Is the "Family Management Company" Strategy Legitimate?

It generally fails the economic substance doctrine

Hiring a child in a business can provide valuable tax benefits. The benefits and challenges of this strategy were discussed in depth in a prior edition of this newsletter.

One major roadblock is that if a parent operates their business in a corporation, they cannot exempt their child’s wages from employment taxes. The strategy is less attractive since the payroll tax costs reduce the potential annual tax savings.

Family Management Company Explained

Certain tax strategists purport to get around this issue using a so-called family management company. Here is a summary of it from a social media post:

Assuming the only employee of the family management company is the owner’s child, this arrangement has no non-tax objective; it only exists to attempt to exempt the child’s wages from employment taxes.

Economic Substance Doctrine Defined

The economic substance doctrine is a common law doctrine that denies tax benefits arising from transactions that do not result in a meaningful change in the taxpayer’s economic position other than the purported reduction in federal tax.

Congress codified the economic substance doctrine for transactions entered into after March 23, 2010, in §7701(o). Under the statutory provision, a transaction is treated as having economic substance only if it (1) meaningfully changes the taxpayer's economic position (apart from federal income tax effects) and (2) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction.

In Notice 2014-58, the IRS gave an example of an activity that could be separated from an overall transaction to disallow the purported tax benefits under the codified economic substance doctrine. This example is particularly relevant to the family management company structure:

…the use of an intermediary employed for tax benefits and whose actions or involvement was unnecessary to accomplish an overarching non-tax objective.

Internal Revenue Manual Exhibit 4.46.4-4 provides a list of facts and circumstances that, if present, indicate that the application of the economic substance doctrine by the IRS may be appropriate. The ones relevant to the family management company include:

• Transaction includes unnecessary steps

• Transaction is not at arm’s length with unrelated third parties

• Transaction creates no meaningful economic change on a present value basis (pre-tax)

• Taxpayer’s potential for gain or loss is artificially limited

• Transaction has no credible business purpose apart from federal tax benefits

• Transaction has no meaningful potential for profit apart from tax benefits

• Transaction has no significant risk of loss

• Tax benefit is artificially generated by the transaction

• Transaction is outside the taxpayer’s ordinary business operations

Potential Penalty Enhancements

Under §6662(a), there is a general 20% accuracy-related penalty on underpayments of tax. Under §6662(b)(6), the penalty applies to the disallowance of claimed tax benefits because of a transaction lacking §7701(o) economic substance or failing to meet the requirements of any similar rule of law.

Under §6662(i), if the position lacking economic substance is not adequately disclosed in the return or a statement attached to the return, the penalty increases to 40% of the underpayment.

Trade or Business Activity?

Another question is whether the family management company in this arrangement is a §162 trade or business activity; if not, the wages paid are not an above-the-line §162 deduction taken against the income received from the corporation.

In Comm. v. Groetzinger, 480 U.S. 23 (1987), the Supreme Court held:

We accept the fact that, to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity, and that the taxpayer's primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.

In the proposed family management company structure, the spouse has essentially no involvement with respect to the child-employee. It is doubtful that the family management company is a §162 trade or business in this arrangement.

Hiring Children Is Not for Everyone

Hiring a child in the business can make sense for the right taxpayer in the right situation. However, not every tax strategy makes sense for every taxpayer!

If paying FICA tax on the child’s wages (because the business is an S corporation) does not make the strategy attractive, a tax advisor should identify other potential savings strategies and not create sham transactions to save tax artificially.

It also may not make sense if reasonable compensation for the child-employee is low. Shifting $5,000 a year from the business to the child may not be worth the administrative headache when the child can get a job from an unrelated employer and earn tax-free income that allows a Roth IRA contribution.

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