Family-owned businesses make up a significant portion of the U.S. economy, but tax rules can get more complicated when relatives work together. Understanding how the IRS treats family wages, ownership transfers, and succession planning can help you reduce your tax burden and avoid common mistakes.
Taxes apply differently depending on your business entity
Your business structure determines how you can hire family members and how their wages are taxed. Schedule C businesses, which include sole proprietorships, husband-wife partnerships, or LLCs treated as sole proprietorships for tax purposes, have unique advantages.
For instance, children under the age of 18 who work for the business are exempt from Social Security, Medicare, and unemployment taxes on their wages. But they are still subject to federal income tax withholding.
These exemptions don’t apply to corporations and partnerships with non-spouse partners. In those cases, a child’s earnings are subject to FICA and unemployment taxes just like any other employee.
How to structure compensation for family members
Paying family members requires the same documentation and practices you’d use with nonfamily employees.
- Pay market-rate wages: Underpaying or overpaying relatives can trigger IRS scrutiny. Compensation should reflect actual duties and industry norms.
- Document hours and responsibilities: Maintain timesheets, job descriptions, and payroll records for each family member.
- Use standard payroll processes: Even when tax exemptions apply, wages must be properly recorded through payroll with required withholding.
- Pay children for real work only: To claim FICA exemptions, children must perform legitimate, age-appropriate tasks.
Take advantage of the standard deduction
The higher standard deduction can significantly benefit children who work in a family business. A child can earn up to the standard deduction amount each year without owing federal income tax, assuming they don’t have substantial income from other sources.
For the 2025 tax year, the standard deduction is $15,750 for single filers, which applies to most working minors. The deduction is scheduled to increase again in 2026 due to inflation adjustments.
For example, if your child earns $12,000 working part-time in your business, the standard deduction shelters their entire income from federal income taxes. This allows them to save money or contribute to a Roth IRA without reducing their take-home pay.
Protect your business and family from a potential IRS audit
Even though IRS audits are rare, you can protect your business and your family from a potential audit by maintaining accurate and thorough business records. Here are some tips to help your family business avoid a tax audit:
- Don’t use rounded numbers in your tax returns since this can indicate a lack of accuracy.
- If your business hires independent contractors, make sure they’re qualified for that status. If they’re not, the IRS can classify them as employees, resulting in back payments on payroll taxes.
- Review any deductions for home offices, meals, travel, and charitable contributions to ensure they fit within the current IRS standards.
- Work with a tax professional or CPA to ensure that your tax returns are neat, organized, and filed on time.
- Make sure you’re paying family members a reasonable wage since compensating them below market value is an audit trigger.
Even when tax exemptions apply, wages must be properly recorded through payroll with required withholding.
Understanding gift taxes in family businesses
Giving a family member cash, business shares, or real estate may be considered a gift. The IRS allows a lifetime gift and estate tax exemption of $13.99 million per person in 2025 (or $27.98 million for married couples). Gifts below this amount generally avoid gift tax, though you may still need to file a gift tax return.
Many business owners gift shares over multiple years to gradually transfer control. A tax professional can help you determine the right timing and structure.
Tax-smart ways to pass down ownership
Transferring ownership strategically can significantly reduce your family’s long-term tax liability.
- Use the annual gift tax exclusion: You can gift up to $19,000 per recipient in 2025 without affecting your lifetime exemption.
- Leverage valuation discounts: Shares with limited control or marketability may qualify for lower valuations, helping you transfer more ownership tax-efficiently.
- Transfer ownership gradually: Spreading gifts over many years helps avoid large taxable transfers and supports a smoother leadership transition.
- Get a business appraisal: A qualified appraiser can determine fair market value and help substantiate valuations with the IRS.
Using trusts and estate planning in family businesses
Trusts can help families retain control of a business, avoid probate, and reduce long-term estate taxes. A revocable trust allows the owner to maintain control of the business while streamlining future transfers, while an irrevocable trust can remove assets from the owner’s taxable estate and offer added creditor protection.
Some families also use specialized structures to transfer appreciating business interests more tax efficiently. However, it’s important to work with attorneys, accountants, and financial advisors who can coordinate your estate strategy with the business’s long-term goals.
Creating a succession plan with tax implications in mind
Succession planning is one of the biggest challenges family businesses face. Planning early gives your family time to discuss long-term goals, outline leadership roles, and transfer ownership gradually in a tax-efficient way.
Work with legal and tax professionals to build a succession plan that reflects your business structure, family dynamics, and financial goals. A clear plan helps preserve your business’s future and ensures a smooth transition to the next generation.
Emily Heaslip and Kaytlyn Smith also contributed to this article.
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