Wages Paid to Children

Recent Tax Court Summary Opinion; Fisher 2016-10

Business deductions are allowed under Internal Revenue Code (IRC) section 162(a) when they are ordinary and necessary expenses paid or incurred in carrying on a trade or business.  The determination of whether expenditures satisfy the requirements for deductibility depends on the facts and circumstances.  Wages paid to compensate employees for personal services rendered are generally deductible. The IRC does not define an age an individual must be in order to qualify as an employee.  Courts generally look to three factors when determining whether or not wages are deductible:

  1. The wage paid is a reasonable amount,
  2. The wage is based on services actually rendered, and
  3. The wage is paid or incurred.

A recent court case illustrates the factors used by the courts when determining the deductibility of wages paid to minor children.

The taxpayer was a sole proprietor who worked as an attorney.  She had three children, all of whom were under nine years old as of the close of the tax years in question.  During summer school recesses, the taxpayer often brought her children into her office, usually for two hours a day, two or three days a week.

While at the taxpayer’s office, the children provided various services to her in connection with her law practice.  For example, the children shredded waste, mailed things, answered telephones, photocopied documents, greeted clients, and escorted clients to the office library or other waiting areas in the office complex.  The children also helped the taxpayer move files from a flooded basement, they helped remove files damaged in a bathroom flood, and they helped to move the taxpayer’s office to a different location.

The taxpayer did not issue a Form W-2 to any of her children for the years at issue.  No payroll records regarding their employment were kept, and no federal tax withholding payments were made from any amounts that might have been paid to any of the children.

In court, the taxpayer claimed that wages paid to her minor children should be deductible because they provided various services to her in connection with her law practice.  The IRS claimed the taxpayer did not establish that the wages were actually paid or that any payment that was made was a payment for an ordinary and necessary business expense.

The taxpayer did not present any evidence to show how much was paid to each child, how many hours each worked, or what the hourly rate of pay was.  Without payroll records detailing this information, the court cannot tell whether the amounts deducted were reasonable, especially when the ages of the children are taken into account. The taxpayer did not present any documentary evidence, such as bank statements, canceled checks, records, or the filing of W-2’s, to support the deductions.

The court said all things considered, the taxpayer had failed to establish entitlement to the deductions for wages to minor children claimed on Schedule C.    However, the court said it was satisfied that each child performed services in connection with the taxpayer’s law practice during each year at issue and each was compensated for doing so. Taking into account their ages, generalized descriptions of their duties, generalized statements as to the time each spent in the office, and the lack of records, the court ruled the taxpayer was entitled to a limited $250 deduction for wages paid to each child for each year.

Author’s comment and bulletproof recommendation:

This is a valuable sole proprietor deduction for hiring the taxpayer’s children and allowed when proper documentation is contemporaneously compiled.  To nail this down, do the following:

  • Set a reasonable wage based on the age of the child and actual duties performed (one example; our young people have tremendous computer and social networking skills these days)..
  • Make checks out to the child for the work performed.
  • Keep date and time sheets of all work performed and describe the work performed on that date and time.
  • Prepare a W-2 for each child (and file the Form 941 payroll return).

A Win-Win Tax Strategy:

By paying your child (children), you get a wage deduction on your Schedule C to lower your taxable income and your self-employment taxes.  You retain the dependency exemption for your child (children) on your personal tax return ($6,300 in 2015) as long as you still provide over 50% of the child’s support (highly likely even with the wages they earn from you).  The optimal strategy would be to pay your child up to the standard deduction ($6,300 in 2015).  Your child will file his\her own tax return to report the W-2 wages and  he/she will not claim a personal exemption on his/her return (since you are claiming them as a dependent) but they are allowed to subtract their standard deduction ($6,300 in 2015) meaning they will pay no income tax on their wages.  For dependents, the standard deduction is the greater of $1,050 or earned income (W-2 wages) plus $350, up to the regular standard deduction ($6,300 in 2015).

Let’s say you pay your child $6,300 and he/she puts $3,000 of that in a Roth retirement account. The earnings will compound annually tax-free over the next 50+ years!  This still leaves your child a good wage to buy things he/she wants and needs.

Consult your tax professional (preferably a CPA or enrolled agent) for complete details and proper recordkeeping.

 

 

Dependent Care Exclusion for Sole Proprietors on Schedule C

MWW15lecture

Lecture at MidWest Writers Workshop

Question:  Can a sole proprietor deduct child and dependent care expenses directly on Schedule C as part of a dependent care benefit plan, rather than claim the dependent care credit on line 49 of Form 1040?

Answer:

Under a qualified dependent care benefit plan, an employer can exclude or deduct the following dependent care benefits:

  1. Amounts the employer paid directly to either the employee or the care provider for the care of the taxpayer’s qualifying person while the employee is at work.
  2. The fair market value of care in a daycare facility provided or sponsored by the taxpayer’s employer, and
  3. Pre-tax contributions the taxpayer made under a dependent care flexible spending arrangement.

The amount that can be deducted or excluded is limited to the smallest of:

  1. The total amount of dependent care benefits the taxpayer received during the year,
  2. The total amount of qualified expenses the taxpayer incurred during the year,
  3. The taxpayer’s earned income,
  4. The spouse’s earned income, or
  5. $5,000 ($2,500 if married filing separately).

An employee’s salary may have been reduced to pay for these benefits.  However, IRS Pub. 503 makes the statement that if the taxpayer is self-employed and receives benefits from a qualified dependent care benefit plan, then the self-employed individual (sole proprietor or general partner in a partnership) is both the employer and the employee.  In this case, the self-employed individual would not get an exclusion from wages.  Instead, the taxpayer would get a deduction on Form 1040, Schedule C, line 14.  To claim the deduction, the self-employed individual uses Form 2441 to support the Schedule C deduction.

Why is this significant?   Deductions taken on Schedule C directly not only lower your taxable income (and federal income tax) and your self-employment tax.

Caution:  If your Schedule C shows a loss before your dependent care exclusion, and Schedule C is your only source of earned income (in other words, you do not have wages from another employer-employee activity), the  dependent care exclusion will not be allowed when you complete Form 2441   If you are married, your spouse’s earned income, if lower than your dependent care exclusion, would also lower the deduction available.  Also, if you have other employees (not subcontractors) that work for you in your sole proprietorship (other than your spouse or dependent), you may not exclude them from your plan.  Get advice on this from your tax preparer, preferably a CPA or enrolled agent.

Since IRS Pub. 503 and the instructions to Form 2441 implicitly give a self-employed individual permission to deduct his or her expenses directly on Schedule C rather than take the credit on line 49 on the Form 1040, with no mention of the anti-discrimination and the 25% rules, there are those who claim a sole proprietor with no employees can take the deduction.

Cross references:

  • IRS Pub. 503, Child and Dependent Care Expenses
  • Form 2441, Child and Dependent Care Expenses
  • IRC Sec. 129

 

 

 

Flex Plan Tax Break for Child Care Costs

You can still claim the dependent care credit to the extent your expenses are more than the amount you pay through your flexible spending account.

The maximum amount of dependent care costs you can fund through a flexible spending account (FSA) is $5,000.  But the credit applies to as much as $6,000 of expenses for filers with two or more kids under age 13.

In that case, you’d run the first $5,000 of dependent care costs through the FSA, and the next $1,000 would be eligible for the credit on Form 2441.  For most filers in this situation, taking the credit will save an extra $200 in taxes.

 

First Year Tax Break for College Grads

College graduates lucky enough to be starting a full-time position, take note:  Use part-year withholding to hike take-home pay by having less tax withheld.

The standard federal withholding tables assume you are working for the full year when figuring how much income tax to take out.  The part-year method sets withholding according to what you’ll actually earn during the portion of the year that you work.  Employees working less than 245 days in a year can ask firms to use this method.

Sole Proprietors: Hire Your Spouse and Deduct Your Healthcare Expenses on Schedule C

Reduce Income Tax and Self-Employment Tax with a Health Reimbursement Arrangement (HRA)

A health reimbursement arrangement (HRA) is solely funded by an employer for the benefit of its employees.  Employees are reimbursed by the employer tax free  for qualified medical expenses up to a maximum dollar amount for a coverage period.

Qualified medical expenses are those specified in the plan that would generally qualify for the medical and dental expense deduction on Form 1040, Schedule A.  Qualified medical expenses include amounts paid for health insurance premiums, amounts paid for long-term care coverage, and deductible/copays that are not otherwise covered by a health insurance plan.

Sole Proprietor with Employee Spouse Strategy

Example:  John is a sole proprietor with this wife, Marsha, as his only employee.  John provides his one employee an HRA that will reimburse up to $9,000 of medical expenses per year.  Marsha uses the $9,000 to pay for health insurance premiums for a policy that she purchases, plus deductibles and copays not covered by her insurance policy.  Marsha purchases a family policy that also covers John as her spouse.  Thus, the $9,000 is 100% deductible by John as a business expense on Schedule C and 100% excludable by Marsha as an employee benefit.

Market Reform Rules

All employee group health plans are subject to the Market Reform rules under the Health Care Reform Act of 2010.  HRAs are generally considered to be group health plans and thus subject to the Market Reform rules.  However, the Market Reform rules do not apply to a plan that has only one participant who is a current employee on the first day of the plan year.  Also, the Market Reform rules do not apply to plans in relation to a provision of reimbursing only excepted benefits, such as accident-only coverage, disability income, certain limited-scope dental and vision benefits, certain long-term care benefits, and certain health FSAs [IRS Notice 2013-54].

Caution

Since Marsha is John’s only employee, the Market Reform rules do not apply to John’s HRA plan.  If John were to hire more employees, John would need to purchase health insurance for each employee and integrate his HRA with other coverage in order for his HRA to meet the Market Reform rules.

Excise Tax

Under the Health Plan Reform Act of 2010, there is established a new Patient-Centered Outcomes Research Trust Fund (PCORTF) designed to carry out provisions relating to comparative effectiveness research.  This trust fund is funded by a fee imposed on specified health insurance providers.  The fee for plan years ending on or after October 1, 2014 and before October 1, 2015, is $2.08 multiplied by the average number of lives covered under the health plan.  The fee is paid as an excise tax by filing Form 720, Quarterly Federal Excise Tax Return, for the quarter covering April, May, and June with a due date of July 31.

In my example above, with John and Marsha, John must pay the excise tax of $2.08 for his one employee (Marsha) covered under his HRA by filing the second quarter Form 720 by July 31 each year.

Recommendation

Retain a competent adviser in benefits administration to assist you in properly setting up your plan and to monitor its compliance.  Also, discuss this strategy with your professional tax consultant before you implement it.

 

 

Shareholder-Employee “Reasonable Compensation” in a S-Corporation

Some writers, publishers, illustrators and many other small business owners have been advised (or otherwise selected on their own) to operate as a Subchapter S corporation under the Internal Revenue Code.  The S-corporation provides the same limited liability of a “C” corporation; however,  the S pays no tax at the corporate level.  The income or losses are “passed through” directly to the shareholders (via a 1120S K-1 form) who place these numbers on their personal Form 1040.

In selecting S returns for IRS audit, one of the major issues in being selected is the lack of “reasonable compensation” paid to the shareholder-employee (in the case of a one-owner S corporation) or to all shareholder-employees in relationship to the personal services they provided to the corporation during the corporate year.  To further compound this problem, shareholder-employees may be advised (or just think it’s a “cool idea”) to just take cash withdrawals in lieu of a salary (to avoid payroll taxes and payroll recordkeeping).

There are several tricky and sticky areas in handling S corporation transactions; for example, how to handle fringe benefits paid to shareholder-employees or shareholders taking “distributions of cash or other property” in excess of their basis of ownership in the business.  I hope to deal with those issues in future pieces.  This piece will focus on the requirement that reasonable compensation be paid to shareholder-employees.

Reasonable Compensation

Payment for services.  S corporations must pay reasonable compensation to a shareholder-employee (issue a W-2) in return for services that the employee provides to the corporation before non-wage distributions may be made to him or her.

Source of gross receipts.  Three major sources of an S corporation’s gross receipts are:

  • Services of the shareholder;
  • Services of non-shareholder employees; or
  • Capital and equipment.

If most of the gross receipts and profits are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation.  Additionally, the shareholder-employee should be compensated for administrative work performed for the other income producing employees or assets.

Reasonable Compensation in the Courts

Several court cases support the authority of the IRS to reclassify other forms of payments to shareholder-employees as wages subject to employment taxes:

IRS Position:  Authority to reclassify

  • Glass Block Unlimited, T.C. Memo 2013-180
  • Joly, 6th Cir., March 20, 2000

IRS Position:  Reinforce employment status of shareholders

  • Joseph M. Gray Public Accountant, P.C., 119 T.C. No. 121
  • Veterinary Surgical Consultants, P.C., 117 T.C. No. 141

IRS Position:  Reasonable reimbursement for services performed

  • David E. Watson, P.C., 8th Cir., February 21, 2012
  • Sean McAlary Ltd. Inc., T.C. Summary 2013-62

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Many S corporations are set up for the primary purpose of avoiding payroll taxes on wages to shareholders.  This approach does not comply with tax law.  A recent study identified the highest noncompliance issue in S corporations as being incorrect wages paid to shareholders.  The growing number of S corporations and the fact that most of them are held by three or fewer shareholders makes this area a prime target for IRS audits. (Treasury Inspector General for Tax Administration Ref. No. 2012-30-062).

Factors Considered in Finding Reasonable Wages

The following factors are often cited in court cases in relation to determining reasonable wages for a S corporation shareholder:

  • Training and experience,
  • Duties and responsibilities.
  • Time and effort devoted to the business,
  • Dividend history,
  • Payments to non-shareholder employees,
  • Timing and manner of paying bonuses to key people,
  • What comparable businesses pay to key people,
  • Compensation agreements, and
  • Usage of a formula to determine compensation.

Salary Comparison Research Tools

One research tool to help determine a reasonable salary is http://www.salary.com.  Use the Salary Wizard to determine what others make in a particular line of work in a particular area.  Comparable wage information specifically for S corporations can also be obtained here.

One Final Note:  You Cannot “Assign” Outside Income to your S-corp

An S corporation does not preclude taxation of income to the service provider (the individual shareholder) instead of the corporation.  Income is taxable to the one who earns it.

Court case:

The taxpayer and his wife each owned separate S corporations under which they ran a tax preparation business and realtor business, respectively.  Each taxpayer assigned payments received for their services to their respective corporations.  Neither corporation paid either taxpayer wages for their services.  Since there was not an employer-employee relationship, nor any contract between the corporation and the taxpayer giving the corporation the right to instruct or control the taxpayer’s actions, the court upheld the IRS’ position that the S corporations themselves did not earn the income.  Rather, the taxpayers personally earned the income outside the corporation and, thus, were subject to self-employment tax (treating each taxpayer as a sole proprietor). [Arnold, T.C. Memo 2007-168]

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I hope this piece will prove to be helpful to you and your tax and financial consultants.  To receive an automatic email alert when future pieces post, sign up for email at the bottom right of my home page at http://www.taxsolutionsforwriters.com.

 

Who Pays Taxes (and who doesn’t)?

The top 1% of individual filers paid 37.8% of all federal income taxes in 2013, the most recent year IRS has analyzed.  That’s down from 38.1% the previous year.  This group reported 19% of total adjusted gross income.  Filers need adjusted gross income of at least $428,713 to earn their way into the top 1% category.

The highest 5% paid 58.6% of total income tax and accounted for 34.4% of all adjusted gross income.  They each had adjusted gross income of at least $179,760.

The top 10% of filers, those with adjusted gross incomes of $127,695 or more, bore 69.8% of the income tax burden while bringing in slightly less than 46% of individuals’ total adjusted gross income.

The bottom 50% of filers paid 2.8% of the total federal income tax take.