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Taxpayer Fails to Prove Compensation Deduction

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It may often be a good idea for a small business owner to have children and other relatives on the company payroll. However, a new Tax Court case put a spotlight on what truly qualifies for the tax deductibility of compensation to that employed relative, and what does not.

Jul 15th 2022
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Certainly, small business clients may know the tax benefits of having family members on the payroll, but a new Tax Court case, Wolpert, TC Memo 2022-70, 7/7/22,  found that the payments must be for actual services rendered.

Background: Hiring your child to work for your company can turn into a tax bonanza. Although the wages are taxable to your child, they will often qualify for tax-free fringe benefits, including health insurance. In addition, the child may participate in the company’s 401(k) or other qualified retirement plan. And there may be payroll savings for a young child employed by an unincorporated business.

To top things off, the business can deduct the amounts paid to the child as long as they are reasonable for the services they legitimately provide. But the burden of proof is on the business if the IRS contests the deduction. That was the rub in the new case.

Key facts: The taxpayer, a resident of Pennsylvania, is a former professor of public affairs and urban planning. His academic career included posts at the Wharton School of the University of Pennsylvania and Princeton University.   

During the two tax years in question—2016 and 2017—the taxpayer engaged in various consulting activities focusing on civic engagement. He didn’t maintain a separate checking or credit card account for his consulting activities. Instead, he made payments from personal checking accounts.

The IRS disputed a number of deductions claimed for business expenses, including vehicle and travel expenses. For this purpose, we will focus on the taxpayer’s claims regarding various checks issued to his three children and one grandchild for work as his “assistants.”

School’s out: After examining the facts and the testimony at trial, the Tax Court concluded that the taxpayer failed to properly substantiate the payments as compensation or reimbursement amounts. Thus, they are treated as being purely personal and nondeductible.

To summarize, the taxpayer didn’t maintain bank accounts to be used for payment of compensation by his business. Notably, there wasn’t any documentary evidence presenting payments being made for services, not were there any copies of negotiated checks to assistants.

The payments from the personal accounts didn’t bear any notation as to the purpose of payment. Also, the taxpayer failed to provide any evidence substantiating expenses of one child who was purportedly being reimbursed. Ultimately, there was no proof that the child worked for her father. 

Finally, the taxpayer’s contention that a child inadvertently threw out business records stored in their residence following her mother's death wasn’t supported. This closed the book on the taxpayer’s case.

Reminder: A taxpayer’s company can deduct payments to a child, or another relative, if the compensation is reasonable in amount. If a client has a bona fide business relationship that can be substantiated, make sure they don’t go overboard and pay the child an excessive salary. Some common sense can go a long way.