If the people I know are any indication, many of you are supporting more than one generation of your family, or anticipate doing so in the near future. You might be supporting family members who were independent for years. Perhaps one or more of your parents or siblings needs help now. Or one of your children is between jobs or back in school and needs your support. Those situations are quite common. You might even be in the “sandwich generation,” supporting both older and younger family members.
The financial burden of supporting someone can be eased greatly if you can provide the support with pre-tax dollars. If you are in the 40% income tax bracket, you have to earn about $1.66 to have $1 after taxes to support the individual.
The family business provides a number of great opportunities to support family members with pre-tax dollars. By structuring things properly you can deduct every dollar you pay the family member. You might even be able to make the payments tax free. Your business deducts the payments, and the benefits are tax-free to the individual you are supporting. Here are some strategies to consider.
Increase your payroll. Children, parents, and siblings can be put on your business payroll. The salaries are deductible as long as the payments are reasonable for the skill of the individual and for the amount of work required. The Tax Court has allowed deductible wage payments to seven year olds. If the individual you are supporting is physically and mentally capable of doing something for the business, pay them to do it.
Most likely you or your business is in a higher tax bracket than the person you are supporting. That means the payments will be deductible from your higher tax bracket and included in the family member’s lower income tax bracket. That is a lot less expensive making after-tax payments from your salary and keeps more after-tax money in the family.
In addition, your family member might qualify for your business’s employee benefit programs, such as health care and child care. If so, that is a way of paying an expense at a lower cost than the relative probably would pay on his or her own and also in a way that is deductible to you and tax-free to the relative. This might be reason enough to put your parents or other relatives on your payroll.
Expand your board of directors. Suppose your parents can’t really work in your business, or you are supporting a child who is away at school. Those situations rule out putting them on your payroll. But you might get many of the same benefits by appointing them to your board of directors.
At most small businesses, the board is at most a formality that has one meeting annually. But it doesn’t have to be that way. Directors can meet regularly to discuss the business’s financial situation and plans for the future. They can approve various policies and make other decisions. Directors can be paid annual retainers plus fees for the time they put in at meetings. At larger firms, directors also qualify for some benefit plans. You also probably can have the business pay the cost of transporting the individual to the board of directors meeting if the individual lives out of town or the meeting is out of town. Some small businesses have directors’ meetings at the same time as family get-togethers.
If the relative you are supporting can’t work on the job, perhaps he or she can serve on the board. As with payroll, a board member’s compensation is deductible by the business if it is reasonable for the work done and the capacity of the individual.
Share ownership. You can give a share of your business to the relative. That diverts part of your annual income to the relative, and taxes are paid at his or her tax rate.
Suppose you have an S corporation. You can give the relative some of your shares. Each year a pro rata portion of the income and expenses of the business will pass through to the relative. These items will be on the relative’s tax return instead of yours. And the relative will get a pro rata share of any cash distributions. The results essentially would be the same if you own a partnership or limited liability company. If you own a regular corporation, the relative would receive a share of dividends.
Any of these methods gets cash to your relative without going through your individual tax return first. You also can set up a special class of ownership for the relative so that you won’t be taxed on dividends or distributions that you don’t want just to ensure that the relative gets cash. The distributions would be paid only to the special class of shares.
Of course, you can put restrictions on the ownership interest so that it eventually will come back to you or the business. You can provide that the relative or the estate eventually will be required to sell the ownership interest back to you or the business at a price determined by a set formula. Or you can count on eventually inheriting the interest after the relative dies.
Share business assets. Another technique, which often is recommended when accumulating tuition for children, is to give the relative some property that is used in the business, then lease back the property. The asset might be a building, land, equipment, or vehicles. You can give the asset to the relative (or have them buy it over time). Then enter into a lease agreement with them. The business continues to use the asset, and it pays rent for the use. The business deducts the rent as long as it is a reasonable amount. Once again, you get pre-tax cash out of the business and into your relative’s hands.
Essentially, you have set the relative up in his or her own business. This is ideal when there are reasons why the individual can’t work for the business or be on the board, and when you don’t want to distribute an ownership interest in the business. It also works well for professionals, because they usually require skilled labor, and state law limits their ability to hire or share ownership with non-professionals.
The family business is a great tax shelter and wealth builder. It is especially helpful when you need to support a relative. But too many advisers overlook the many ways a family business can be used to provide support for a relative with pre-tax dollars or at a greatly reduced after-tax cost. One word of caution, though. The IRS doesn’t like business relationships between relatives. Be sure to consult with a good tax adviser before implementing any of these strategies.