Employing family members.

Author:Young, Patrick L.
 
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Employing family members can be a useful strategy to reduce overall tax liability. If the family member is a bona fide employee, then the taxpayer can deduct the wages and benefits, including medical benefits, paid to the employee on Schedule C, Profit or Loss From Business, or Schedule F, Profit or Loss From Farming, as a business expense, thus reducing the proprietor's self-employment (SE) tax liability (see Frahm,T.C Memo. 2007-351; Eykr,T.C. Memo. 2007-350).

Employing the taxpayer's children can reduce overall tax liability. Children who work for their parents are not subject to FICA taxes (for children under age 18) or FUTA taxes (for children under age 21) (Sees. 3121(b)(3)(A) and 3306(c)(5)). In addition, wage income would be taxed at the child's lower tax rate and may be wholly or partially offset by the child's standard deduction of up to 112,200 (for 2019). The wages must be reasonable for the work done.

Additionally, a sole proprietor can provide up to $5,250 in annual tax-free educational assistance (for both undergraduate and graduate courses) to each eligible employee and deduct the costs (thus saving both income and SE taxes). Properly arranged, this benefit is available to the sole proprietor's child who is (1) age 21 or older; (2) a legitimate employee of the business; (3) not more than a direct 5% owner of the business; and (4) not a dependent of the parent business owner. See Sec. 127(b) for the qualification rules for these tax-free educational assistance programs.

Caution: Should the IRS choose to examine wages paid to family members, the taxpayer should be able to prove the deduction. For payments to family members, it is especially important to ensure that basic business practices (e.g., keeping time reports, filing payroll returns, and basing pay on work performed, not on a relationship to the employer) are followed (see Alexander,T.C. Summ. 2006-127; Fisher,T.C Summ. 2016-10; Embroidery Express, LLC, T.C. Memo. 2016-136).

Medical reimbursement plans

Employing the spouse can reduce overall tax liability because under Sec. 105(b), the spouse can receive tax-free reimbursement of medical expenses from the business, even though the business deducts the reimbursements. However, if the business has other employees, this technique will not work. The self-insured reimbursement plan can cover the entire family, so the family's out-of-pocket medical expenses (including health insurance premiums) are paid with pretax dollars.

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