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.

 

 

My Second Video Credit! Mike Martin’s “More of Your Taxes Explained”

Just released today!

Mike Martin’s “More of Your Taxes EXPLAINED!” debuted today on YouTube.

Mike is also a Young Adult novelist. His book, THE END GAMES, is available at all online booksellers, including Amazon: http://dft.ba/-theendgamesmartin

This video covers “self-employment” tax issues and general information applicable to all taxpayers.

I was fortunate to be a co-writer and tax adviser for this video. Look for my name “in lights” at the end of the video (it’s even in large type).  To view it, click here.

I hope your tax preparation and filing is going well this year and that some of my blogs have been helpful.

Lower Your Taxes! Build Your Retirement!

The One-Participant 401(k) Plan

By Gary A. Hensley, MBA, EA

Small business (self-employed) owners have an incentive to establish a 401(k) plan instead of an IRA-based plan to increase their retirement savings thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Public Law No. 107-16.  This article will focus on the rules for a one-participant plan that covers a self-employed individual (filing a Schedule C as part of their Form 1040) who has no employees.[i]

EGTRRA opened up the options for small business owners by increasing the allowable percentage of elective salary deferrals to qualified plans from 25% of compensation to 100% of compensation and by changing the effect of elective salary deferrals on the overall contribution limits for qualified plans.  A one-participant 401(k) plan cannot be established if the business has any eligible employees other than the business owners and their spouses.[ii]

For self-employed individuals, compensation is defined as net earnings from self-employment after deducting 50% of the self-employment tax and the employer contribution to the plan for the self-employed individual.[iii]  Just for clarity, in the case of a Schedule C sole proprietor, you are both the employer and the employee for the purpose of figuring your maximum 401(k) contribution.

As the employer, you can make up to a 25% contribution.  As the employee, you can make elective deferrals up to $17,500.  If you are age 50 or older, the catch-up provision raises this limit to $23,000.

Maximizing Plan Contributions

Let’s review an example of how this works:  Sarah, age 48, a successful mystery writer for several years, has a net business profit, in 2013, of $70,000.

Net business profit                              $70,000

SE tax deduction[iv]                            –   4,945                                                            Adjusted net profit                                $65,055

Employer contribution:

$65,055 x 0.20[v]                                   $13,011

Employee contribution:

Salary deferral (max)                             17,500

< 50 years old

Maximum contribution                           $30,511

Amazing!  Sarah’s profit of $70,000 will be reduced by one-half of her self-employment tax, $4,945 (entered on Form 1040, page 1, line 27) and by her employer/employee 401(k) contributions of $30,511 (entered on Form 1040, page 1, line 28).  This takes her business profit of $70,000 down to $34,544– more than a 50% reduction!  Her adjusted gross income (AGI) will be $34,544 (assuming no other income) and she will have $30,511 growing tax-deferred in her retirement account.

Assuming she is single, her standard deduction and personal exemption will drop AGI down another $10,000 leaving her just $24,544 of taxable income.  Her final income tax due?  $3,235 on a $70,000 profit.  Now, for the icing on the cake. If she had been 50 years old or older, in 2013, she could have added another $5,500 to her elective deferral (using the catch-up provision), dropping her taxable income down to $19,044 and her income tax to $2,410.  Had Sarah set up a SEP IRA plan, instead of a 401(k), her allowed retirement deduction would have been limited to $13,011.

The 401(k) plan needs to be in writing and set up no later than December 31st for calendar year taxpayers; however, the employer contribution, does not have to be made until the return due date (4/15/2014) or the extended due date (10/15/2014) if you file an extension for your Form 1040.   You can set up the 401(k) plan through a bank, credit union, insurance company or a mutual fund.  The paperwork is minimal and your annual administrative fee should be quite reasonable.

Be aware that your elective salary deferral maximum for 2013 is $17,500 ($23,000 if age 50 or older) across all active plans you participate in.  So, if you work for an employer and participate in a 401(k), 403(b), or similar plan, you must subtract the contributions you made to that plan from the $17,500 ($23,000 if age 50 or older) to determine how much is left to use in your self-employed retirement plan.  The total of employer and employee contributions cannot exceed $51,000 per employee in 2013.

The one-participant 401(k) plan provides an excellent opportunity for sole proprietors (and others) to reduce their tax bill while funding their retirement.   It’s not too late to set up your plan for 2013.  Compile your income and expense amounts at the end of November to determine this year’s profit or loss.  If you have a tidy profit, consider this strategy to bring it and your tax bill down.


[i] Self-employed, under EGTRRA, has a wider meaning than reviewed here.  The term self-employed generally includes sole proprietors, partners, and members of limited liability companies (LLCs) taxed as partnerships.  A single-member LLC, that has not elected “corporate” status, is treated as a “disregarded entity” or sole proprietorship and files a Schedule C as part of their Form 1040.  Thus, this article would pertain to such single-member LLCs.

[ii] A one-participant 401(k) is also called a Solo-k, a Solo-401(k), a Uni-k, or a Single-k.  The term itself is a misnomer because the plan may cover more than one person.  Participation is limited to a married couple who own an incorporated or unincorporated business, or the partners in a business partnership and their spouses.  Benefits cannot be provided to anyone else.

[iii] Because this is a circular computation, an equation is used to determine the allowable employer contribution rate:  the stated plan contribution rate is expressed as a decimal and then divided by the total of 1 plus the stated plan contribution rate.  For example, a 25% stated contribution rate becomes 20% (0.25 / 1.25)

[iv] [$70,000 x 0.9235 x 0.153) = $9,890 x ½ = $4,945

[v] Based on a 25% employer contribution [0.25 / (1 + 0.25)]

Self-Employed Professionals and Foreign Income – Part 3

Foreign Earned Income

To claim the foreign earned income exclusion or the foreign housing deduction (only when paid from self-employed earnings), you must have foreign earned income.   Foreign earned income generally is income you receive for services you perform during a period in which you meet both of the following requirements:

  • Your tax home is in a foreign country.  (Covered in Part 1 of this series).
  • You meet either the bona fide residence test or the physical presence test.  (Covered in Part 2 of this series).

As a self-employed professional, your foreign earned income includes your professional fees earned and business profits.   The source of your earned income is the place where you perform the services for which you received the income.  Foreign earned income is income you receive while working in a foreign country.  Where and how you are paid has no effect on the “source” of the income.  For example, income you receive for work done in Austria is income from a foreign source even if the income is paid directly to your bank account in the United States.

Royalties received by a writer, author or illustrator are earned income if they are received:

  • For the transfer of property rights of the writer in the writer’s product, or
  • Under a contract to write a book or series of articles.

Such royalties are reported on Schedule C for the self-employed writer, author or illustrator.

Foreign Earned Income Exclusion

Your foreign earned income exclusion is limited to your foreign earned income minus your foreign housing deduction.  You may be able to exclude up to $95,100 in 2012 ($97,600 in 2013) of your foreign earned income.  For 2012, you cannot exclude more than the smaller of:

  • $95,100, or
  • Your foreign earned income for the tax year minus your foreign housing deduction.

EXAMPLE:  You are a self-employed professional living and working in a foreign country and meet the bona fide residence or physical presence test.  Your net earnings (profit) from self-employment (after all business expenses) shown on Schedule C is $105,000.  You are allowed to deduct your foreign housing deduction of $9,084 (see Foreign Housing Deduction Example below) from this amount leaving a balance of $95,916.  Of this amount, you would be allowed to exclude $95,100, leaving only a balance of $816 subject to income tax on your U.S. Form 1040. Your personal exemption, allowed on your U.S. Form 1040, would offset this amount.

Income tax

Income tax (Photo credit: Alan Cleaver)

Foreign Housing Deduction

As a self-employed professional, you are allowed a foreign housing deduction to the extent these expenses were paid for by your self-employment earnings.  As with the foreign income exclusion, your tax home must be in a foreign country and you qualify as a bona fide resident or meet the physical presence test.

The Floor and the Ceiling

Your housing amount is the total of your housing expenses (such as rent, utilities, property insurance, rental of furniture and accessories, and residential parking) for the year minus the base housing amount.   The computation of the base housing amount is tied to the maximum foreign earned income exclusion.  The amount is 16% of the exclusion amount (computed on a daily basis), multiplied by the number of days in your qualifying period that fall within your tax year.  For 2012, the maximum foreign earned income exclusion is $95,100 per year; 16% of this amount is $15,216 or $41.57 per day.   To figure your base housing amount if you are a calendar-year taxpayer, multiply $41.57 by the number of your qualifying days.  Subtract the result from your total housing expenses (up to the applicable limit) to find your foreign housing deduction amount.

Your qualified housing expenses are generally limited to 30% of the maximum foreign earned income exclusion (computed on a daily basis), multiplied by the number of days in your qualifying period that fall within your tax year.  For 2012, the standard ceiling would be $28,530 ($95,100 times 30%), or $77.95 per day.  If you live in a high-cost locality, you will be allowed a higher ceiling amount.  The limits for high-cost localities are listed in the instructions for Form 2555.

EXAMPLE:  Your qualifying period includes all of 2012.  During the year, you spent $24,300 for your housing.  You did not live in a high-cost locality.  Since your actual housing expenses do not exceed the standard limit ($28,530), your actual housing costs ($24,300) minus the base housing amount ($15,216), or $9,084, will be your foreign housing deduction.

The housing deduction cannot be more than your foreign earned income minus your foreign earned income exclusion.  You can carryover to the next year (and the next year only) any part of your housing deduction that is not allowed because of the limit.  Situations involving married couples (both having foreign earned income) or involving separate households in a foreign country or countries will require further computations.  This series presents the requirements and benefits for a single, self-employed person.

As a self-employed professional, you will file Form 2555 with your annual return.  You are not eligible to use Form 2555-EZ.

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In Part 4, the conclusion to this series, I will review where items are reported on your return, discuss how self-employment taxes are handled, and provide some helpful resources.  

Schedule C-EZ: Do You Qualify?

You may use Schedule C-EZ instead of Schedule C if you:

  • Had business expenses of $5,000 or less.
  • Use the cash method of accounting.  (See “Cash Basis” post).
  • Did not have an inventory at any time during the year.
  • Did not have a net loss from your business.
  • Had only one business as either a sole proprietor, qualified joint venture, or statutory employee.
  • Had no employees during the year.
  • Are not required to file Form 4562, Depreciation and Amortization, for this business.  (See the instructions for Schedule C, line 13, to see if you meet this test).
  • Did not deduct expenses for business use of your home (home office deduction).

In Schedule C-EZ, Part II, line 2, you report all your expenses for the year on this one line and they must total $5,000 or less.  There is a short worksheet at the bottom of page 2 to summarize your expenses which you keep for your records.  You must maintain your records and documents to support these deductions for at least 3 years from the due date of your return.

If you are claiming car or truck expenses on line 2, you must answer the questions in Schedule C-EZ, Part III.

Questions F and G on Schedule C-EZ ask whether you made payments that would require you to file Form 1099 and, if required, whether you filed them or not.  Read my “Form 1099” post for more information on this topic.

Writers and the Self-Employment Tax

Once your self-employment income as a writer, editor, illustrator or researcher shows a profit on Schedule C, that income will be subject to federal income tax and self-employment tax.  It is not unusual for a self-employed person, finally breaking into profitability, to avoid federal income tax due to the standard deduction and personal and dependent exemptions, and other items on their tax return. However, the self-employment tax [SECA] is not part of that computation and usually survives as a “balance due” item.

When you are self-employed, you are required to pay your own self-employment tax on your business profit because you have no employer doing this for you.  When you are an employee, working for someone else, they have historically withheld 7.65% of your gross wages from your paycheck for social security (FICA) and medicare, and they were required to match this amount with their own 7.65%.

Congress, to put more money into the ailing economy, lowered the employee percentage to 5.65% for 2011 and 2012 and lowered the self-employed rate from 15.3% to 13.3%.   As of this writing, it seems likely this will not be extended and will go back up to the historical rates on January 1, 2013.

So, as a self-employed business man or woman, you are required to pay the combined self-employment rate of 13.3% in 2012 if you have a profit of $400 or more; if your profit is $399 or less, this is not an issue for you or if you show a loss.

As I said earlier, a significant amount of sole proprietors escape the federal income tax bite in that first and second year of profitability (since it is generally a lower amount and they have other offsets) but they get surprised by the independent self-employment tax calculation and assessment which is part of the personal Form 1040 tax preparation.  For example, if your self-employment profit amounts to $2,000, your self-employment tax (by itself) would be $266 ($2,000 X 13.3%).    Just to avoid any confusion, once your profit is more than $399, all your profit is subject to the self-employment assessment.

These payments are reported to the Social Security Administration and become part of your retirement contribution to determine your retirement benefits.  The self-employment tax is computed on Form 1040 (SE) and is attached to your Form 1040 at the time of regular or e-filing along with your Schedule C and other required forms.

FICA stands for Federal Insurance Contributions Act and SECA stands for Self-Employed Contributions Act.  However, these “contributions” are mandatory.   Although you are not allowed to deduct this tax on Schedule C as a business expense, a portion of the self-employment tax is allowed on page 1 of your Form 1040 to lower your adjusted gross income and, thus, your taxable income.