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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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.

 

Five Key Tax Tips about Tax Withholding and Estimated Tax

If you are an employee, you usually will have taxes withheld from your pay. If you don’t have taxes withheld, or you don’t have enough tax withheld, then you may need to make estimated tax payments. If you are self-employed you normally have to pay your taxes this way. Here are five tips about making estimated taxes:
1. When the tax applies. You should pay estimated taxes in 2015 if you expect to owe $1,000 or more when you file your federal tax return next year. Special rules apply to farmers and fishermen.
2. How to figure the tax. Estimate the amount of income you expect to receive for the year. Also make sure that you take into account any tax deductions and credits that you will be eligible to claim. Use Form 1040-ES, Estimated Tax for Individuals, to figure and pay your estimated tax.
3. When to make payments. You normally make estimated tax payments four times a year. The dates that apply to most people are April 15, June 15 and Sept. 15 in 2015, and Jan. 15, 2016.
4. When to change tax payments or withholding. Life changes, such as a change in marital status or the birth of a child can affect your taxes. When these changes happen, you may need to revise your estimated tax payments during the year. If you are an employee, you may need to change the amount of tax withheld from your pay. If so, give your employer a new Form W–4, Employee’s Withholding Allowance Certificate. You can use the IRS Withholding Calculator tool help you fill out the form.
5. How to pay estimated tax. Pay online using IRS Direct Pay. Direct Pay is a secure service to pay your individual tax bill or to pay your estimated tax directly from your checking or savings account at no cost to you. You have other ways that you can pay online, by phone or by mail. Visit IRS.gov/payments for easy and secure ways to pay your tax. If you pay by mail, use the payment vouchers that come with Form 1040-ES.

Additional IRS Resources:
Publication 505, Tax Withholding and Estimated Tax
Estimated Tax – frequently asked Q & As
Tax Topic 306 – Penalty for Underpayment of Estimated Tax

Substantiating Your Business Expenses Is Critical to Keeping Them

By Gary A. Hensley, MBA, EA

By and large, the rules are straightforward:  the burden of substantiating the “income” of a taxpayer falls on the Internal Revenue Service (IRS) and the burden of substantiating expenses (or deductions) falls totally on the taxpayer.

The position of the IRS and their field revenue agents has been and will be inadequate or no expense documentation/substantiation equals no deduction.  The next recourse for the taxpayer is to go to IRS Appeals and argue that the revenue generated couldn’t have taken place without incurring “some” associated expenses (the Cohan Rule).  The results at the Appeals level varies widely in each case and, generally, the best case scenario is an allowance of “some” of the deductions claimed.  The expense of going to Appeals can more than offset whatever expenses are allowed by the appeals officer (especially if you retain professional representation).

Recent Court Decisions

Under Internal Revenue Code (IRC) section 274(d), for certain expenses, taxpayers are required to be able to provide specific detailed information to substantiate the expenses.

As demonstrated In the recent case of Garza, T.C. Memo. 2014-121, the result boiled down to an all-or-nothing proposition.  Without proper substantiation, no deduction is allowed for a Sec. 274(d) expense, even if the court believes that a legitimate expenditure was made.

Sec. 274(d) identifies four classes of expenses for which specific substantiation is required:

  • Sec. 274(d)(1) for travel expenses (including meals and lodging while away from home);
  • Sec. 274(d)(2) for any item with respect to an activity that is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connection with such an activity;
  • Sec. 274(d)(3) for business gifts (which are limited to $25); and
  • Sec. 274(d)(4) for expenses with respect to any listed property (as defined in Sec. 280F(d)(4)).

In Garza, the court said that “while we believe that petitioner had business travel expenses in relation to his employment, the Court must heed the strict substantiation requirements of section 274(d).”  To support its ruling, the court cited DeLima, T.C. Memo. 2012-291, in which the Tax Court indicated that it had no doubt that the taxpayer used a vehicle for business purposes, but it was bound to deny the vehicle expense deduction because she failed to follow the requirements of Sec. 274(d) and the regulations.

Substantiation Required

Sec. 274(d)(4) requires the taxpayer to substantiate “by adequate records or by sufficient evidence corroborating the taxpayer’s own statement”:

  • The amount of the expense or other item;
  • The time and place of the travel, entertainment, amusement, recreation, or use of the facility or property, or the date and description of the gift;
  • The business purpose of the expense or other item; and
  • The business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift.

In light of the above requirements, the message from the above paragraph is that “a taxpayer’s own statement” by itself is not sufficient in the IRS’s consideration of whether to allow a deduction.  As Garza and other cases show, the IRS and the courts look for contemporaneous records with the details listed above and, without it, they may disallow the deduction.

Taxpayers and their tax advisers need to understand what type of substantiation is required to take a deduction (with a solid foundation) on a tax return.

 

 

 

Mid-Year Tax Planning – 2014

Tax Season 2014 has come and gone and now it’s time to think about tax planning for tax year 2014. Items which could impact your 2014 taxes include certain life events and expired tax provisions.

Certain Life Events

Have you recently had a birth, adoption or death in your family? Have you gotten married, divorced, retired, or changed jobs this year? If so, you and your tax professional need to discuss the potential impact on your 2014 taxes. For example:

1) For Qualifying Children under the age of 17, a tax credit up to $1,000 per qualifying child may be allowed (which may be refundable.)
2) If you have retired (or are planning on retiring), you need to analyze how your change in income resulting from receiving IRA or pension distributions, and/or Social Security benefits will impact your tax liability.
3) A divorce or marriage could impact your tax situation in multiple ways (for example, alimony paid or received, deductions for mortgage interest and real estate taxes on your home, QDROs (qualified domestic relations orders) and potential changes in the standard deduction and personal exemptions allowed.)

Expiring Tax Provisions
Given the current political climate, it is not known if or when an agreement on extending the Expiring Tax Provisions (“extenders”) may be reached. These extenders have made tax planning a challenge for both taxpayers and tax professionals. Therefore, if any of these provisions impact you, it is important that you contact your tax professional or personally monitor legislative activity so that you are aware of the possible tax consequences:

1) Sales Tax Deduction: Prior to 01/01/2014, taxpayers may have been eligible to deduct state and local general sales taxes instead of state and local income taxes as an itemized deduction on Schedule A. This included the sales tax paid on the purchase of a vehicle. This deduction is no longer available to individuals.
2)Mortgage Insurance Premiums: Prior to 01/01/2014, taxpayers may have been eligible to deduct the amounts paid for qualified mortgage insurance premiums along with their mortgage interest (subject to adjusted gross income limitations). Effective 01/01/2014, no deduction is allowed for these premiums paid or accrued after this date.
3)Tax-free Distributions from Individual Retirement Plans for Charitable Purposes: Prior to 01/01/2014, taxpayers over 70 ½ may have been eligible to exclude from their gross income distributions up to $100,000 from their IRA to a qualified charitable organization. This permitted taxpayers to satisfy their Required Minimum Distribution (RMD) and not include the amount in their income. As this reduced their Adjusted Gross Income (AGI), which favorably impacted the taxable amount of Social Security benefits received, this was a large tax advantage for taxpayers. This special distribution provision is not available for distributions after 2013.
4) Qualified Principal Residence Debt Exclusion: Prior to 01/01/2014, the discharge of principal residence debt (qualified mortgage on a taxpayer’s main home incurred to buy, build or substantially improve his or her main home) was generally excluded from gross income. As many taxpayers are still experiencing financial difficulties resulting in foreclosures, short sales or debt forgiveness on their primary residence, the tax ramifications for 2014 will have major tax consequences.

Other Steps to Consider Before the End of the Year

You should thoroughly review your situation before year-end to determine the best tax strategies for 2014 and the impact on 2015 as well. Accelerating income/deferring deductions into 2014 or deferring income/accelerating deductions to 2015 are just a couple of approaches that could benefit you.

If you have any foreign assets, be aware that there are reporting and filing requirements for those assets. Noncompliance carries stiff penalties.