Follow tax laws when hiring relatives

The tax savings come because, in essence, you are shifting business income to a relative. The business can take a deduction for reasonable compensation paid to an employee, which in turn reduces the amount of taxable business income that flows through to you, according to the American Institute of Certified Public Accountants’ financial literacy Web site, www.360financialliteracy.org.

Of course, you have to do it right. The Internal Revenue Service can, for instance, question compensation paid to a family member if the amount doesn’t seem reasonable FOR the services performed. Also, the AICPA says businesses should be sure to comply with child labor laws when hiring family members who are minors.

There are other benefits to hiring family members. Business owners are responsible for paying Federal Income Contributions Act and Federal Unemployment Tax Act taxes on wages paid to your employees. FICA is the law requiring employers and employees to pay Social Security and Medicare taxes. FUTA is the law that establishes federal unemployment taxes.

As with wages paid to all employees, wages paid to family members are subject to withholding of certain taxes in some states. Typically, the payment of these taxes will be a deductible business expense for tax purposes. But if you hire a family member – a child, spouse or parent – to work for your business, you may not have to pay FICA and FUTA taxes.

For instance, you don’t have to pay FUTA taxes for services performed by your child if that child is under 21. And you need not pay FICA taxes for your child who is under 18 and works in your business, or a partnership owned solely by you and your spouse. For family members under 18, the parent does not have to withhold for FICA, Medicare, FUTA or State Unemployment Compensation Tax Act taxes.

If a spouse is employed by the business, the business does not have to withhold for FUTA or SUTA, but must withhold for FICA and Medicare.

Here’s an example: Jacob, who is 15, proofreads press releases for his mother’s public relations business, which is operated as a sole proprietorship. Jacob is his mother’s employee, but she doesn’t have to pay FUTA taxes until Jacob turns 21, and she need not pay FICA taxes until he reaches 18.

Note, however, that these rules don’t apply if you hire your child to work for your business unless all of the partners are parents of the child. Thus, if Jacob works in a landscaping business that half owned by his father and half owned by his uncle, FICA and FUTA will have to be paid.

Also, if your child has no unearned income, such as dividend income or interest, you only have to withhold income taxes from your child’s pay if it exceeds the standard deduction for the year. The standard deduction for 2004 was $4,850, but the amount is adjusted every year for inflation.

Children who are paid less than the standard deduction amount need not pay any income taxes on their earnings. The parent-owned business must, however, withhold income taxes if the child has more than $250 in unearned income for the year, and the child’s total income exceeds $750. If you pay your child more than $600 for the year, you must file Form W-2 with the IRS.

Regardless of how much you pay your child, each year you should fill out IRS Form W-4 and have your child sign it. Form W-4 is the Employees Withholding Allowance Certificate. If you pay your child more than $200 per week, keep a copy of the form for your records and file a copy of it with the IRS.

This article was produced by the Financial Planning Association and provided by William O. Woody of Stovall Woody Associates.