Employment of Family Members as a Means of Wealth Transfer
One method of wealth transfer involves the employment of a family member (normally a child) in the family business. This allows a portion of the business profits to be paid to the employed family member as salary or wages, which are, in turn, deductible as a business expense by the owner. This has the effect of shifting income from the owner’s high bracket to the employed family member’s lower bracket, and it may allow the latter to establish an individual retirement account (IRA) to shelter this income further.
Employing family members, however, is not without its problems and abuses. An attempt to employ a family member who is: (1) a minor, or (2) away at school may result in serious problems. While there is no set age limit in terms of an employment relationship with family members, employment of a very young child may result in disallowance of the deductions and possible imposition of civil penalties. The IRS has unsuccessfully argued that child labor laws prevent the employment of an owner’s child in the business. On the other hand, a court probably will be more inclined to believe that a 15-year-old is more able to provide useful services to the family business than an 8-year-old. Absence of the employed family member also will preclude the finding that the family member provided useful services. Numerous cases have resulted in the disallowance of a salary on the basis that the supposedly employed family member was either away at school or employed full-time in another business.
In addition to the practical problems associated with the employment of a young or absent child, the tax law prohibits the claiming of a personal exemption by a dependent child. This restricts the amount of earned income that may be sheltered from taxation. The child may use his or her own standard deduction amount ($4,850 in 2004) to offset earned income; however, a valid business purpose behind the child’s employment must be proved to avoid construing that the income was a gift by the parent. Nonetheless, it should be noted that employment of a family member (particularly a child under age 14) may be used as a method of transferring income to a child without imposition of the unearned income rules, thereby allowing greater income shifting within the family to take place. Another consideration involves the payment of the FICA and the unemployment taxes. Wages paid to an employer’s child under age 18 are not subject to the FICA or the unemployment taxes. For this rule to apply, the parent’s business must be unincorporated.
