Hiring family members

Tax-saving strategies Sole proprietors may be able to reduce their tax burden by hiring their children, spouse, or parents to work as bona fide employees.

There are three ways to save tax dollars for the business owner. First, sole proprietors may be able to avoid some payroll taxes on wages paid to their sons, daughters, spouses, and parents. Secondly, they are shifting income to persons who might be in a lower tax bracket. Thirdly, sole proprietors can deduct other employee benefits to amplify their tax savings.

1. Reducing payroll taxes. Sole proprietors don’t have to pay federal unemployment insurance (FUTA tax) on wages paid to parents, spouses, or children under age 21. Many states also exempt family members from state-level unemployment insurance (SUTA tax). Sole proprietors don’t have to pay Social Security and Medicare tax (FICA) on wages paid to their sons and daughters under age 18. That means the child doesn’t have the 7.65% FICA tax withheld from his/her wages, and the sole proprietor doesn’t have to pay the employer’s portion of FICA either.

2. Shifting income into lower tax brackets. By paying wages to family members in lower-income tax brackets, you end up deducting the wages paid on your tax return with its potentially higher tax rates, and the income gets taxed at a lower rate on your family member’s tax return.

3. Deducting employee benefits. As a sole proprietor, you can offer pre-tax benefits to your employees, such as group health insurance, term life insurance, and employer contributions to their retirement plans. This opens the opportunity, for example, to deduct health insurance premiums for the family as an employee benefit on Schedule C, instead of as a deduction on Form 1040, Schedule 1. This helps reduce the sole proprietor’s self-employment tax.

Following are the do’s and don’ts of hiring family members:

• Do have them fill out Form W-4.

• Do pay a reasonable salary for services performed.

• Do report their pay on Form W-2.

• Do withhold federal and state income tax.

• Do file quarterly and annual payroll forms.

• Do provide your family members with the same benefits you offer to other employees.

• Don’t pay unreasonably high salaries.

• Don’t pay them for doing nothing.

Qualified Small Employer Health Reimbursement Arrangements

What to look for and how to protect yourself Under the right circumstances, sole proprietors and other small businesses can reimburse employees for legitimate out-of-pocket medical expenses up to the annual limits.

By implementing a Qualified Small Employer Health Reimbursement Arrangement (QSEHRA), employers can report these reimbursed medical expenses as a business deduction. If all the formalities are met, the reimbursements are not subject to income tax or payroll taxes.

The annual limits for year 2019 are $5,150 for self-only coverage and $10,450 for family coverage.

A QSEHRA can reimburse qualified medical expenses for the employee or the employee’s family members. These expenses include:

• Insurance premiums for individual health plans

• Fees for doctors, dentists, hospitals, and lab testing

• Long-term care insurance premiums • Transportation to and from medical care facilities

• Prescribed medication

Your business is eligible to set up a QSEHRA if:

• Your business has at least one and fewer than 50 full-time employees

.• Your business does not offer group health insurance to any employees.

• You agree to offer the QSEHRA benefits on the same terms to all eligible employees.

• Before reimbursing health insurance premiums, you verify that the employee or the employee’s family member is covered by health insurance.

Reasonable compensation

Is your S corp paying you enough? Entrepreneurs often struggle with the question of how much to pay themselves. The underlying rule is that individuals who own and operate their business through an S corp need to pay themselves a “reasonable” salary. This rule also applies to any family members hired to help with the business, such as a spouse, parent, child, and even your grandchildren.

S corp shareholders are often tempted to pay themselves less because salaries are subject not only to federal and state income tax, but also to Social Security and Medicare taxes, federal and state unemployment insurance, and other various state and local payroll taxes. However, S corp profits passed through to the shareholder are not subject to these extra payroll taxes.

The IRS is aware of the tendency for S corp shareholders to underpay certain employees, and sometimes raises this issue when auditing closely held businesses. If the IRS determines that a shareholder’s salary is unreasonably low, the S corp may be on the hook for unpaid payroll taxes. To limit this risk, S corp shareholders should be proactive in documenting that their salaries meet the “reasonable” salary requirement.

Here’s a quick way to tell if your salary is reasonable. Suppose you sold your S corp to an outside investor, and the new owner hired you to continue running the business. How much would this outside investor be willing to pay you for the work you do? In other words, a reasonable salary is an amount that similar businesses, under similar circumstances, would pay you for the same services. To document this, S corp shareholders should record their decisions regarding shareholder compensation in the corporate meeting minutes. And they should mention the factors that went into deciding the salary amounts for each shareholder. For example, shareholders should make note of the current financial condition of the S corp, how many hours the shareholder works, and the type of work that the shareholder performs.

Making home improvements?

Rules for deducting interest on home equity debt Homeowners can deduct interest paid on home equity loans or home equity lines of credit if they use the loan proceeds for making home improvements. However, if the home equity loan is used to pay for anything else, like college tuition or a new car, the interest on that loan won’t be tax deductible.

Homeowners need to be careful when taking out a loan secured by their house. Not all home equity loans qualify for the mortgage interest tax deduction. We need to look at how you spent the loan proceeds when figuring out if your loan interest is deductible.

For tax years 2018 through 2025, homeowners can deduct interest paid on mortgages and home equity debt as long as they spend the loan proceeds to buy, to build, or to substantially improve their main home or a second home.

Here’s how to make sure your home equity loan or line of credit will be tax deductible:

• The loan must be secured by your main home or a second home.

• The new home loan, plus any existing mortgages, must have a combined loan balance of $750,000 or less ($375,000 for married couples who file separately). Interest on balances over this limit is not tax deductible.

• The proceeds of the home equity debt must be used to substantially improve your home.

From the IRS’s perspective, home improvements are “substantial” if the improvement adds value to your home, extends the useful life of your property, or adapts your home to new uses.

Examples of substantial home improvements:

• Adding a bedroom or bathroom to your house

• Adding a deck, porch, patio or garage

• Building a swimming pool

• Building or replacing a fireplace

• Installing a security system

• Installing built-in appliances

• Installing heating or central air conditioning systems

• Installing new windows, siding or a satellite dish

• Laying new carpet or flooring

• Modernizing the kitchen

• Building a new fence or retaining wall

• Installing new insulation in the attic, walls, floors, or around pipes

• Installing new water heaters and filtration systems

• Paving the driveway

• Replacing the roof

• Replacing the septic system

• Re-wiring the house

Examples of what’s not a substantial improvement:

• Repainting your house

• Making ordinary repairs that maintain your home in good condition

Let us know about any new or refinanced home loans. We can help you determine if the interest will be tax-deductible and can help you keep proper documentation for tax purposes.

Using an IRA to make charitable contributions

A tax-free way to help your favorite cause Normally, money distributed from an Individual Retirement Account (IRA) is taxable. However, if the funds are donated directly to charity, the distribution is completely tax-free. This is a significant tax-planning opportunity for older taxpayers. To qualify for tax-free treatment, a charitable IRA distribution must meet three criteria:

• You must be at least 70½.

• Your IRA administrator must send the distribution directly to a qualified church or charity.

• The funds must be distributed from a traditional IRA or Roth IRA. SEP IRA, SIMPLE IRA, 401(k), and 403(b) plans don’t count for this special rule.

You don’t get an itemized deduction for this charitable gift. Instead, the amount of the charitable IRA distribution is not included in your income for the year, but counts as your required minimum distribution. This helps keep your income (and adjusted gross income) lower than if you took the money out yourself and subsequently donated the same amount to charity.

Keeping your income low can help you avoid higher Medicare premiums, because the cost of Medicare insurance increases once your adjusted gross income for the year goes over $85,000 ($170,000 for married couples).