Payroll Tax Breaks: Can Relatives Qualify?

A temporary new payroll tax exemption and a related new hire retention credit were signed into law earlier this year. Designed to encourage employers to hire and retain new workers, these two tax benefits are especially beneficial to employers who are adding positions to their payrolls as the economy recovers. Although family members generally do not qualify, there are some crucial exceptions. Here are the rules of the new tax breaks and how to claim them, as well as a rundown of how your business can occasionally qualify when hiring relatives.

TWO VALUABLE HIRING INCENTIVES

Keeping money in the family is always a worthy goal. If you’re a business owner, one way to accomplish this is to hire relatives. As an added bonus, if you act quickly, you might qualify for two temporary payroll tax breaks. Here is what you need to know.

Social Security Tax Break for New Hires

The Hiring Incentives to Restore Employment (HIRE) Act grants a temporary employer Social Security exemption for wages paid by a qualified employer to an eligible new employee between March 19 and December 31, 2010. Specifically, such wages are exempt from the 6.2 percent employer portion of Social Security tax that your business pays as part of the FICA tax.

For each qualified employee, the employer’s 2010 Social Security tax bill can be cut by up to $6,621.60 (6.2 percent times the $106,800 Social Security tax ceiling equals $6,621.60). The reduction has no effect on the employee’s future Social Security benefits.

Your Spouse Can Be Eligible

A qualified new employee is one who begins employment between February 4 and December 31, 2010 and was not employed for more than 40 hours during the 60-day period ending on the start date. (Part-time workers can qualify.) Keep in mind, though, that the Social Security tax exemption is not allowed for wages paid to a worker who is hired to replace another worker, unless the person quit voluntarily or was discharged for cause.

Mind the Related Party Disallowance Rules

The Social Security exemption is disallowed for wages paid to any person who has a prohibited relationship to the employer under the related party disallowance rules that apply for purposes of the Work Opportunity Tax Credit. We’ll call these ineligible employees, but keep reading because the rules for different business entities are not as restrictive as you might think.

Businesses that Operate as Sole Proprietors or Single-Member LLCs. In these cases, the owner as an individual taxpayer is considered the employer and ineligible employees include:

A child, including a stepchild, adopted child, eligible foster child, or descendent of your child (most often a grandchild);

A brother, stepbrother, half brother, sister, stepsister, half sister, or a descendent of one of these individuals (generally a niece or nephew);

A son-in-law, daughter-in-law, father, stepfather, father-in-law, mother, stepmother, mother-in-law, brother-in-law, sister-in-law, aunt, or uncle; and

Any non-relative who is classified as a dependent because he or she lives in the same household.

Surprisingly, a spouse does not appear on the list of ineligible employees. This means that wages paid to your newly hired spouse are eligible for the Social Security tax exemption if he or she meets the other requirements (unemployed, hired between the correct dates, and so on).

Key Point: Most other new hires related to you (including in-laws) are on the list of ineligible employees.

Example: You operate your business as a sole proprietorship. Therefore, you are treated as the employer of any employees. Assume you hire your unemployed spouse, who meets the description of a qualified new employee. You can take advantage of the Social Security tax exemption for wages paid to your spouse between March 19 and December 31, 2010. However, if you also hire your unemployed son, he is ineligible because of his prohibited relationship with the employer.

Corporate Employer Related Party Rules. If you run your business as a corporation, ineligible employees include:

Relatives (defined earlier) of an individual who owns (directly or indirectly) more than 50 percent of the company’s stock.

Dependents of relatives (defined earlier) of a more than 50 percent shareholder.

Under this rule, the spouse of a majority shareholder is not an ineligible employee except in highly unusual circumstances. This means that wages paid to a majority shareholder’s spouse are generally eligible for the Social Security exemption if the spouse meets the other requirements.

Most other new hires related to a majority shareholder are ineligible (including in-laws). However, new hires who are only related to minority shareholders (taking into account both direct and indirect stock ownership) can be eligible if they meet the qualification requirements. This includes relatives who are students hired to work in the summer.

Example: Doug, Elaine, and Frank each own one-third of the shares in DEF, Inc. They aren’t related. The company hires Frank’s unemployed wife, Barbara, who meets the qualified new employee rules. DEF can take advantage of the Social Security exemption for Barbara’s wages between March 19 and December 31, 2010. Assume DEF also hires Doug’s unemployed son, Tom, who also meets the new employee requirements. The company can claim the Social Security exemption for him, too, because being related to minority shareholders doesn’t disqualify him.

Warning: With family businesses, the related-party rules can be tricky, as the following example illustrates.

Example: Robert owns 60 percent of the shares in Bobco, Inc. Assume Bobco hires Robert’s unemployed wife, Julia, who meets the description of a qualified new employee. Bobco can take advantage of the Social Security tax exemption.

Assume Bob’s daughter Cindy owns the other 40 percent of Bobco’s stock. If Bobco hires Cindy’s unemployed husband, Clark, he is an ineligible employee because he has a prohibited relationship (son-in-law) with Bob, who is the company’s majority shareholder. However, if Cindy was unrelated to Bob, Clark could meet the requirements because he is only related to a minority shareholder.

Related Party Rules for Partnerships and LLCs. If your business is a partnership or a multi-member LLC treated as a partnership for tax purposes, ineligible employees include relatives (defined earlier) of an individual who owns (directly or indirectly) more than a 50 percent interest in the partnership’s capital and profits.

Under this rule, the spouse of a majority partner is not an ineligible employee. This means that wages paid to a majority partner’s spouse are eligible for the Social Security exemption if the spouse fits the qualifications.

Most other new hires related to a majority partner (including in-laws) are ineligible. However, new hires who are related to minority partners (taking into account both direct and indirect ownership) can be eligible. This can include relatives who are students hired to work over the summer.

Example: Glenda, Hank, and Ingrid are unrelated one-third partners in the GHI Partnership. Assume GHI hires Glenda’s unemployed husband, Glen, who meets the new employee requirements. The company can claim the exemption for eligible wages paid to Glen.

Assume GHI also hires Hank’s unemployed daughter, Helen, who meets the qualified new employee description. The business can take advantage of the Social Security exemption for eligible wages paid to Helen, because being related to minority partners does not disqualify her.

Temporary Credit for Retaining New Hires

In addition to the temporary Social Security exemption, the HIRE Act also grants a temporary tax credit of up to $1,000 for wages paid to each qualified new employee, using the same eligibility rules. However, a business must meet two additional requirements:

The new hire must be retained for at least 52 consecutive weeks; and

Wages paid during the second 26 weeks of the 52-week period must equal at least 80 percent of wages paid during the first 26 weeks.

To be clear, your business can claim the Social Security exemption for wages paid to a new employee, and it can also claim the employee retention credit if the two additional requirements are met. Claiming one break does not exclude claiming the other.

The employee retention credit equals the lesser of 6.2 percent of wages paid to the qualified new employee during the 52-consecutive-week period or $1,000. To claim the maximum credit, the new hire must be paid at least $16,130 during the 52-week period (6.2 percent times $16,130 equals $1,000).

In contrast to the Social Security tax exemption, the amount of the retention tax break doesn’t depend on exactly when you hire someone as long as you do it by the end of the year. The full $1,000 employee retention credit can potentially be claimed for a new hire starting work any time between February 4 and December 31, 2010.

The credit is allowed for the tax year during which the 52-week requirement is first met for a worker. Since that requirement cannot possibly be met before February of 2011, the credit cannot be claimed for tax years that end in 2010. (If your business is a calendar-year taxpayer, the credit can be claimed on its 2011 return.)

The Bottom Line: If your newly hired spouse or relative fits the description of a qualified employee for the Social Security exemption, that person is also qualified for the retention credit – assuming the two additional requirements are satisfied.

The availability of the two temporary tax breaks does not make the case for hiring a family member. But they can be meaningful for business owners who were going hire a spouse or relative anyway. Finally, if you have a family business with several related owners, make sure you understand the implications of the related party disallowance rules. Consult your tax adviser if you have questions.

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BUSINESS WISDOM FOR TODAY’S ECONOMY

How to Claim the Exemption The IRS has issued the newly revised payroll tax form that most eligible employers can use to claim the payroll tax exemption that applies to eligible new workers hired this year.

Form 941, Employer’s QUARTERLY Federal Tax Return, revised for use beginning with the second calendar quarter of 2010, will be filed by most employers claiming the exemption for wages paid to qualified employees. The HIRE Act does not allow employers to claim the exemption for wages paid in the first quarter but provides for a credit in the second quarter. (Your tax pro can handle the details.)

The HIRE Act requires employers to get a signed statement from each eligible new hire certifying – under penalties of perjury – that he or she was not employed for more than 40 hours during the 60 days before beginning employment. Employers can use the new Form W-11 [60.8 KB PDF], Hiring Incentives to Restore Employment (HIRE) Act Employee Affidavit, to meet this requirement.

Employers do not file these statements with the IRS. Instead, they retain them along with other tax records.