Employing Family Members: Tax Benefits, FICA Exemptions, and IRS Compliance for Family Businesses

Family employment tax rules summary:

Children (under 18) employed by a parent’s sole proprietorship:

• FICA exempt (IRC 3121(b)(3)): no Social Security or Medicare tax on the child’s wages
• FUTA exempt (under age 21): no federal unemployment tax
• Child earns up to $15,000 (2025 standard deduction) tax-free
• Parent deducts wages as a business expense (reduces income tax AND SE tax)
• Child can contribute earnings to a Roth IRA
• Exception: does NOT apply if the employer is a corporation, partnership, or estate

Spouse employed by a sole proprietorship:

• Subject to income tax withholding and FICA
• FUTA exempt (IRC 3306(c)(5))
• Enables employer-sponsored health insurance (deductible by the business)
• Doubles retirement plan contribution capacity (spouse participates in the plan)
• Must perform real work at a reasonable rate

Parents employed by a child’s sole proprietorship:

• FICA exempt if the parent is employed by a child’s sole proprietorship (IRC 3121(b)(3))
• Must perform real work (bookkeeping, cleaning, reception)
• Can shift income to a potentially lower bracket

Entity type matters:

• FICA and FUTA exemptions for family employment ONLY apply to sole proprietorships (and single-member LLCs taxed as sole proprietorships)
• If the business is a corporation (including S-Corp) or a partnership (unless only the parents are partners), these exemptions do NOT apply
• An LLC owned by both spouses in a community property state can elect qualified joint venture treatment (IRC 761(f)), preserving the sole proprietorship FICA exemptions