Tax Court: Don’t Fudge Wages for Your Kidsby
If you need to hire someone to help out in your office, you may not have to look any further than your kitchen table. Hiring your child provides a multitude of tax benefits, but you must be careful to observe all the IRS rules.
Case in point: The Tax Court just penalized a taxpayer who completely ignored the technicalities (Ray, TC Memo 2018-160, 9/20/18).
What sorts of tax benefits are available for hiring a child? The following are a few ways to save:
- Regular Income Tax: Suppose you reduce your compensation by the amount of salary you pay your child. Instead of being taxed to you at rates currently reaching as high as 37 percent, the income is taxable to your child, frequently at a rate as low as 10 percent. Also, they can earn up to the standard deduction amount ($12,200 in 2019) without paying any federal income tax.
- Kiddie Tax: Generally, unearned income above a stated limit ($2,200 for 2019) received by dependent child under age 19, or a full-time student under age 24, is subject to a higher “kiddie tax” rate. But this doesn't apply to any "earned income," like wages, that your child is paid.
- Business Expense Deductions: The wages paid to your child are deductible by the business, just like the wages paid to any other employee. However, when another family member is involved, you must take care to ensure that the wages are reasonable in amount for the services actually provided.
- Payroll Taxes: If a child under age 18 is employed by a parent in an unincorporated business, the earnings are exempt from FICA tax. This exemption also applies to FUTA tax up until the child turns 21. These payroll tax breaks can provide significant savings for a parent who is self-employed or a partner in a partnership.
- Fringe Benefits: As an official employee, the child is eligible to receive tax-free company fringe benefits. This may include health insurance coverage, group-term life insurance coverage up to $50,000 and educational assistance plans. As with wages, these payments are generally tax deductible by the business.
On the other hand, you can’t realize the tax rewards without meeting certain obligations imposed by the IRS.
In the new case, the taxpayer and his spouse lived on a farm in Oregon with six of his children, ranging in age from 13 to 25. During the six tax years in question—spanning 2006 through 2011— he served as the sole financial officer for a nonprofit organization he co-founded. The nonprofit, which involved home education, was funded by outside contributions but also generated revenue from book sales and research contracts.
Instead of using employment contracts with any workers, the taxpayer had exclusive authority for determining wages for all workers, including himself. Apparently, the only other employees he hired were five of his children, who were referred to as “office assistants.” The taxpayer also personally received income from a related consulting business.
Upon audit, the IRS discovered the taxpayer had not initially filed returns for the tax years in question. Subsequently, he reported between $15,000 and $24,000 in annual income from the consulting business and zero income from the nonprofit. At the same time, the nonprofit purportedly paid more than $260,000 to his kids, although the taxpayer never issued them any W-2s or 1099s. The money was deposited into a shared family credit union account.
To no one’s surprise, the Tax Court turned thumbs down on this arrangement. It attributed the income to the taxpayer and tacked on interest and penalties.
Moral of the story: This can be a powerful tax-saving technique, but clients can’t become greedy. Instruct them to pay their children a reasonable amount for work actually performed. These amounts should be reflected on W-2s or 1099s filed with the IRS.
Ken Berry, Esq., is a nationally known writer and editor specializing in tax, financial, and legal matters. During his long career, he has served as managing editor of a publisher of content-based marketing tools and vice president of an online continuing education company. As a freelance writer, Ken has authored thousands of articles for a...