The IRS encourages you to hire your family members in your business. What this can do is shift income from a higher tax bracket to a lower tax bracket. This strategy can be powerful depending on your level of income from your real estate related businesses. In this article, we will go through paying your spouse, children, and parents. We will use examples to best illustrate the concepts to show how you can lower your taxes.
Social Security and Medicare Tax (FICA) - Taxed as 7.65% for the employer and the employee.
Federal Unemployment Tax Act (FUTA) - A tax paid by employers as a safeguard against losing their funds. It’s a tax of 0.8% on the first $7,000 of wages.
Paying Family Members
Regardless of your relationship to your family members, having payroll brings on additional tax consequences. You will need to file quarterly and yearly payroll tax returns for federal and state. For this, you would want to talk to a payroll specialist and ideally someone (or service) that does the payroll tax returns for you. Candidly, it is not your best use of time to be filing payroll tax returns. There are a variety of services and companies that you can use.
Further, you need to ensure payroll is an ordinary and necessary expense in your business. Your family members must do legitimate work (i.e. mowing lawns, answering phone calls, bookkeeping, etc). You should also keep track of the hours worked by maintaining time sheets or time cards. It is also best practice to have a written employment agreement. Within this employment agreement, compensation must be reasonable. Compensation is defined as salary plus fringe benefits. In other words, you can’t pay your kid $150 per hour to shuffle paper in your office. It has to be what you’d pay another person. It is always best practice to do research as to what those wages would be. Last but not least, you need to follow applicable laws for employment. This article spells out the types of documents you need to obtain prior to employing an employee in a business. We will now detail how each family member is different.
The IRS clearly spells out that paying your spouse are subject to income tax withholding and FICA taxes. They are not subject to FUTA taxes. If you’re married filing jointly and are using a single member LLC, you are not getting a ton of tax benefit from this and depending on the wages paid, it may not make sense. Effectively, you’re only saving FICA on the employer side (7.65%). This is best served with an example.
Spouse A has a successful flipping business that nets $200,000 (before payroll expense). For simplicity, let’s say this is their only source of income and it is held as a single member LLC (which is a disregarded entity for tax purposes). Ultimately the income is reported on Schedule C (Self-Employment Income). Let’s also assume there are no kids.
Spouse B is employed from the flipping business and makes $50,000. Now, income drops to $150,000. Effectively, you will still get taxed on the $200,000 (150,000 in self employed earnings plus 50,000 in wages) but also save on the FICA taxes since they are a deduction. In effect, you would be increasing your deductions by $3,825 ($50,000 * 7.65%). To figure out how much you’d be saving in real dollars, you’d find out your marginal tax rate. In this instance, these spouses would be in the 24% tax bracket. As such, $918 would be saved (3,825 * .24), not including applicable self employment and state taxes. To make it worth it, you would need to be paying less than that for the payroll service and other related fees.
The IRS states that the “wages for the services of a parent employed by their child are subject to income tax withholding and FICA taxes. They’re not subject to FUTA tax.” Typically, this situation works out well when the parents are in a lower tax bracket than the children. Let’s run through an example of how this can be beneficial.
Let’s assume the same facts as the above ($200k in income, single member LLC, married filing jointly). At this tax rate, they would be in 24% marginal tax bracket. Let’s say that both their parents are employed in the business and earn $15,000 each. In effect, $30,000 total is allocated from the child to the parent. At a 24% tax rate, that could save them at least $7,200 (plus applicable self-employment and state taxes). The parents are in a lower tax bracket (12%), so this is a win-win for all involved.
The IRS states that payments for services of a child under age 18 aren’t subject to FICA taxes if the business is a sole proprietor or a partnership in which each parent is a parent of the child. Payments to a child under age 21 aren’t subject to FUTA. Payments are subject to income tax withholding, regardless of the child’s age. Generally speaking, you can’t hire a child until they are at least seven years old. You would want to check with your CPA/tax advisor prior to hiring them to see what work they could reasonably do.
The best part about paying your children in your business is that you have control. Generally, your kids are not going to have any tax implications as the standard deduction ($12,550 in 2021) will shield the income you pay them (assuming it’s reasonable compensation). With that control, you may opt to set your child up well for the future. Since they have earned income, you could opt to invest the monies in a Roth IRA. The maximum for this would be $6,000 per year. Now, let’s go through an example.
Let’s assume the same facts as the above ($200k in income, single member LLC, married filing jointly). At this tax rate, they would be in the 24% marginal tax bracket. Let’s say that there are four kids (ages 15, 14, 13, and 11). You pay your children $10,000 each throughout the year (which you deem reasonable compensation). As such, you are paying your children $40,000, which is a deduction to income. At a 24% tax rate, that could save them at least $9,600 (plus applicable self-employment and state taxes). The children are in a 0% tax bracket (meaning zero tax is due on the money for federal), you can contribute to a Roth IRA for each of them, and the parents save a lot of money in taxes for being proactive. This is a win-win-win for all involved.
Wrapping It Up
Paying family members can be a powerful strategy to reduce your taxes. You need to be abreast of all of the rules and regulations you subject yourself to. It is always advisable to discuss any potential proactive measures with your CPA prior to making them, especially for paying family members. My hope is that this article can provide a framework to discuss with your tax advisor about how you can best use the tax code to pay your family members.
If you have questions on your real estate tax strategy, you can reach me (Aaron Zimmerman) at firstname.lastname@example.org.
Attribution rules - family members have to pick it up in compensation if an S Corp.
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