The Tax Benefits of Family Employees Our expert explains the tax laws that'll save you money by employing members of your family.

Many self-employed people want to hire family members to work for them. But as with many things in life, there's a right way and a wrong way to do this. Doing it correctly not only promotes family togetherness, it can also create tax savings for you.

When you hire a family member your business can take a deduction for reasonable compensation paid to this employee, which consequently reduces the amount of taxable business income that flows through to you. I emphasize reasonable compensation because the IRS can question compensation paid to a family member if the amount doesn't seem reasonable given the services actually performed. Also, you must be sure your business complies with child labor laws when hiring a family member who's a minor.

There are other benefits to hiring a family member. As a business owner, you're responsible for paying Federal Income Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes on wages paid to your employees. FICA is the law requiring employers and employees to pay Social Security and Medicare taxes. FUTA is the law that establishes federal unemployment taxes.

As with wages paid to all employees, wages paid to family members are subject to withholding of certain taxes in some states. Typically, the payment of these taxes will be a deductible business expense for tax purposes. But if you hire family member--a child, spouse or parent as an employee--to work for your business you may not have to pay FICA and FUTA taxes.

For instance, you don't have to pay FUTA taxes for services performed by a child under 21 years old. And you don't have to pay FICA taxes for a child under 18 and works in your trade or business or a partnership owned solely by you and your spouse. For family members under age 18, you don't have to withhold for FICA, Medicare, FUTA and SUTA. If your spouse is employed, you don't have to withhold for FUTA and SUTA, but must withhold for FICA and Medicare.

For example, Cody, age 15, proofreads press releases for his mother's public relations business, which is operated as a sole proprietorship. Cody is his mother's employee, but she doesn't have to pay FICA taxes until Cody turns 18, and FUTA taxes until he turns 21.

Note that these rules don't apply if you hire your child to work for your corporation or your partnership, unless all the partners are parents of the child. For example, Callie works in a landscaping business that's half-owned by her father and half-owned by her father's brother. FICA and FUTA taxes will have to be paid because it's a partnership and not all the partners are Callie's parents.

Additionally, if your child has no unearned (dividend or interest) income, then you must withhold income taxes from your child's pay only if it exceeds the standard deduction for the year. For 2005, the standard deduction is $5,000; this figure is adjusted every year for inflation. Children who are paid less than this amount don't have to pay any income taxes on their earnings. If your child has more than $250 in unearned income for the year and his or her total income exceeds $750, then you must withhold income taxes.

If you pay your child more than $600 or more during the year, you must file a Form W-2 reporting the earnings to the IRS. Regardless of how much you pay your child, each year you should fill out and have your child sign IRS Form W-4, Employee's Withholding Allowance Certificate. If you pay your child more than $200 per week, keep a copy of the form for your records and file a copy of the form with the IRS.

For small-business owners who are concerned about succession planning, hiring children can provide non-tax benefits as well. Children who play a role in a business can help it survive past the owner's involvement.

Meanwhile, if you employ your spouse to work in your trade or business, the payments are subject to FICA taxes and federal income tax withholding, but not FUTA taxes. This rule doesn't apply if your spouse works for a corporation--even if you control it--or a partnership--even if your spouse is a partner along with you. In that case, you will have to pay FUTA taxes.

Finally, if you employ a parent in your trade or profession, his or her wages are subject to income tax withholding and the FICA taxes, but not FUTA taxes.