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Relatively speaking, family employees are good business

Psst. Want to lower your taxes, lure great employees, save more for the future and make your small business deliver a bigger bang for your whole household?

Hire the family.

What's the catch? There isn't one.

Hiring your spouse and kids is A-OK with the Internal Revenue Service. And if done with some forethought, it can contribute big time to both your family's financial health and your business's bottom line.

This is welcome news to the increasing number of Americans migrating to self-employment. Usually, they receive the bad news first: those many and sundry ways in which the little guy pays proportionately more for everything while the corporate giants pay proportionately less. Hiring the family may not exactly level the playing field, but it is something you can do legally that a corporation cannot.

Got your attention? Good. Here's the lowdown on why and how you should hire your family, today if possible.

The way it used to be
First step: check your attitude.

Squeamish about putting the kids on the payroll? Don't be, says Jane Hilbert Davis, executive director of the Cambridge Center for Creative Enterprise and chair of the Family Firm Institute.

"It's only been within the last century that most kids didn't work with their families, whether it was on the family farm or as an apprentice to their dads. Women worked with their moms," she says. "The kids did learn from both parents about responsibility and commitments and hanging in there when the going gets tough. I think family businesses are a way to capture that and teach it."

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But family workers shouldn't be free employees. Presuming you have valid work for your spouse or kids, it's in your best interest to pay them a fair wage for it, says Craig Aronoff, co-chairman of the Family Business Consulting Group and founder-director of the Cox Family Enterprise Center at Kennesaw State University in Kennesaw, Ga.

"There is a tendency to use family members in a way that kind of exploits them," he says. "The wife who comes in and keeps the books and doesn't receive any compensation, for example, would be a situation like that. If you're bringing someone in to do a job, then compensating them and recognizing their value in the same way as other employees is very important."

If you heed the advice of family counselors on how to work with your spouse and separate your work life from your home life, bringing the family into the business could be the best thing you ever did.

The business case for employing family
Hiring the family makes sound business sense for a number of reasons:

  • Operations: Family members can be a ready source of dedicated, trusted and inexpensive labor during your startup phase. They'll be more inclined to work odd hours, take up the slack and cheer you on as needed. They'll also be better prepared to succeed you.

  • Payroll: If you're a sole proprietor, or if you and your spouse are the only principals in a partnership or limited liability company, you may save on some federal income taxes and state unemployment taxes. If you hire your children, you are relieved from withholding income taxes and paying payroll taxes, including Social Security, until the child turns 18. Also, you need not pay federal unemployment taxes until the child turns 21. If you hire your spouse or parents, you don't need to pay federal unemployment taxes on them either, though you must withhold federal income tax and pay FICA on them. Corporations are not allowed these tax breaks.
  • Income Splitting: Spreading income over several family members increases the amount that is taxed at the lower tax brackets. This is especially true when hiring your children. Last year, you could have paid a child up to $4,700 without either of you incurring a tax liability. A child's earning limit is adjusted annually for inflation, and mirrors the standard deduction amount for a single filer. (Your child may have to file a return, if he or she has investment income as well as wages.) Plus, you can deduct the compensation as a business expense, thus taking it off of your gross income. The same holds true for older parents who are in a lower tax bracket than you. Just make sure the compensation is reasonable for the services provided.
  • Insurance: You can save plenty on health insurance and other benefits when you cover your family as employees. Not only will you qualify for broader plans at better rates, but you can write off the total cost of coverage as a business expense (vs. the 70 percent the feds currently allow the self-employed) and establish a tax-deductible reimbursement plan to write off medical expenses not covered by insurance.
  • Child care: Uncle Sam allows you a maximum $4,800 credit for child care costs. Why not hire your spouse and pay him or her the full amount of your child care as a fringe benefit? That way, you can deduct the total as a business expense and it's nontaxable to your spouse.
  • Savings Programs: Once a child earns wages, they can establish an Individual Retirement Account, meaning they can tuck away $3,000 (or as much as they earn if it's less than that) in a tax-deferred account. Consider a Roth IRA if the kids are likely to want to tap their account early, say for college or a first home. Since taxes are already paid on money put into a Roth, there will be no tax due if it's taken out early, penalty-free, for IRS-allowable expenses. Even if they don't use the money before retiring, the long-term tax advantages of Roth are usually better for younger savers since all distributions can be taken out tax-free after age 59½.
  • Social Security: Because a survivor's benefits under Social Security are only half the decedent spouse's benefits, it's a good idea to build up each spouse's Social Security earnings. Hiring a spouse, especially a non-working one, helps achieve this goal.

Tax-smart family hires
The IRS is generally encouraging to family hiring if you follow the rules.

The easiest way to flag the taxman is to pay an inordinate amount or pay for a fictitious job or compensate a family member who clearly could not perform the task. In addition, the money you pay them must be in their control. Otherwise, it's still considered yours.

That's the long way of saying be prepared with documentation in case you're audited, or your family's incomes could boomerang right back onto your gross, at your tax bracket.

"The key is to be very upfront, be very businesslike," Aronoff advises. "If it's going to be business, it needs to be business. And the rules and procedures and policies need to be established and everybody needs to be clear about them. If not, there is a high probability that these things will lead to additional problems."

Davis suggests that you actually interview your family hires as if they were non-relatives. Discuss what the job entails, short- and long-term goals, a pay range based on industry standards. Then draw up a written contract setting out what you've both agreed to. In addition, because you're family, it's important to agree upon exit strategies (should either side want out) and a means of resolving conflict.

"Even if the IRS isn't as stringent with family businesses, I think it's really important for families to be, both in teaching the next generation and learning themselves how to settle things in a fair way and make arrangements between family members where money and work are concerned," she says.

"Informality is fine, but you should never be informal where business practices are concerned. They should be spelled out."

Jay MacDonald is a contributing editor based in Florida.

-- Updated: Jan. 22, 2003

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