New business owners commonly ask about the idea of paying a spouse wages or paying children wages. And on a face of it, the idea of a creating a new tax deduction for a business by placing a family member on the payroll seems to make sense. You will get a tax deduction if you pay your husband or wife or you pay your child. However, a handful of bookkeeping problems sometimes exist with this idea:
1. Amounts you pay to a spouse or to children will probably be taxed to your spouse or children
In the case of your spouse, for example, amounts you claim as a wages deduction on the LLC tax return will end up right back on your 1040 return when your spouse reports the wages she or he receives. A child may also possibly report wages on his or her return–though often, however, children don’t pay much income tax.
In any case, notice what happens if you pay your spouse or your children wages: While you do create a tax deduction one place on a tax return, you create tax income someplace. You don’t necessarily, therefore, reduce your family’s overall taxable income. You may just be just “spreading” the income around. In many cases–particularly when you’re paying a spouse–you may not reduce your family tax bill at all.
2. Payroll taxes may increase if you put family members on your payroll
If you own a limited liability company that is taxed as a sole proprietorship or partnership, you will pay payroll taxes in the form of self-employment tax on all of your profits. And in this case, paying a family member wages often doesn’t have much or even any negative payroll tax effect.
However, you may also elect to have your limited liability company treated as an S corporation. In this case, not all of your business profit will be subject to payroll taxes. Probably, if your tax accounting treats your limited liability company as an S corporation, only a portion of your business profit is subject to self-employment tax or Social Security and Medicare employment taxes.
In an “S corporation” LLC, therefore, any money you pay to a spouse or to a child for work they perform will probably be subject to payroll taxes. Accordingly, paying your spouse or child wages when you’re operating your LLC as an S corporation will probably increase the payroll taxes the family pays. And it gets worse, unfortunately. You will also subject this “redirected business profit now called family wages” to a new payroll tax. That new payroll tax is the Federal Unemployment Tax, which equals 6.2% of the first $7,000 of wages you annually pay to an employee.
Note: One unique tax loop hole relates to sole proprietorships and limited liability companies treated for tax accounting purposes as sole proprietorships. Sole proprietors may hire the proprietor’s minor children, pay them wages, and skip paying payroll taxes on those wages. In other words, if you have minor children (under the age of 18), you may be able to pay them wages but avoid have to pay Social Security, Medicare or Federal Unemployment tax on those wages. Again, I will note that children often pay very little income tax on the first few thousand dollars of their earned income. So this loop hole can be a real tax saver for LLCs operating as sole proprietorships for tax purposes. Note, however, that you need to be paying your children for real work. You can’t, for example, pay your eight year old son $5,000 a year for emptying the waste basket in your home office. And, yes, I have regularly seen sole proprietors audited on this very issue.
3. Extra payroll accounting work
Before you add a spouse or a dependent to your business’s payroll, you probably also want to think about one other issue–the possibility that the payroll accounting will become too large a hassle and headache.
Payroll processing triggers quite a bit of extra bookkeeping work. For example, you need to regularly write checks. You need to quickly remit any money withheld from employee checks to the IRS. You need to regularly file quarterly and annual payroll tax returns, including the quarterly 941 Social Security and Medicare tax returns, quarterly state unemployment tax returns, annual 940 Federal Unemployment Tax returns, annual W-2 and W-3 wage statements and so on.
If you’re already doing payroll for your business because you’ve already had to hire non-family-member employees, adding family members to the payroll typically doesn’t create much extra work. But you probably don’t want to start doing payroll just for your spouse for just for your teenage daughter.