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Why Paying Your Kids is a Tax-Smart Strategy

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May 23rd 2016
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Can your children help out with some of the tasks connected with your business? Then a savvy way to take care of their allowances or spending money – at the expense of the IRS – is to pay them wages for work they do on behalf of the business. This is a perfectly legal way to keep income in the family while shifting some out of your higher bracket and into their lower bracket.

For this business expense to withstand IRS scrutiny, your children must actually render services. Also, wages paid to them can’t be more than the going rate for unrelated employees who perform comparable tasks.

The IRS doesn’t require you to be a parsimonious paymaster who doles out only the minimum wage. But you must treat your children the same as any other employee and keep the usual records showing amounts paid and hours worked.

Give them W-2 forms, even if they qualify to exempt their wages from withholding for income taxes, and use checks drawn on business accounts to evidence the payments. Otherwise, the IRS might contend that the payments exceeded the going rate or that your youngsters weren’t bona-fide employees; they merely rendered the token kinds of services that parents expect their children to perform.

The family phone. The IRS prevailed in a 1974 decision by the Tax Court. It decided that the “salary” at issue, which had been turned over by Dr. Anthony R. Furmanski, an Encino, California-based neurologist, to his teenage daughter, was merely an allowance and not, as he claimed, wages paid for secretarial services at his office and for regularly answering calls from patients at his home when the answering service was off and he didn’t want to be disturbed.

Among other things, a dubious judge noted that children normally answer the family phone. Nor was the doctor’s case helped by his admission that he made the entire payment to his daughter in advance – and paid nothing to his son for answering calls. The clincher was his failure to keep any records showing when she worked for him at the office or at home, or, in this particular situation, to withhold taxes on the payment.

The frequently cited case of Walter and Dorothy Eller. The Ellers hired their three children – ages 7, 11, and 12 – to work at their mobile home parks in California. During a three-year period spanning 1972 to 1974, the kids did the following:

  • Cleaned the grounds and laundry rooms.
  • Performed landscape work.
  • Maintained the swimming pools.
  • Read gas meters.
  • Answered phones.
  • Delivered leaflets and messages.
  • Made minor repairs.

The Ellers deducted nearly $18,000 of their payments to the children as “outside services,” of which the IRS disallowed about 90 percent as unreasonable.

But the Tax Court concluded that, had the children not done the work, the parents would’ve had to hire someone else to do it. As the children performed “substantial services,” the court approved more than $15,000 as allowable.

Most of the disallowance was attributable to the 7-year old, although around $4,000 of his earnings were allowed.

“Experience teaches that 11- and 12-year old children can generally handle greater responsibility and perform greater services than 7-year-old children,” the judge explained.

The key to winning these kinds of disputes. Truly treat the children like employees: Be able to document that the children actually perform the chores for which they are paid, make sure that the work is necessary for the business, and pay only reasonable amounts for the jobs performed.

Additionalarticles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 110 and counting).

Stay competitive with your fellow accountants who turn to the articles when, say, they correspond with clients or they want to show clients how to nimbly sidestep pitfalls while capitalizing on opportunities to diminish, delay, or deep-six payments of sizable amounts that would otherwise swell IRS coffers.

Also be mindful of the articles when you strive to build name recognition, a goal attainable only by choosing and implementing strategies that set you apart from ferocious competition. Use the articles to prepare talks to audiences, such as business owners, investors, and retirees.

Related article:

Hire Your Kids and Save on Taxes

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By Reed Kloc
Jun 7th 2016 10:48 EDT

Can we share this content on Social Media?

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By CurtisNygren
Jun 7th 2016 13:19 EDT

Remember this strategy is only for non-corporate entities. If you operate as a Corporation (C or S) you still have to withhold FICA taxes & also match the withholding.

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