket.
Education Expenses: The wages earned by family members can be used for education expenses, allowing them to avoid the high tax burden that comes with student loans.
This provides both an immediate tax benefit for your business and a long-term benefit for your family members.
Staying Compliant with the IRS
It’s important to note that while hiring family members can be a smart tax strategy, the IRS has clear guidelines regarding what qualifies as legitimate work and reasonable compensation. To stay compliant, ensure the following:
Legitimate Work: Your family members must actually perform real work for your business. The IRS expects them to contribute meaningfully, whether that’s administrative tasks, sales, marketing, or another role.
Reasonable Compensation: The amount you pay your family members must be reasonable for the work performed. This means you can’t just pay them a large salary without expecting an appropriate return on that compensation.
Documenting the hours worked, duties performed, and wages paid is crucial to avoid issues during a tax audit. Keep clear records of the work done by your family members to protect yourself and your business.
Hiring family members can be a powerful tax strategy for small business owners. It allows you to reduce your taxable income, shift income to lower tax brackets, and save on payroll taxes. Additionally, it helps your family members build wealth and financial security.
As with any tax strategy, it’s important to consult with a tax professional to ensure compliance with IRS rules and to ensure you’re maximizing the benefits while avoiding pitfalls. When done properly, hiring family members can provide significant tax advantages that make a real difference to your bottom line.