Payroll in Practice: 2.21.2023

Question: An S corporation wholly owned by an individual plans to employ the owner’s child during the summer break from school. Someone told the owner that the child’s wages are not subject to FICA taxes because the child is working for the parent. Is this correct?

Answer: A child working for a parent can be exempt from Social Security and Medicare (FICA) taxes, but this exemption only applies if the child is under age 18 and is working for the parent’s sole proprietorship or partnership. It does not apply for a subchapter S corporation, which is a separate legal entity from the parents and cannot act as a parent of the child. Thus, the child is employed by the corporation rather than the child’s parents, and the exemption from FICA taxes does not apply.

The S corporation is required to withhold and pay Social Security and Medicare taxes on wages paid to the child. Payments to a child working for a corporation, including an S corporation are subject to taxes and withholding as if the child worked for an unrelated employer.

The situation is different when the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child. Such businesses are not separate entities from the parents for purposes of FICA taxes, and the child is treated as working directly for the parents and only the parents.

Payments to children younger than age 18 are not subject to Social Security or Medicare taxes for services performed for their parents in a trade or business that is a sole proprietorship or a partnership in which each partner is a parent of the child.

Payments also are not subject to Social Security and Medicare taxes when the child is younger than age 21 and performing services for the parent other than in the parent’s trade or business. An example of such services is domestic work in the parents’ private home.

For Federal Unemployment Tax Act purposes, payments to a child younger than age 21 for services performed for a parent, whether in the parent’s trade or business or in nonbusiness employment, are not subject to taxes. The exemption applies equally to children employed by individuals, sole proprietorships, and partnerships but, as with FICA, does not apply to children employed by S Corporations.

Wages for the services of a child are subject to income tax withholding and Social Security, Medicare, and FUTA taxes if the child works for a corporation, even if it is controlled by the child’s parents; a partnership, even if the child’s parent is a partner, unless each partner is a parent of the child; or an estate, even if it is the estate of a deceased parent.

Question: A company sends engineering and project teams to work on-site for projects in multiple states. Employees often work in several different states during a year. Frequently, the teams work in states where the company does not have business locations. Do the project teams create nexus and, if so, how does an employer handle multistate withholding?

Answer: These project and engineering teams are likely engaged in activities that would be considered doing business within a state. It is likely the teams are creating nexus within those states. Generally, employees working within a state, other than simply soliciting orders for tangible personal property, are considered to create nexus through a physical presence or significant economic activity by the business within the state.

Traditionally, nexus meant the physical contact between an employer and a state that allowed the state to levy taxes on the business. A company deemed to have nexus must register with the state and pay any corporate, sales, excise, and employment taxes to the state. In recent years, most states have also adopted the concept of economic nexus, particularly for sales and use taxes, under which a threshold volume or value of sales in a state creates nexus, and physical presence in the state is no longer necessary to create nexus.

From a payroll standpoint, the employer must determine the withholding requirements for the states where the employees work. If required, the employer should register to withhold tax and comply with the laws just as if the company had a physical location within that state.

Other considerations include states with no income tax and states with reciprocal agreements. In most cases, the employer will need to determine the amount of time each employee works in each state so that the employee’s tax liability can be determined for each state and the employer can determine the amount of tax to withhold for each state.

Several states require withholding state income tax from employee wages as soon as the employee starts work within the state. Other states allow a minimum threshold of time or earnings before withholding is required. The rules for when an employee becomes subject to tax on wages paid for work performed within a state also vary from state to state. The rules for when an employee becomes subject to tax may be different from the rules covering when an employer must begin withholding for the employee.

Once it is determined that an employer has nexus for a particular state, the employer is to register for withholding and reporting wages and taxes to the state. The employer should obtain state withholding certificates from the employees for the states where they are working. The earnings of the employees must be tracked for each state and appropriate taxes withheld according to each state’s requirements.

A reciprocal agreement is an agreement between two states allowing residents of either state to be taxed only by their resident state. That is, the state where the employee works will not tax employees who are residents of the other state. For example, under the agreement between Michigan and Ohio, an Ohio resident who works in Michigan is not be subject to Michigan income tax. However, as with most reciprocal agreements, the employee must provide the employer with a certificate of Ohio residency; otherwise, the employer must withhold any required Michigan tax.

The employee’s Michigan and Ohio wages are reported only to Ohio on the employee’s Form W-2, Wage and Tax Statement. However, if wages were withheld for Michigan because the employee did not provide the necessary certificate, the Michigan withholding would be reported to Michigan so the employee could claim a refund.

The concern with nexus is not so much the withholding implications, but that the company may also become subject to corporate income, franchise, or other business taxes, sales and use taxes, and apportionment issues. The company tax group should review the apportionment rules for each state and determine the numbers to use in the apportionment formulas to calculate the company’s tax obligations to each state.

This column does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., or its owners.

Author Information

Patrick Haggerty is the owner of a tax practice in Chapel Hill, North Carolina, and an enrolled agent licensed to practice before the Internal Revenue Service. The author may be contacted at phaggerty@prodigy.net.

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