Newsletter
|
Business Expenses
Children’s Wages Nondeductible
Alexander, TC Summ. Op. 2006-127
Paying wages to a child is usually a good way to reduce family’s income tax
bill, if the child’s tax rate is lower than the parents’. For a child under age
18, FICA tax is avoided too. But, wages must be reasonable for the work
performed to be deductible—and family member wages are especially scrutinized.
The Alexander case is a roadmap for “how not to do it” for taxpayers who want
to pay deductible wages to their children.
|
Facts. Mrs. Alexander (Chris) ran two businesses out of her home. She
paid her 21-year-old son $4,000 to help in her seamstress business. From her
beagle-breeding business, she paid $4,250 each to her three under-age-18
daughters.
IRS position. The IRS disallowed all of the deductions for the payments
to the children, as they were more in the nature of personal, living or family
expenses than deductible business expenses.
Court’s ruling. The Court ruled for the IRS, noting that when payments
are made to dependent children, it is “normal” to assume that they are personal
in nature. In determining whether the payments were true business expenses,
many factors weighed against the taxpayers, including:
1) There was little correlation between the payments to the children and the
time work was performed. The son was paid all year, though he only worked in
the summer. The daughters typically did not receive cash. Instead, Chris kept a
running total of each girl’s earnings. When one wanted something, Chris bought
it for her and subtracted the amount spent from her earnings. If a girl’s
running total was insufficient for a purchase, she was allowed to “go
negative”.
2) The compensation was a flat amount determined at the start of the year, when
Chris calculated an amount she could pay her son and credited each of the
daughters with $4,250 of earnings. The Court found it unlikely that each girl
earned the same amount, noting that $4,250 was the standard deduction for the
year, and concluding that the amounts were based on something other than work
performed.
3) Chris couldn’t produce evidence that she kept records of the hours worked
and amounts earned. Although she did produce a summary with hours for the
children’s tasks, it was unclear when the summaries were created.
4) Chris didn’t file any payroll tax returns or give the children a Form W-2.
5) Many of the tasks performed (such as vacuuming, shopping with Chris, mowing,
cleaning and taking out trash) were routine family chores.
Conclusion. It’s always up to a taxpayer to prove a deduction. For
payments to family members, it’s especially important to ensure the basic
business practices (e.g., filing payroll returns and basing pay on work
performed, not on a relationship to the employer) are followed. Chris seemed to
make no effort to make the payments to her children appear to be anything other
than normal support, which isn’t deductible.
|
|