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.

 

 

No Office-in-Home for Motor Home

Dunford, Tax Court Memo, 2013-189

A married couple lived in Illinois.  For 2005 and 2006, the tax years at issue, they filed a joint tax return with a Schedule C consulting business.  Most of the work was performed away from the taxpayer’s home in Illinois, sometimes working at or near client’s business locations.

For 2005, the taxpayers were away from home for half the year (the colder months), and for 2006, they were away the entire year.  During these periods, they traveled and stayed in their motor home.  The motor home had a sleeping area, a bathroom, and a kitchenette with a countertop.  Across the vehicle from the kitchen counter was a second countertop that was used as a desk, and on which the taxpayer had a computer and office supplies.

Throughout 2005 and 2006, the taxpayers traveled all across the U.S., but most of their travel time they were in Florida, California, and Nevada. The taxpayer’s three children also lived in Florida, Nevada and Quincy, Illinois, locations where the taxpayers spent significant time.  They kept no contemporaneous log that showed the business character of their travel. A reconstructed log of their travel that was entered into evidence in court often contradicted the documentary evidence of their whereabouts.  They had blended purposes, personal and business, for their travel, but their dominant motive for their travel plans was personal (the pleasure of being in the locations they chose and of being near their children).  Their clients reimbursed most of their travel expenses for airline, auto rental, standard mileage rate, per diem, meals, and office-related expenses.

The reimbursements included nearly all of the mileage they recorded in their activity log.  All of these reimbursements were deducted as travel expenses or meal expenses on Schedule C.  During the audit, the IRS did not dispute the deductibility of reimbursed expenses that the taxpayer’s had billed to their clients.  The disallowed deductions were for non-billed expenses.

Included in the expenses disallowed by the IRS were vehicle expenses including repairs and maintenance, depreciation, insurance, tax and licenses, and utilities.  These travel-related expenses were disallowed for at least one of the following reasons:

  •  The taxpayers used the motor home as a residence during 2005 and 2006, so IRC section 280A disallows the deductions.
  • The taxpayers had already claimed and been allowed deductions for their business use of their motor home and other vehicles based on the standard mileage rate, so that deductions for actual costs would be duplicative, and
  • The taxpayers failed to adequately substantiate their entitlement to many of their vehicle-related deductions.

IRC section 280A states that no deduction is allowed with respect to the use of a dwelling unit which is used by the taxpayer during the tax year as a residence, unless the business use of home exception is met.  IRC section 280A(c)(1) allows a deduction “to the extent such item is allocable to a portion of the dwelling unit which is exclusively used on a regular basis” for business.  The taxpayers did not prove that there was an identifiable portion of their motor home that was used exclusively for business purposes. The area they seemed to put forward as the home office was the countertop that was used as a desk.  But they did not make any showing of the percentage of the vehicle that constituted this area (it would be a very small percentage), and it is implausbile to suggest that, in the cramped quarters of a motor home, an unclosed area like the countertop would somehow be exclusively reserved to business activity.  Accordingly, the court ruled all deductions (other than deductions for interest expenses on Schedule A) claimed with respect to the use of their motor home were disallowed.

Actual expenses for the use of their motor home were also disallowed on the grounds that many would be duplicative to the standard mileage rate deduction that the IRS had already allowed based on the taxpayers billing their clients for reimbursement of travel expenses.  Actual expenses for the use of their motor home were also disallowed on the grounds that they failed to provide adequate substantiation for these travel costs.  A motor home is considered listed property, and deductions for business use of listed property require a higher level of substantiation than the taxpayrs provided.

 

 

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.

Warning! Form 1099-MISC and Payments to LLCs

By Gary A. Hensley, MBA, EA

Most of you are aware that you need to issue a Form 1099-MISC to independent contractors you paid $600 or more for services (not goods) during 2014 no later than February 2, 2015 (also you send a copy to the IRS by March 2, 2015).  The payments reported cover only those payments made in the course of your trade or business.

Many entrepreneurs believe (incorrectly) that if a vendor has LLC or L.L.C. after their company name (meaning limited liability company) that no Form 1099-MISC is required to be sent.  Compounding this belief?  The member(s) of many LLCs will tell those that they have rendered services to that it isn’t necessary or required to send them a Form 1099-MISC.  The requirement to file Form 1099-MISC is the government’s attempt to reduce the multi-billion underground (untaxed) economy.  Thus, if you are required to file a Form 1099-MISC and do not, a penalty will be assessed for each form not filed.  The penalty for not filing or filing late depends on the extent of tardiness.

A LLC can fall into three different categories:  (1) a single-member LLC which is a sole proprietorship (filing Schedule C as part of the individual’s personal Form 1040); (2) two or more members organized as a partnership LLC (filing Form 1065); and (3) one or more members filing as a corporate LLC (either a “C” corporation or a “S” corporation, filing Form 1120 or Form 1120-S, respectively).  Categories (1) and (2) should always be sent a Form 1099-MISC if they provided $600 or more in services to you in 2014.  With very few exceptions, you are not required to send Form 1099-MISC to category (3) organizations.  Most LLCs choose to be taxed as sole proprietors (commonly referred to as a “disregarded entity” in tax-speak) and partnerships.  When in doubt, send a Form 1099-MISC to all vendors you paid $600 or more for services in 2014.  There is no down side in doing so.

One exception that will be relevant to writers, literary agents and publishers:  Any amount you pay in royalties of $10 or more, in the course of your trade or business, requires you to send a Form 1099-MISC.  [Please refer to my article on properly reporting royalties.]

The following steps will help you nail down your compliance in this area:

  1.  Review all your payments for services to each vendor during 2014 and determine who received $600 or more in payments from you.
  2. Review your vendor records to determine if you have the complete name and address for those identified in step 1 above and also that you either have the vendor’s Social Security Number (SSN) or Employer Identification Number (EIN).  If you are lacking any of these critical items, you will need to mail a Form W-9 to the vendor requesting this information.  Keep a copy of the W-9 in your vendor file documenting your attempt to get the needed information along with the date you mailed it.  A USPS Certificate of Mailing is an inexpensive way to show proof of mailing.  In the future, obtain the W-9 information at the time you retain the vendor.  If the vendor refuses to furnish the information or sign the form—buyer beware!
  3. Next, you will use the official IRS Form 1099-MISC for each vendor.  The form is in triplicate with the top copy (shaded in red) going to the IRS and the other two copies going to the vendor and your vendor file.
  4. Finally, you will summarize your Form 1099-MISC information on IRS Form 1096 which you can mail to the IRS or file electronically along with the red copy(ies) of Form 1099-MISC.

You may wish to engage a local accountant or payroll processing specialist to help you with steps 3 and 4.

For additional IRS information on this topic, you may refer to IRS Form 1099 at the IRS website—www.irs.gov.

I hope this article will clarify your reporting requirements and further audit-proof your returns.