I’m often asked if it is advantageous for a small business to hire family members. Some entrepreneurs have asked if hiring relatives presents legal issues, while others have asked if it is ethical. Whether you believe this practice is good business or nepotism, there are a lot of companies hiring relatives in full-time and contract positions.
In the U.S. today, there are 5.5 million family-owned businesses, employing 63% of the American workforce. That adds up to many family business owners working with family members. These scenarios could be fraught with angst or, if done right, lead to business success.
Can You Hire a Family Member?
Some entrepreneurs aren’t sure if they can hire a family member to work in the business. But, in fact, it’s quite common for small businesses to employ family members. This is especially true in very small companies or micro-businesses with less than 10 employees.
There are many reasons small business owners may decide to hire family members. For instance, they may be the best person for the job. Or they may want to instill a sense of responsibility into younger family members. Or perhaps they want to build a legacy company that will stay within the family for generations.
Hiring family members enables business owners to pass on valuable lessons in entrepreneurship and financial responsibility to younger generations. And putting family members on the payroll also helps enterprises benefit from specific tax advantages, which depending on your business structure, can save your business thousands come tax season.
Can You Hire a Spouse?
According to the IRS, a spouse is considered an employee when one spouse “substantially” controls the business (management decisions, etc.) and the second spouse follows directions from the first spouse. In such a case, wages are subject to payroll taxes (income tax withholding and Social Security and Medicare taxes), just like any other employee with one exception—you do not have to pay FUTA (unemployment) taxes for a spouse. However, FUTA taxes are owed if the business is a corporation.
If the spouses run the business together and have an equal say in the business, the spouses may be considered partners and can file as a partnership using Form 1065, U.S. Return of Partnership Income (PDF).
Married co-owners with no other partners also have the option not to file as a partnership per the Small Business and Work Opportunity Tax Act of 2007. That provision permits the couple to divide equally all income, gains, losses, deductions, and credits, giving each spouse credit for social security earnings. However, the couple must meet the following requirements to qualify:
- Be a married couple filing a joint tax return and the only 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 partnership, limited liability company (LLC), or corporation
To find out more information on qualified joint ventures, check the IRS’ Election for Married Couples Unincorporated Businesses.
Other things to know about hiring a spouse:
- Can an LLC hire a spouse? LLC rules vary by state, but a spouse can generally work for an LLC for no pay—however, it is not recommended. Hiring your spouse as an employee offers tax benefits since employee costs are deductible. Another option is to hire a spouse as an independent contractor. Either way, monies paid to a spouse lower the business’s net income and reduce its tax obligations.
- You can also choose to pay your spouse with tax-free fringe benefits such as health insurance, education, and life insurance. You do not need to pay payroll taxes or file a W-2 for your spouse with fringe benefits. Warning: Although the spouse does not have to be an employee to receive these tax-free benefits, the spouse must do actual work for the company. It’s essential to have documentation proving the spouse is receiving benefits as compensation for work performed.
Can You Hire Your Children?
Can an LLC owner hire their children? Of course, just like any legal entity or non-entity, you can, but the amount of employment taxes you pay depends on your business’s legal structure. Plus, if the child earns no more than $12,400, they are not subject to federal income tax, though they need to pay state income taxes.
If the business is a sole proprietorship or a partnership where both partners are the child’s or children’s parents, children under 18 years of age are not subject to Social Security and Medicare taxes. Also, working children under 21 years of age are not subject to the FUTA tax. However, income tax withholding applies to all working children, no matter what age.
In a partnership where only one partner is the parent of the working child, the child’s wages are subject to Social Security, Medicare, FUTA, and income tax withholding. The same applies if the business is a C Corporation or S Corporation.
As stated previously, hiring family members puts your business in the spotlight with the IRS and your state’s Department of Labor. So make sure you document the work your children do for the company, even if it’s just cleaning the office or simple data entry.
Can You Hire Your Parents?
There are many good reasons for business owners to hire their parents. They bring years of working experience with them and are loyal employees. They’re also subject to the same rules as hiring other family members. Per the IRS, wages for the services of a parent employed by their child are subject to income tax withholding, Social Security and Medicare taxes, and not FUTA taxes.
Can You Family Members as Contractors?
One way to hire family members without paying payroll taxes is to hire them as independent contractors. However, if the family member is actually working as an employee, it’s crucial not to misclassify them as independent contractors, or your business could be violating state laws and IRS regulations.
With independent contractors, the business contracts the worker for a specific time frame or specific project. The IRS classification rules are based on three categories:
- Behavioral Control: A worker is an employee when the business can control the work performed, such as when to work, where to work, and what tools to use. The worker is also considered an employee if there is any training or detailed instruction.
- Financial Control: A worker is an employee when the business controls the financial aspects of the worker’s job, for example, buying the equipment used for the project or paying a regular wage. Independent contractors are often paid a flat fee.
- Relationship: A worker is an employee if the business has no end date for performing the services and if the performed services are a vital component of the company.
In addition, under California’s AB5 law, to be considered an independent contractor, the worker must be “customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.” This test and the three from the IRS make it very difficult to classify a family member as an independent contractor. Even if you’re hiring family members to work part-time around the holidays, you should still classify them as employees.
If this sounds complex, don’t worry. At CorpNet, our specialists are ready to help you choose a business structure, register your business for payroll taxes, and more.