Tax Court Denies Unreasonable “Wages” Paid to 10 Year-Old Child
The IRS says that the compensation paid to workers – including children of higher-ups – must be “reasonable” for the services actually rendered. Don’t stretch things too far. In a new case, the IRS disallowed a self-employed taxpayer’s ...
Dec. 09, 2016
There are some tax perks on the table for business owners and managers who employ their children. For instance, if your child is home for school during the holiday season, you might pay him or her to do odd jobs around the office. The wages are generally deductible by the business and taxable to the child at a relatively low rate.
But you can’t go overboard. The IRS says that the compensation paid to workers – including children of higher-ups – must be “reasonable” for the services actually rendered. Don’t stretch things too far. In a new case, the IRS disallowed a self-employed taxpayer’s deduction for wages purportedly paid to a pre-teen (Alexander, TC Memo 2016-214, 11/23/16) .
The facts: The taxpayer in the new case claimed a deduction for $6,315 of cash wages he allegedly paid to his 10-year-old step-son. He testified that the payments were made for work performed for a network marketing business, such as taking out the trash, vacuuming, setting up chairs and cleaning the pool.
To substantiate the payment of cash wages to his step-son, the taxpayer offered a handwritten ledger with dates and amounts that was prepared by an individual with the initials “PW” on “8-29/14,” as well as a computer printout of tasks performed by his step-son. But the Court wasn’t convinced that either the handwritten ledger or the printed timesheet was contemporaneously prepared or that the documentation provides a credible assessment of work performed by the child.
In addition, some of the tasks for which the taxpayer purportedly paid his step-son don’t appear to be “ordinary and necessary” business expenses. This includes entries for “Help with new baby Mason,” Malcolm 11 Birthday,” “Helping Kids” and “paint.” Furthermore, the taxpayer did not issue his step-son a Form 1099-MISC (Miscellaneous Income) or a Form W-2 (Wage and Tax Statement) reporting the cash wages supposedly paid in 2010.
As a result, the Tax Court could not conclude that that step-son did any jobs for the network marketing business or that the taxpayer actually paid him for this work. Deduction denied.
The case points out the benefit of formalizing work arrangements with relatives. By reporting the payment as wages to the IRS, instead of slipping a child some cash on the sly, you have a better chance of standing up to IRS scrutiny. Although the wages are taxable, a child may owe little or no tax after claiming the standard deduction. Furthermore, when a child under age 18 is employed by his or her parent in an unincorporated business, the earnings are exempt from FICA tax. This exemption also applies to FUTA tax up until age 21.
Although the age of the child was a factor in the new case, but the courts have previously approved deductions for youngsters where it could be proved that a reasonable amount was paid for actual work performed. Learn this lesson well.