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.

 

 

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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.

 

No Deduction Allowed for Substantial Use of RV

Jackson, Tax Court Memo. 2014-160

The taxpayer was an insurance agent who specialized in selling insurance policies specific to recreational vehicles (RVs).  To gain access to RV owners, the taxpayer was a member of several RV clubs.  The clubs held RV rallies which were primarily social events.  Only RV owners could attend these rallies.  Ownership was also required by certain RV parks, which often prohibited RV’s older than a certain age.

The taxpayer gathered sales leads at every rally.  He attached to his RV advertisement promoting his insurance business.  He invited potential customers to come to his RV and discuss the prospective client’s insurance needs.  It would often take months, if not years, for a relationship with a potential customer to develop into an actual sale.

The court stated there was no question the taxpayer used his RV for some personal purposes.  The taxpayer claimed, however, that he was entitled to deductions related to the business use of his RV.

The court acknowledged that the taxpayer actively sold insurance polocies during his time at the rallies, and that business activities conducted in using his RV generated a significant amount of revenue.  After reviewing the evidence in the record and considering the taxpayer’s testimony, the court concluded that the taxpayer spent two-thirds of his time during these rallies on business and one-third of his time for personal pleasure.  Thus, the primary use of the RV was for business, not pleasure.  However, none of the deductions for the business use was allowed because of IRC section 280A.

The Tax Court has previously ruled that an RV qualifies as a dwelling unit for purposes of the office-in-home rules under IRC section 280A.  Under the general rule, any personal use, including watching TV in the RV, makes the entire day a personal day.  IRC section 280A(c) has an exception to this general rule which allows a taxpayer to allocate costs to business use if a portion of the dwelling unit is “exclusively used” on a regular basis “as a place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his trade or business.”  The court said exclusivity is the key to this case.  The taxpayer did not use any portion of his RV exclusively for business.  Therefore, no deduction for the expenses allocated to the business use is allowed.

 

IRS Announces 2016 Standard Mileage Rates

By Gary A. Hensley, MBA, EA

IRS, in Notice 2016-1, announced the optional 2016 standard mileage rates for taxpayers to use in computing the deductible costs of operating an automobile for business, charitable, medical, or moving expense purposes.

Highlights:

Business mileage:  The standard mileage rate for transportation or travel expenses for 2016 is 54 cents per mile (compared to 57.5 cents in 2015) for all miles of business use (business standard mileage rate).

Charitable mileage:  The standard rate for 2016 is 14 cents per mile (same as 2015) for use of an automobile in rendering gratuitous services to a charitable organization.

Medical care and moving:  The standard mileage for 2016 is 19 cents per mile (compared to 23 cents in 2015) for use of an automobile for medical care or as part of a move (for which the expenses are deductible under IRC 217).

Basis Reduction Amount

For automobiles a taxpayer use for business purposes, the portion of the business standard mileage rate treated as depreciation (when sold or traded in) is 23 cents per mile for 2012, 23 cents per mile for 2013, 22 cents per mile for 2014, 24 cents per mile for 2015, and 24 cents per mile for 2016.

Remember:  A taxpayer is not required to use the standard business mileage but instead may substantiate using actual allowable expense amounts if the taxpayer maintains adequate records or other sufficient evidence.

 

Appearance at 42nd Midwest Writers Workshop

Looking forward to my repeat visit to the 42nd Midwest Writers Workshop at Ball State University in Muncie, IN to talk about the “business side of writing.”  I will be giving classroom lectures on Friday, July 24th and Saturday, July 25th.  I will also be part of a round-table discussion on Saturday morning and have several one-on-one consultation appointments.

The conference is sold out this year.  Lecture topics include “Basic Taxation for Writers” and “Are You a Professional Writer?  Don’t Wait for an IRS Audit to Find Out!”

More about the Midwest Writers Workshop at Twitter @MidwestWriters. or on the web at http://www.midwestwriters.org.

The energy and creativity at this event is awesome!

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.