Employing family members can be a useful strategy to reduce overall tax liability. If the family member is a bona fide employee, then the taxpayer can deduct the wages and benefits, including medical benefits, paid to the employee on Schedule C, Profit or Loss From Business, or Schedule F, Profit or Loss From Farming, as a business expense, thus reducing the proprietor's self-employment (SE) tax liability (see Frahm, T.C. Memo. 2007-351; Eyler, T.C. Memo. 2007-350).
Employing the taxpayer's children can reduce overall tax liability. Children who work for their parents are not subject to FICA taxes (for children under age 18) or FUTA taxes (for children under age 21) (Secs. 3121(b)(3)(A) and 3306(c)(5)). In addition, wage income would be taxed at the child's lower tax rate and may be wholly or partially offset by the child's standard deduction of up to $12,200 (for 2019). The wages must be reasonable for the work done.
Additionally, a sole proprietor can provide up to $5,250 in annual tax-free educational assistance (for both undergraduate and graduate courses) to each eligible employee and deduct the costs (thus saving both income and SE taxes). Properly arranged, this benefit is available to the sole proprietor's child who is (1) age 21 or older; (2) a legitimate employee of the business; (3) not more than a direct 5% owner of the business; and (4) not a dependent of the parent business owner. See Sec. 127(b) for the qualification rules for these tax-free educational assistance programs.
Caution: Should the IRS choose to examine wages paid to family members, the taxpayer should be able to prove the deduction. For payments to family members, it is especially important to ensure that basic business practices (e.g., keeping time reports, filing payroll returns, and basing pay on work performed, not on a relationship to the employer) are followed (see Alexander, T.C. Summ. 2006-127; Fisher, T.C. Summ. 2016-10; Embroidery Express, LLC, T.C. Memo. 2016-136).Medical reimbursement plans
Employing the spouse can reduce overall tax liability because under Sec. 105(b), the spouse can receive tax-free reimbursement of medical expenses from the business, even though the business deducts the reimbursements. However, if the business has other employees, this technique will not work. The self-insured reimbursement plan can cover the entire family, so the family's out-of-pocket medical expenses (including health insurance premiums) are paid with pretax dollars.
Properly structured and administered, a self-insured medical reimbursement plan established for the self-employed owner's employee-spouse can save both income and SE taxes. The plan should be in writing (including an annual cap on reimbursements); the employee-spouse should observe all the formalities of being a true employee (employment agreement with expected duties and hours to be worked, time sheets to document hours and tasks performed, etc.); the employee-spouse's compensation (including the medical reimbursements from the plan) must be reasonable in relation to the work actually performed; and the employee-spouse should pay the out-of-pocket expenses to the medical providers and actually be reimbursed by the plan with a check drawn on the company account, supported by substantiated copies of billing notices, invoices, and canceled reimbursement checks (Shellito, 437 Fed. Appx. 665 (10th Cir. 2011); Albers, T.C. Memo. 2007-144; Eyler, T.C. Memo. 2007-350; Francis, T.C. Memo. 2007-33). In addition, the spouse would be subject to FICA on the spouse-employee's compensation. If the business has more than $132,900 (for 2019) in net income, the decrease in income taxes for the spouse's compensation would be partially offset by the increase in Social Security taxes.
Caution: The self-insured health plan must involve insurance risk in order to qualify for these benefits (Chief Counsel Advice 201719025).Qualified small employer health reimbursement arrangements
Eligible employers that do not offer group health insurance coverage to any of their eligible employees can offer a qualified small employer health reimbursement arrangement (QSEHRA) for plan years beginning on or after Jan. 1, 2017. Employers eligible to provide QSEHRAs are employers that are not applicable large employers (ALEs) (Sec. 4980H(c)(2)) and do not offer a group health plan to any of their employees (Sec. 9831(d)(3)(B)). An eligible employee is broadly defined as any employee of the employer (Sec. 9831(d)(3)(A)).
Observation: Small employers with two or more employees that cannot afford to offer coverage that meets the Patient Protection and Affordable Care Act (PPACA) standards may find that a QSEHRA can be a good alternative since employees can buy individual coverage and be reimbursed for some of the premiums.
A QSEHRA must be provided on the same terms to all eligible employees and funded entirely by the employer. Payments and reimbursements from the arrangements are limited to $5,150 per year ($10,450 for family coverage) (for 2019) (Rev. Proc. 2018-57), subject to annual proration for new employee coverage. A QSEHRA can reimburse an employee for medical care expenses incurred by the employee and the employee's family members and for premiums paid by the employee for individual health insurance policies.
Amounts paid or reimbursed from a QSEHRA generally are not taxable to the employee. However, any payments or reimbursements from a QSEHRA for medical care (including insurance premiums) when an individual does not have minimum essential coverage are included in the employee's income (Sec. 106(g)). Notice 2017-67 provides guidance in a question-and-answer format.
Converting entities in a community property state to minimize SE tax
For SE tax purposes, the normal community property rules (50/50 split) are ignored, and the SE earnings are attributed entirely to the spouse carrying on the trade or business (Sec. 1402(a)(5)(A)). However, where two spouses are the sole owners of an unincorporated trade or business entity that is owned by them as community property, the IRS will accept the treatment of the entity by the spouses as either a disregarded entity (sole proprietorship) or a jointly operated partnership for federal tax purposes (Rev. Proc. 2002-69).
If the business is treated as a partnership, each spouse would report his or her distributive share of the SE income instead of it being reported 100% by the spouse conducting the business, as previously mentioned. This could result in significant SE tax savings when the other (nonbusiness) spouse has already reached the maximum FICA limit ($132,900 for 2019) through wages or other income sources.
Example. Converting a sole proprietorship into a spousal partnership: Assume the husband's existing sole proprietorship generates $100,000 of SE income while the wife earns a $150,000 salary from her unrelated job. If the sole proprietorship is converted (pursuant to Rev. Proc. 2002-69) into a "new" 50/50 spousal partnership, $50,000 of SE income is shifted from the husband to the wife. That would reduce the couple's SE taxes by $6,200 ($50,000 of SE income shifted to the wife's Schedule SE, Self-Employment Tax, and taxed at only 2.9% instead of being taxed at 15.3% on the husband's Schedule SE).
The conversion is accomplished by contributing for federal tax purposes the assets (if any) of the sole proprietorship (or single-member LLC) to the new spousal partnership (or spousal LLC). In most cases, the only actual federal income tax impact of the conversion will be ceasing to file Schedule C and instead filing Form 1065, U.S. Return of Partnership Income, for the new spousal partnership (or spousal LLC).
This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 20th edition (March 2019), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters, Carrollton, Texas, 2019 (800-431-9025; tax.thomsonreuters.com).