Not only is employing family an age-old practice, the Internal Revenue Service gives entrepreneurs a tax break for doing so. However, what tax breaks you can take -- if any -- depends on the type of business you run. Incorporating your business eliminates many payroll exemptions, but might create more enviable tax deductions.
When a child works for her parents in a sole proprietorship or partnership, the parents do not need to pay Social Security or Medicare taxes. However, the IRS requires corporations to pay payroll taxes on all salaries, even if the parents own the corporation and employ their children. The IRS does allow businesses, including corporations, to deduct employee wages as a business expense.
Parents can still receive some tax breaks for employing their children in a corporation. For example, children can earn a few thousand dollars -- the exact amount varies with inflation -- without paying federal income taxes. Also, paying family keeps profits in-house. The IRS penalizes some corporations that keep an excessive amount of profits, and if the company pays dividends, corporate profits face a double taxation: once on the corporate tax rate and another tax on the dividends paid to shareholders.
Owners of a corporation can receive greater tax breaks even though they cannot deduct Social Security taxes. For example, corporations can pay their employees tax-free fringe benefits and deduct them on the corporation's tax return. For example, the corporation can pay the child's health care premiums and offer tuition assistance, up to certain limits, and deduct all of these expenses. The employees won't pay taxes on these benefits either.
Consult an accountant about incorporating your business and its effect on your taxes. Incorporating might increase your available tax deductions, but also comes with annual fees and U.S. Securities and Exchange regulations, such as an annual profit statement and shareholder meetings. Also, do not give children excessive compensation. The IRS can construe excessive compensation as an attempt to avoid paying dividends.