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.

 

 

Tax-Saving Strategy: Sole Proprietors Should Consider Hiring Their Children

By Gary A. Hensley, MBA, EA

If you are operating your business as a sole proprietor (filing Schedule C) then you have a great opportunity to reduce your federal income tax and self-employment tax.  In most states you will also reduce your state income tax.

As a sole proprietor you include Schedule C with your federal Form 1040.  The Schedule C reports the income and expenses of your business.  The net profits from the Schedule C are included in your gross income (on page 1 of your Form 1040) and in your self-employment income on Schedule SE which is also part of your Form 1040.  The income tax is assessed based on your marginal tax rate and your self-employment tax is assessed at a rate of 15.3% on the first $118,500 in 2015 and at 2.9% on the amount above $118,500.

The law allows sole proprietors to hire their children as employees

For those children who have not reached age 18, the law does not require the 7.65% withholding and the employer-matching 7.65% of Social Security and Medicare Tax.  As a result, this is a direct 15.3% family tax savings.  The child must provide a legitimate function necessary to operate the business.  In my opinion, it’s a good idea to write out a list of the child’s duties (responsibilities) and record the days and hours he or she works.  The child must be issued a W-2 form which will report his or her federal wages for the year.  Nowadays, these children are skilled in using computers and analyzing the use of software programs and time-saving skills through the use of data entry, filing, etc.

Tax-saving strategy

In 2015, each taxpayer (including your child) has a standard deduction amount of $6,300.  Don’t confuse their standard deduction with their dependent exemption which you will still get on your return for providing over 50% of their support.

If your child is under age 18 and you pay your child $6,300 for the year, your business income will drop by this amount.  If you, as the parent, are in the 25% federal income tax bracket, this will save you $1,575 (25% X $6,300) in federal income tax and further saves you $963.90 (15.3% X $6,300) in self-employment tax.  This is a total tax savings of $2,538.90 per child.  [Note:  When your child files his or own return (and does not claim a personal exemption since they are your dependent), their wages of $6,300 will be totally offset by their $6,300 standard deduction, leaving them with no federal tax liability on their wages.]

If your child is 18 or older, you will still be allowed to deduct his or her wages of $6,300 on your Schedule C plus your half of the Social Security and Medicare Tax employer match (7.65% = $481.95).  You will need to withhold the employee 7.65% portion from your child’s paychecks.

Contact your tax professional for specific advice related to your personal situation and IRS payroll filing requirement rules.

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Gary A. Hensley is a member of the National Association of Enrolled Agents (NAEA) and can be followed on Twitter @GaryAHensley.