By Nellie Akalp
It’s common for entrepreneurs, especially those who own very small companies, to hire family members. After all, you are already familiar with these “employee candidates” as people and you know their capabilities. However, before bringing your spouse or your children into the business, there are tax considerations to be aware of. Let’s take a look at some of them.
Hiring your spouse
The IRS states a spouse is considered an employee when one spouse “substantially” controls the business (e.g., in charge of management decisions, entering contracts, etc.) and the second spouse follows directions from the first spouse. Typically under those circumstances, the employed spouse receives company wages subject to payroll taxes (income tax withholding and Social Security and Medicare taxes).
In that respect, they are treated like any other employee, except that the business does not have to pay FUTA (unemployment) taxes for a spouse. However, FUTA taxes are owed to the IRS for the spouse if the company is a corporation.
If both spouses operate the business together, having an equal say in running the company, the spouses may be considered partners. As partners, neither is on payroll, and they can file taxes as a general partnership, using Form 1065, U.S. Return of Partnership Income.
While an unincorporated business jointly owned and operated by a married couple is generally considered a partnership by the IRS, there’s a “qualified joint venture” election for small businesses owned by a married couple that files a joint tax return. IRS qualification requirements for the joint venture election:
- Be a married couple filing a joint tax return.
- The spouses must be the only owners of the joint venture.
- Both spouses actively participate in the trade or business.
- The company cannot be registered as a legal entity such as a limited liability company (LLC) or corporation.
- Both spouses elect to not be treated as a partnership.
Married co-owners of a business with no other partners can elect to not be treated as a partnership, thus avoiding the need to file partnership returns while allowing both spouses to receive credit for Social Security and Medicare coverage.
Do you have to pay your employee spouse a wage?
Going back to the scenario where one spouse runs the company and the other spouse is hired as an employee: in that case, the business is considered a sole proprietorship. In most states, a sole proprietor who employs their spouse does not have to compensate them in wages or salaries. Instead, they can pay them via tax-free fringe benefits (e.g., health insurance, medical leave, retirement plans), which avoids payroll taxes, employment tax returns, and W-2 filings.
Warning: The spouse must do actual work for the company. It’s essential to have documentation proving the spouse is receiving benefits as compensation for work performed.
Can the owner of an LLC or corporation hire their spouse?
Generally, yes, although some requirements vary by state. Hiring a spouse as an employee offers tax benefits since employee wages and salaries are deductible for the business entity.
When a spouse is an employee of a business entity (such as an LLC or corporation) rather than an individual business owner, the company must have the spouse on payroll and abide by minimum wage laws and other employment regulations.
Hiring your kids
Hiring children is allowed provided they meet the state’s labor law requirements for family-owned businesses.
Wages to all working children (regardless of age) are subject to income tax which must be withheld from their pay. In a sole proprietorship or partnership where both partners are the child’s parents, the child’s wages are not subject to Social Security and Medicare taxes if the child is younger than 18. Also, payments to working children under the age of 21 are not subject to federal unemployment tax.
In the following instances, payments to a working child in a family business are subject to income tax withholding, Social Security, Medicare, and FUTA taxes if:
- They work for a partnership or LLC with any partners/members who are not the child’s parent.
- They work for a corporation, even one controlled by the child’s parent or parents.
Hiring family members may put a business in the spotlight with the IRS and the state’s department of labor. Therefore, it’s critical to document the work the owner’s children do for the company.
Hiring your mom and dad
Parents can bring years of experience, strong work values, trustworthiness, and loyalty to the work environment. Business owners must follow many of the same rules that apply when hiring other family members.
According to the IRS, wages for the services of a parent employed by their child are subject to income tax withholding and FICA (Social Security and Medicare taxes), but not FUTA taxes.
Advertisement
More articles from AllBusiness.com:
- 10 Remote Employee Onboarding Tips to Help New Hires Succeed
- How to Hire Employees for Potential, Not Just Past Experience
Hiring family members as independent contractors
One way to avoid paying payroll taxes is to hire family members as independent contractors. However, certain conditions must be met to classify them as contractors rather than employees. Generally, with independent contractors, a business contracts the worker for a specific project or time period. A business can face substantial fines and penalties for violating the state’s laws and IRS regulations.
The IRS looks at three categories of control when classifying workers as either employees or contractors:
1. Behavioral control
If the business controls when the person works, where they work, and what tools they use, then the individual is considered an employee. Also, a worker may be considered an employee if the hiring business provides training or detailed instruction to the individual.
2. Financial control
If a business controls the financial aspects of the worker’s job (such as buying a laptop or paying a regular wage or salary), the worker is an employee. Independent contractors typically purchase their own equipment and send invoices (often based on a flat project fee).
3. Nature of the relationship
If the worker is performing services that are key to the business’s operations, and/or there’s no agreement in place to specify that the worker is acting as an independent contractor and has control over the work they do, the individual will likely be considered an employee. Other things that typically apply to employees but not contractors are employee benefits (like health insurance, paid vacation, sick days, etc.) and hiring a worker with the expectation of using their services indefinitely.
California, with its Assembly Bill (AB) 5 law, has taken even a stronger stance to protect workers in the state from being misclassified. The law requires that for a worker to be considered an independent contractor, the worker must satisfy all three of the following conditions:
- Is “customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.”
- Performs work that is outside of the usual course of the hiring company’s business.
- Is free from the control and direction of the hiring business in connection with the performance of the work.
Considering the IRS stipulations and those that states may enforce, business owners may find it difficult to classify family members as independent contractors—even if they are hired part-time over summers and holidays.
Before making your business a family affair
Just as when you would hire any employee, it’s essential to understand and abide by the federal, state, and local employment laws that apply to your business. It can be helpful to consult with legal, accounting, and HR professionals who have in-depth knowledge in their respective areas of expertise.
The more you know, the better prepared you will be—and the more peace of mind you’ll have—when hiring family members.
About the Author
Nellie Akalp is Founder and CEO of CorpNet.com, a trusted resource and service provider for business incorporation, LLC filings, and corporate compliance services in all 50 states. See Nellie’s articles and full bio at AllBusiness.com.
RELATED: Partners in Life and in Business: How Married Business Owners Make It Work
