It's all relative: the tax benefits of employing family members

Entrepreneur, April, 1997 by Joan Szabo

Getting the family involved in the business can mean solid tax savings. Not only will such a strategy help reduce the family tax bill, but it can also provide each member with some valuable nontax advantages as well.

"It's a great idea," declares Ward Bukofsky, managing partner of accounting firm Braverman, Codron & Co. in Beverly Hills, California. "Hiring family, particularly children, to work in your business allows you to move income out of a higher tax bracket into a lower one."

It also gives you the opportunity to transfer some wealth from yourself to your children without incurring federal gift or estate taxes. Keep in mind that the salary paid must be reasonable for the work done. There are some rules to follow, but complying is relatively straightforward.

* BRINGING IN THE KIDS

It is possible to put even your preteen children to work doing such tasks as delivering mail, running business errands, and stuffing and addressing envelopes. If they work in the business, their salary is considered earned income and not subject to the "kiddie tax" rules that apply to youngsters under age 14, says Christopher B. Parsons, a partner with accounting firm Deloitte & Touche LLP.

A kiddie tax is imposed on unearned annual income in excess of $1,300. Unearned income includes interest, dividends and capital gains. This income is taxable to the child at the parent's highest income tax rate.

With earned income, which your child earns working for you, the maximum standard deduction available to your youngster in 1997 is $4,150. If you pay your son or daughter $4,150 in compensation, the standard deduction eliminates all tax on this income.

In addition, if you have an unincorporated business, wages paid to a child under age 18 are not subject to Social Security taxes. This means your child is not responsible for paying FICA taxes on his or her wages, nor are you required to pay the employer's share of these taxes.

Another long-term tax-savings benefit is the ability of your employed youngsters to make deductible contributions to an individual retirement account (IRA). The annual sum that a child who is working can contribute is $2,000 or their total earned income, whichever is lower. These contributions can offset earned and unearned income. Combining the IRA deduction with the standard deduction, your child could receive $6,150 in gross income ($4,150 earned and $2,000 unearned) and pay no taxes, says Parsons. For young people, the tax-deferred buildup of investment earnings is the chief attraction of an IRA. (For more on IRAs, see last month's "Personal Finance" column.)

To prevent the IRS from questioning the validity of a family member's employment in your business, it's important "to document the type of work they are doing and demonstrate that it is well worth what they are being paid," Bukofsky cautions. You don't want the IRS to think you're putting your family on the payroll solely to get tax breaks. "Be sure they have a job description and that you keep time records to show how much they are working." In addition to making certain the wages are reasonable for the work done, the services performed must be necessary to the business.

Another way to keep the IRS at bay is to be sure you pay family members who work in the business on a regular basis, just as you would any employee. You don't want to pay a year's worth of salary in the last month of the year, for example. Such a move would certainly arouse suspicion.

Even if you employ your children in the business, don't neglect the tax-free giving you are entitled to do each year. This is especially true for high-income individuals who are looking for ways to shift income to family members in lower tax brackets. As you may remember, it's possible to give annual gifts to children of up to $10,000 ($20,000 if a spouse joins in the gift) with no federal gift tax consequences.

The main benefits of this strategy include removing property from your estate at no gift or estate tax cost, and shifting income-earning property to family members in lower federal tax brackets.

* AND THAT'S NOT ALL

But tax savings are not the only goodies you gain from employing family members. Hiring family members also provides each one of them with a number of employment benefits - some of which may even come with tax advantages. For example, it's possible for your spouse or child to receive coverage under your business's qualified retirement plan. Congress recently lifted the restrictions in this area, making it even more attractive for next of kin to work in a family business.

In the past, family members working for the business were required to aggregate their incomes and be treated as one employee for pension purposes. As a result, immediate family members in the business were restricted to putting less money into a pension plan than they probably would have if they were not working for kin.

Before Congress changed the law, Bukofsky says, "family members' [aggregate] pension contributions were limited to the maximum amount of compensation for just one family member." But with the recent repeal of the family aggregation rules, "each member of the family who works in the business, in effect, is considered a separate employee and has his or her own separate maximum pension contribution limit." This gives family members considerably more freedom on pension contributions and makes for a valuable employment benefit.