Hiring a child or another family member in a family business can save taxes for both the business and for the family as a whole. The business saves taxes because it can deduct the compensation paid as a business expense, just as it could if the services were performed by an unrelated party. The family saves taxes because the income can be spread over more taxpayers.

To obtain the compensation deduction, the employment relationship must be structured so that real services are performed, and the compensation is reasonable for these services. No business deduction is allowed to the extent the amount paid to the child is considered to be a disguised gift or unreasonable compensation.

To obtain the benefits of income-splitting, the arrangement must be structured so that the child (or other family member) has some control over the income earned -- a parent who is responsible for a child's earnings and retains total control over the earnings may be required to include those earnings in the his or her own gross income. If this requirement is met, the compensation paid to the child is taxed to the child, whether or not the child actually receives it and regardless of state law provisions relating to who is entitled to it.

Income-splitting can pay off regardless of what family members are involved, since spreading income over several taxpayers increases the amount that is taxed at the lower brackets. However, employing a child generally produces the largest benefits. First, a child is likely to be in a lower tax bracket than the parent. Second, the basic standard deduction for a child is available to a dependent to the extent of earned income. Otherwise, it is subject to a cap. For 1999, the standard deduction for a taxpayer claimed as a dependent on another taxpayer's return cannot exceed the greater of $700 or earned income plus $250. Thus, a child who is employed can earn up to $4,300 tax free. In contrast, if a parent tried to split income by giving the child income-producing property, only $700 would be free of tax. And there is no danger that a child will lose dependent status, since there is no ceiling on the amount the child or other dependent can earn if under 19 or if under-24 and a full-time student. On the other hand, hiring a spouse is less likely to pay off in terms of income-splitting because the rates for married taxpayers filing separately make it less advantageous to split income between two returns and because no standard deduction is permitted for separate filers.

Hiring family members can also save taxes by allowing insurance coverage and other benefits to be provided to the family members at a lower tax cost. For example, a self-employed taxpayer who provides health insurance to his spouse or other family member as an employee may deduct the cost of the coverage as a business expense if the spouse is a bona fide employee. In addition, the cost of the insurance coverage and insurance reimbursements are excludable from the spouse's gross income. Similarly, in a family corporation or sole proprietorship, income earned from employment can qualify the family member for fringe benefits and retirement benefits that are deductible by the business and non-taxable to the employee. This can be a relatively inexpensive way to provide benefits such as health insurance for parents or other relatives, as well as spouses or children.

Finally, hiring a family member can help build up their retirement benefits. In addition to allowing coverage under any plan provided by the business, hiring a spouse can help to build up the spouse's Social Security benefits. Since survivor's benefits under Social Security are only half the decedent spouse's benefits, this may be appropriate where the spouse is not otherwise employed. The taxpayer-employer can then continue the spouse as an employee until the minimum necessary contribution has been made to qualify the spouse for maximum benefits. In the case of children, earned income in excess of the standard deduction can be contributed to an IRA, to obtain both a tax deduction and a head start on retirement savings.

If the family business is organized as a partnership or as a sole proprietorship, the benefits of employing a child can be obtained at minimal cost in employment taxes (and may even result in employment tax savings if a family member is hired instead of an unrelated employee). No Social Security taxes are due if a child under age 18 performs services for a parent in the parent's trade or business, and no FUTA taxes are due when services are performed by a child under age 21. And while these exemptions are not available for services performed for a corporation (or for services performed by a partnership unless the partners are the child's parents), and services performed by a spouse or other relative are subject to Social Security (but not FUTA) taxes if performed in the course of a trade or business, the other advantages will outweigh any employment tax cost in most situations. (From Kleinrock's TAX LIBRARY)