In October 2019, the Internal Revenue Service (IRS) published an article about the tax treatment of family members working in a family business. Employing family members in a business has many advantages and may be a strategy used to lower a taxpayer’s tax liability. This article will highlight the tax treatment and employment tax rules that may apply to you as an employer when a spouse, child, or parent works in the family business.
When spouses engage in a trade or business together and share in the profits and losses, a partnership exists even if a written partnership agreement does not. As such, the spouses are required to report to the IRS the profits and losses of the business on Form 1065: U.S. Return of Partnership Income. Each partner receives a K-1 and reports his or her individual share of income on an individual income tax return.
The Internal Revenue Code allows spouses to elect to treat their business activity as a “qualified joint venture.” This election mandates both spouses materially participate in an active trade or business. In addition, they must be the only partners in the venture, and both must choose not to treat the activity as a partnership. Spouses cannot make the qualified joint venture election if: a) the sole activity of the joint venture is mutual ownership of property that is not trade or business property or, b) the business is formed as a limited liability company (LLC).
The qualified joint venture election allows each spouse to treat his or her share of profit and loss as if the spouse is a sole proprietor. If the election is made, the partnership would be terminated at the end of the previous tax year. Once the election is made, it remains in effect so long as the married couple meets the requirements of the election.
Electing to treat the business as a qualified joint venture is relatively simple. The couple must file an individual income tax return (Form 1040: U.S. Individual Income Tax Return) as “married filing jointly.” Each spouse would then account for his or her share of profit or loss on Schedule C and report self-employment income on Schedule SE. For example, if the spouses choose to make the election for the 2019 tax year, they would file Form 1040 jointly, accompanied by the necessary schedules. If the election is made in 2019, the partnership is considered terminated December 31, 2018.
This election is advantageous for married couples, as both spouses receive credit for their share of Social Security and Medicare coverage for self-employment tax purposes. This positively impacts their eligibility to make separate qualified retirement plan contributions. In addition, the election allows each spouse to file a Schedule C. This lessens the administrative burden of filing a partnership return and maintaining partnership files and records.
In some cases, one spouse is employed by another. This arrangement nullifies the option to make the qualified joint venture election. While this election cannot be made if one spouse employs another, there are employment tax rules to consider. Wages earned by the employed spouse are subject to federal income tax withholding, Social Security tax, and Medicare tax. These wages are not subject to the federal unemployment tax (FUTA), per IRS Publication 15. In the case of an employee spouse, the spouse must be considered a bona fide employee—meaning, the employer can control when, how, and what work is done by the employee. Finally, the wages paid to the spouse should be reasonable, given the work completed.
Spouses are not the only family members who may work in the family business. Children may also be employed by parents. The wages earned by children employed by their parent(s) are subject to varying tax treatments. One factor driving the tax treatment of the child’s wages is his or her age. When a child under the age of 18 is employed by a parent, the wages earned are not subject to either the Social Security or Medicare tax. These wages are, however, subject to federal income tax withholding. Wages earned by children under the age of 21 and employed by their parent(s) are also subject to special tax treatment. These wages are not subject to FUTA, but are subject to federal income tax withholding. Regardless of age, the child must be paid wages that are reasonable, given the work completed.
The employment tax treatment described above applies only if the trade or business of the parent is an unincorporated business—a sole proprietorship or partnership. When the trade or business is a partnership, both parents must be partners and also parents of the child, and there can be no additional partners.
When a child receives wages from a corporation or an estate, such wages are subject to federal income tax withholding, Social Security, Medicare, and FUTA taxes. In this instance, the child is working for the entity and not the parent. The unique employment tax rules that apply when children work for their parents will not apply even if a parent controls the corporation.
Wages earned by parents employed by their children are also subject to different employment tax rules. Their wages are subject to federal income tax withholding, Social Security, and Medicare taxes. Similar to the wages earned by spouses and children working in the family business, the parent’s wages are not subject to FUTA.
If you would like to speak with a tax professional regarding the tax treatment of family businesses or other business and employment tax rules, or if you would like assistance with any matter involving tax planning and strategy or business advisory, contact a PYA executive below at (800) 270-9629.