Family-owned businesses account for 60% of the workforce and generate 64% of the United States’ GDP. If you run a family-owned business, the right strategies can help you reduce your tax burden, lower the risk of an audit, and pass the business on to future generations.
[Read more: What is Tax Form 941, And Who Needs to File It?]
What is considered a family business?
A family business is one where a family owns a majority of the company. Many people think of family-owned businesses as small mom-and-pop shops, but these businesses can range in size from just one or two people to Fortune 500 companies. Walmart and Berkshire Hathaway are examples of family businesses.
In general, there are three types of family businesses:
- Family-owned businesses: These businesses are led by family members who have a majority ownership stake in the business.
- Family-managed and -owned: One family member has a controlling stake, and other family members determine the business’s policies and goals.
- Family-led and -owned: One family member owns the business, while a different family member serves on the business’s board of directors in order to guide major decisions.
[Read more: 9 Commonly Overlooked Small Business Tax Credits]
Taxes apply differently depending on your business entity
The IRS has different rules for family-run businesses depending on your business entity. Schedule C businesses, which include sole proprietorships, husband-wife partnerships, or LLCs treated as sole proprietorships for tax purposes, have different rules than corporations.
Schedule C businesses are permitted to hire children under the age of 18, and the child’s wages are exempt from Social Security, Medicare, and unemployment taxes. This exemption applies to both the employee’s share and the employer’s share of FICA taxes — a win-win for your business and your family. But if your business is incorporated, your child’s wages will be subject to FICA and employment taxes.
Navigating tax liabilities across generations
According to the IRS, there are different tax regulations for different types of family members.
Spouses
Spouses who operate a business together may be regarded as partners, regardless of whether they have a formal partnership agreement. As a single entity, the proprietor and their spouse are exempt from unemployment taxes, even though they are liable to income tax withholding and Social Security and Medicare taxes.
However, spouses may opt out of a partnership in favor of a qualified joint venture. A couple may qualify if they are married and file a joint tax return and if both spouses contribute to the business. Both spouses must also agree to not be treated as a partnership.
When filing federal taxes, spouses who elect for qualified joint venture status are each considered sole proprietors and must report their profits and losses with individual Schedule C forms.
If one spouse is classified as an employee of the other spouse, then the employed spouse’s wages are subject to Medicare and Social Security taxes, as well as income tax withholding. However, the employed spouse’s wages are exempt from unemployment taxes.
Children
Children’s tax statuses largely depend on their ages. Children under the age of 18 and employed by parents operating a sole proprietorship or a partnership don’t have to pay Social Security, Medicare, or unemployment taxes.
Children aged between 18 and 20 are given the same tax treatment as spouses and are only exempt from unemployment taxes. However, once they turn 21, they’re liable for the same withholding taxes as any other employee.
The child’s wages are also subject to Medicare, Social Security, and unemployment taxes if the parent is in a business partnership with someone other than their spouse. Additionally, the child’s wages are subject to additional taxes if the family business is a corporation or the child works for an estate.
Other working arrangements
If a child employs their parent, the parent is liable to pay income tax withholding, Social Security, and Medicare taxes, but they are exempt from unemployment tax. And if the family business employs other family members — like grandparents, aunts, or cousins — their wages are subject to FICA and unemployment taxes.
[Read more: How W-2 Employees Are Treated Differently Than 1099 Contractors]
Having strong documentation practices will make it easier to prove your tax returns are correct in the event of an audit.
Take advantage of deductions in the Tax Cuts and Jobs Act
Before the Tax Cuts and Jobs Act (TCJA), a child employed at the family business was only able to take a standard deduction of up to $6,350. For the 2024 tax year, children under the age of 18 can earn up to $14,600 before their wages are subject to federal income taxes unless they also earn income from other sources.
For example, a teenager who earns $10,000 working part-time for the family business can use the 2024 standard deduction to shelter their earnings from income taxes. This allows your child to utilize their earnings to support the family financially or invest in their future by contributing funds into a college savings account or Roth IRA.
It’s also worth noting that a child who earns less than the standard deduction does not owe any federal income taxes. If your child is simply working a part-time job at your family business over the summer, it may be smart to ensure their wages fall under this $14,600 threshold.
[Read more: How to File an R&D Tax Credit]
Protect your business and family from a potential IRS audit
Even though IRS audits are rare, you can protect your business and your family from a potential audit by maintaining accurate and thorough business records. Having strong documentation practices will make it easier to prove your tax returns are correct in the event of an audit.
Here are some tips to help your family business avoid a tax audit:
- Do not use rounded numbers in your tax returns. Consistently using rounded figures can indicate a lack of accuracy. Refrain from rounding a $47 expense up to $50, even if it makes your return easier to calculate.
- Double-check how your workers are classified. If your business hires independent contractors, make sure they’re qualified for that status. If they’re not, the IRS can classify them as employees, resulting in back payments on payroll taxes.
- Ensure your deductions are accurate. There are specific guidelines when making deductions for home offices, work-related travel and meals, and charitable donations. Review any deductions you’re claiming to be sure they fit within the current IRS standards.
- Work with a tax professional or CPA. Working with an expert can ensure that your tax returns are neat, organized, and filed on time. A tax professional can also help you navigate the complex requirements for family-owned small businesses.
Understanding gift taxes in family businesses
If you transfer property to another individual and either receive nothing in return or less than fair market value, that transfer may be subject to a gift tax. A gift can include cash, real estate, or shares in a family business.
Fortunately, the IRS does offer a lifetime exemption of $13.61 million. As long as the gift is below that amount, you won’t have to pay a gift tax on it, though you may need to report it to the IRS. The gift tax applies to each spouse, so married couples can give a gift of up to $27.22 million without paying a gift tax.
Many families gift shares of the family business as part of their succession planning. It’s a good idea to work with a financial planner who can help you figure out how to spread these gifts out over time.
Creating a succession plan with tax implications in mind
Succession planning is often one of the biggest challenges for family-owned businesses. It’s hard to balance what’s best for the business with unique family dynamics. Different family members often have very different ideas about what’s best for the business and who should be involved. For example, decisions about who should take over the business or act in leadership roles can lead to perceptions of favoritism.
This potential for conflict often causes family members to avoid talking about succession planning altogether. But in the long run, this lack of communication will likely lead to more chaos, not less. Plus, this doesn’t give you an opportunity to plan for ways to reduce your tax burden.
It’s important to start succession planning sooner than you think you need to. That way, you can transfer ownership gradually over time and minimize your tax liability. Many family businesses use trusts to seamlessly transfer their assets while still maintaining control over the business.
Begin working with legal and tax professionals who can help you outline your goals for transitioning the business. That way, you can outline a succession plan that addresses your unique business needs.
Emily Heaslip and Kaytlyn Smith also contributed to this article.
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