Hiring Family Members in a Small Business: Taxes, Rules & More
There’s something uniquely satisfying about building a business alongside the people you love. Whether it’s a spouse who shares your vision, a teenaged child learning the ropes or a parent whose experience proves invaluable, hiring family members can add a dimension that no outside hire ever quite replicates.
Of course, doing so also comes with its own set of considerations, legal, financial and personal in nature. The tax code, for instance, has specific rules governing how family-member employees must be treated, and significant consequences for failing to heed those rules.
But if the arrangement is structured correctly, there are real benefits to be had for everyone involved.
Let’s talk about what small business owners should know if they’re thinking about putting a family member on the payroll.
The Business Case for Hiring Family
Most people are vaguely aware that employees who are spouses and children enjoy beneficial tax treatment.
However, businesses can benefit from these arrangements, too.
We’ve recently highlighted the cost crunch facing many small businesses. Bringing on a family member can, in some cases, help address that pressure through legitimate tax strategies (more on that below).
But also, family members tend to be invested in the business’s success in ways that outside employees simply aren’t. They often bring flexibility, loyalty and a willingness to wear multiple hats. These are qualities that undeniably improve a business’s efficiency, even if you can’t quite put a specific price tag on it.
Hiring Your Spouse
Bringing a spouse into the business is commonplace among small business owners, and it comes with some notable tax advantages.
Wages you pay your spouse are generally subject to income tax withholding and Federal Insurance Contributions Act (FICA), which goes toward Social Security and Medicare) taxes, but not Federal Unemployment Tax Act (FUTA) taxes, if your business is a:
- Sole proprietorship
- Partnership in which your spouse is not a partner
- LLC taxed as a sole proprietorship or partnership (as long as your spouse is not a partner)
If your spouse is a legitimate W-2 employee, they can pay for any premiums with pretax dollars, just like any other W-2 employee. However, if your business falls under any of the structures above (as well as some real estate rental and farm businesses), you could instead pay your spouse through tax-free employee benefits.
The most notable way of doing this is a medical reimbursement arrangement, which is run through a 105-HRA plan. The business reimburses the spouse for healthcare premiums and out-of-pocket medical expenses. This is tax-free income for your spouse, and a tax-deductible compensation expense for the business.
A few caveats apply, of course. Your spouse must be a bona fide employee, meaning they perform real work and are paid a reasonable wage for it. The IRS scrutinizes spouse-employment arrangements, so documentation matters. Keep records of hours worked, duties performed and the basis for compensation.
Also, this arrangement is simpler when your spouse is your sole employee. If you have other employees, you’ll need to use an ICHRA plan, which has more requirements.
If you’re interested in this kind of arrangement, it’s best to reach out and talk to a small business consultancy about the specific steps to move forward.
Hiring Your Children
Putting your kids to work in the family business is a time-honored tradition and the tax code is surprisingly generous about it.
Wages paid to your child under age 18 are exempt from FICA taxes, and payments to children under 21 are exempt from FUTA taxes, if your business is a:
- Sole proprietorship
- Partnership in which both partners are the child’s parents
- Single-member LLC taxed as a sole proprietorship
- Qualified joint venture (unincorporated business jointly owned by a married couple)
You can also reap an income-shifting benefit. If your child earns wages that fall within the standard deduction threshold, they might owe little to no federal income tax on that income. Thus, paying them allows you to shift income from being taxed at your higher rate to being taxed at the child’s lower rate.
Some key rules you’ll need to keep in mind:
- The work must be legitimate and age-appropriate, and the pay must be reasonable for the work performed.
- You’ll need to set up proper payroll, issue a W-2 at year-end and withhold income taxes (even if exemptions apply to payroll taxes).
- Children must be old enough to legally work in your state and industry. Child labor laws still apply.
The IRS is not naive about these arrangements. Paper-thin setups, like paying a 7-year-old an executive salary, will draw scrutiny. Keep it real and well documented.
Hiring Your Parents
Hiring a parent is less common but entirely permissible. Wages paid to a parent are subject to income tax withholding and FICA taxes, but they are exempt from FUTA taxes if your business is a sole proprietorship or a single-member LLC taxed as a sole proprietorship.
Beyond the tax treatment, the practical case for hiring a parent often comes down to trust and experience. If your parent has relevant skills, such as bookkeeping, customer service, operations knowledge, and you need help, this can be a cost-effective and reliable solution.
The same rules around legitimate employment apply here. The work must be real, the pay must be fair and the paperwork must be in order.
The Personal Side of the Equation
Hiring family members also adds a layer of complexity that purely professional relationships don’t carry. A few things worth considering:
Set clear expectations from day one. Job descriptions, reporting structures, work schedules and performance standards should be spelled out, in writing if possible. That should be the norm for any new hire. But it’s especially important to remember when it comes to family employees, where the relationship will be under more scrutiny. Speaking of which …
Be prepared for other employees to notice. Non-family staff will watch how you treat family members on the job. Favoritism, whether real or perceived, can damage morale. Hold family members to the same standards you hold everyone else.
Separate work from home. Many family-in-business arrangements struggle not because of the work itself, but because business tensions follow everyone to the dinner table. Agreeing on boundaries — when work talk is and isn’t appropriate — can protect both the relationship and the business.
Mixing Business and Family? Let Us Help.
Hiring family members can be a smart move, but only when it’s done correctly. The tax benefits are real, and so are the compliance risks if the arrangement isn’t structured properly.
McManamon & Co. is an accounting, tax, fraud, forensic and consulting firm serving small and midsize businesses. Our accounting team can help you navigate the tax implications of hiring family members, ensure your payroll and documentation are set up correctly, and build a compensation structure that holds up to IRS scrutiny, while making the most of every legitimate tax advantage available to you.
Call us at 440.892.8900 or contact us online to learn how we can help you make your business work for you and your family.
Tags: hiring, McManamon, McManamon & Co., small business, small business accounting, small business finances, small business taxes, taxes | Posted in McManamon & Co., small business, small business taxes