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Here’s Everything Your Small Business Needs To Know Before Hiring Family Members

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By Nellie Akalp

It is common for entrepreneurs, especially those who run a very small business, to hire relatives. After all, you already know these ’employee candidates’ as people and you know their capabilities. Before bringing your spouse or your children into the business, however, you should consider tax considerations. Let’s take a look at some of them.

Hire your spouse

The IRS states a spouse is considered an employee when one of the spouses “substantially” controls the business (e.g., is responsible for management decisions, entering into contracts, etc.) and the second spouse follows the instructions of the first husband succeeds. Under those circumstances, the working spouse typically receives business wages that are subject to payroll taxes (income tax and Social Security and Medicare taxes).

In that regard, they are treated like any other employee, except that the company does not have to pay FUTA (unemployment) tax on a spouse. However, FUTA taxes to be owed to the IRS for the spouse if the business is a corporation.

If both spouses run the business together and have equal say in running the business, the spouses can be considered partners. As partners, neither are on the payroll and can file tax returns as a general partnership, using Form 1065, US 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 is a “qualified joint ventureelection for small businesses owned by a married couple filing joint tax returns. IRS Qualification Requirements for the Joint Venture Election:

  • Be a married couple and file a joint tax return.
  • The spouses must be the sole 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 choose not to be treated as a partnership.

Married co-owners of a business with no other partners can choose not to be treated as a partnership, avoiding the need to file partnership returns, while giving both spouses credit for Social Security and Medicare coverage.

Do you have to pay your employee-spouse wages?

Going back to the scenario where one spouse runs the business 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 through tax-free benefits (e.g., health insurance, sick leave, retirement plans), avoiding payroll taxes, tax returns, and W-2 returns.

Warning: The spouse must actually do work for the company. It is essential to have documentation proving that the spouse is receiving benefits as compensation for work performed.

Can an LLC or Business Owner Hire His Spouse?

Generally yes, although some requirements vary by state. Hiring a spouse as an employee provides tax benefits as the wages and salaries of employees are deductible to 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 the payroll and adhere to minimum wage laws and other employment regulations.

Hire your kids

Hiring children is allowed, provided they meet state employment law requirements for family businesses.

The wages of all working children (regardless of age) are subject to income tax which must be withheld from their wages. 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 under the age of 18. Also, payments to working children under 21 are not subject to federal unemployment tax.

In the following cases, payments to a working child in a family business are subject to withholding income tax, social security, health care, and FUTA taxes if:

  • They work for a partnership or LLC with partners/members who are not the parent of the child.
  • They work for a company, even one that is operated by the parent or parents of the child.

Hiring relatives can put a business in the spotlight with the IRS and the state employment agency. That’s why it’s critical to document the work that the owner’s children do for the business.

Hire your mom and dad

Parents can bring years of experience, strong work values, reliability and loyalty into 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 withholding tax and FICA (Social Security and Medicare taxes), but not FUTA taxes.

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Hiring family members as independent contractors

One way to avoid paying payroll taxes is to hire relatives as independent contractors. However, certain conditions must be met in order for them to be classified as contractors rather than employees. Generally, with independent contractors, a company contracts the employee for a specific project or period. A company can face significant fines and penalties for violating state laws and IRS regulations.

The IRS looks at three categories of control when classifying employees as employees or contractors:

1. Behavioral Control

If the company determines when the person works, where he works and what tools he uses, then the person is considered an employee. An employee may also be considered an employee if the hiring company provides the person with training or detailed instructions.

2. Financial Control

If a company controls the financial aspects of the employee’s job (such as buying a laptop or paying a regular wage or salary), the employee is an employee. Independent contractors typically purchase their own equipment and send invoices (often based on a flat project rate).

3. Nature of the relationship

If the employee performs services that are essential to the business of the company, and/or there is no agreement to specify that the employee acts as an independent contractor and has control over the work he does, the person is likely to be treated as an employee considered . Other things that typically apply to employees, but not contractors, are employee benefits (such as health insurance, paid vacation, sick days, etc.) and hiring an employee with the expectation that they will use their services indefinitely.

California, with its Assembly law (AB) 5 law, has taken an even stronger stance to protect workers in the state from misclassification. The law requires that an employee to be considered an independent contractor must meet all three of the following conditions:

  • Is “usually involved in an independently established trade, profession or business of a similar nature to the work performed for the user entity.”
  • Performs activities that fall outside the normal business operations of the user company.
  • Is free from the control and direction of the user company in connection with the performance of the work.

Given the IRS regulations and the provisions states can enforce, business owners may find it difficult to classify family members as independent contractors, even if they are hired part-time during the summer and holidays.

Before turning your business into a family affair

Just as if you would hire an employee, it is essential that you understand and comply with the federal, state and local employment laws that apply to your business. It may be helpful to consult legal, accounting and HR professionals who have in-depth knowledge in their respective areas of expertise.

The more you know, the better prepared you’ll 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 source and service provider for business incorporation, LLC filings, and business compliance services in all 50 states. See Nellie’s articles and full bio at AllBusiness.com

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