This article is reproduced with permission from Spidell Publishing, Inc.
Hiring family members can be a great strategy for small business owners, but it is important to know how these employees are taxed. Also, making sure they are actually performing duties and keeping good records is important in case the employer-employee relationship is ever questioned.
Spouse employed by spouse
The wages for the services of an individual who works for his or her spouse in a trade or business are subject to income tax withholding and FICA (Social Security and Medicare taxes), but generally not Federal Unemployment Tax Act (FUTA) tax. FUTA tax will only apply if the spouse works for:
- a corporation, even if it is controlled by the individual’s spouse; or
- a partnership, even if the individual’s spouse is a partner.
One benefit of having a spouse on the payroll is to take advantage of Internal Revenue Code (IRC) Section 105 medical reimbursement plans, which are not allowable for self-employed individuals. If a self-employed taxpayer’s spouse is an employee, then the spouse is eligible for the IRC Section 105 medical plan that can cover the spouse and their family, which would include the self-employed taxpayer.
Parent employed by child
The wages for the services of a parent employed by their child are subject to income tax withholding and FICA. Payments made to a parent are not subject to FUTA, regardless of the type of services provided. If a taxpayer pays wages to a parent for services not performed in the taxpayer’s trade or business, then FICA generally does not apply.
A taxpayer-business owner must apply FICA to domestic services performed by a parent if both of the following conditions are met:
- The parent cares for the taxpayer’s child who lives with the taxpayer and is under age 18 or requires adult supervision for at least four continuous weeks in a calendar quarter due to a mental or physical condition; and
- The taxpayer is widowed, divorced, or married to a person who, because of a physical or mental condition, cannot care for the taxpayer’s child during that period.
Minor child employed by parent
Amounts received for payment of services of a minor child must be included in the child’s gross income, not the gross income of the parent. This is true even in the case where the amounts are not received by the minor.
Generally, services performed by a child who is under age 18 and employed by a mother or father are exempt from FICA tax. For FUTA tax purposes, the exemption applies to a child under age 21. These rules apply to a sole proprietor but not to:
- corporations, even if the parent(s) are the only shareholders;
- partnerships, unless the child’s parents are the only partners; or
- as estate, even if it is the deceased parent’s estate.
Although services performed by children who meet the age requirements are not subject to FICA or FUTA, the wages are subject to income tax withholding.
Family members must actually do work
If a family member or a spouse is put on the payroll, they must do legitimate work, and they must be treated the same as an unrelated employee:
- Make sure that title and salary are appropriate for the position they are hired for;
- Make sure they fill out all the forms and payroll authorizations, as with any new hire;
- Make all required deductions and withholding from their pay, including the appropriate withholding and payroll taxes;
- Establish a work schedule, pay schedule, expected duties to be performed; and
- Offer them the same benefits coverage provided to other employees.
For more information about this article, please contact our tax professionals at taxalerts@windes.com or toll free at 844.4WINDES (844.494.6337).