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Tom Talks Taxes - September 7, 2023
What is required if a taxpayer hires their child in their business?
It can be a smart tax strategy for a taxpayer to hire their child in their closely-held business. This is an income-shifting strategy; the business deducts the wages, and the child reports the income. In almost all cases, the child incurs either no tax or a lower tax rate on that income, creating tax savings. The earned income also allows the child to contribute to a Roth IRA and enjoy decades of tax-free compound growth.
Under §3121(b)(3)(A), if the child is under age 18 and an employee of the parent’s sole proprietorship or a partnership in which the parents are the only partners, neither the business nor the child have to pay Social Security and Medicare taxes on those wages. Under §3306(c)(5), if the child meets the same requirements and is under age 21, the business does not have to pay unemployment taxes on those wages.
If the business is a corporation, both the child and corporation must pay all the above taxes; hiring the child may still make sense if the payroll tax cost is less than the income tax savings from the income-shifting strategy.
Whenever a tax planning strategy involves deducting payments made to relatives, the IRS can attempt to reclassify them as non-deductible gifts instead of deductible business expenses. In Holtz. v. Comm., T.C. Memo 1982-436, the Tax Court said:
A normal supposition when payments are made to dependent children or when items are purchased for them is that the money or items are in the nature of support and thus nondeductible under section 262.
Therefore, if taxpayers want to enjoy tax savings from this strategy, they must fully comply with all standard employer requirements, just as the business would with an unrelated employee. Some so-called tax “strategists” purport you can ignore some or all of the requirements listed below. I recommend ignoring this poor advice.
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In Alexander v. Comm., T.C. Summary Opinion 2006-127, the Tax Court denied a deduction for wages paid to a business owner’s child in part due to their failure to treat the child as a bona fide employee:
On the basis of all of the facts and circumstances, we conclude that the payments to Steven represent personal, living, or family expenses. See sec. 262(a). The tasks that Steven performed are mostly in the nature of routine family chores. Petitioners predetermined the amount they would pay him and failed to observe the formalities of the employee-employer relationship, such as paying employment taxes, filing information returns, and paying Steven promptly for the hours he worked. Thus, petitioners cannot deduct the payments to Steven as wage expense. Respondent's determination is sustained.
In Ross v. Comm., T.C. Summary Opinion 2014-68, the Tax Court provided a specific list of so-called “red flags” related to deducting wage payments to children:
Facts that militate against the deductibility of such payments include: (1) failing to pay employment taxes and file information returns with respect to the child; (2) paying the child a flat amount determined at the beginning of the year that is not based on the services actually performed; (3) a lack of correlation between the dates and amounts of payments and the hours allegedly worked by the child; (4) failing to maintain adequate records of the child's hours worked and amounts earned; and (5) compensating the child for services which are in the nature of routine family chores.
Reasonable Wage. Per Treas. Reg. §1.167-7(a), a business can only deduct wages that are reasonable and payments purely for services; reasonable in this context would be the amount paid to an unrelated third party to perform those services.
In Denman v. Comm. 48 T.C. 439 (1967), the Tax Court held that the parent must establish that specific compensation was paid and that the amount is reasonable for the services performed. For example, paying a child a wage equal to their standard deduction each year regardless of the work performed is not a reasonable amount; it is simply a tax avoidance scheme.
To be compliant, a business employing the owner’s child must determine a fair wage for the bona fide business-related services performed by the child, have the child track time under the business’s normal process, and then pay the child regularly for the services performed.
Form W-2. A business must file Form W-2 if gross wages paid to the employee for the calendar year are $600 or more, regardless of any tax withholding. See General Instructions for Forms W-2 and W-3 (2023), p. 5. In addition, the penalty for failing to file Form W-2 can range from $60 to $630 (for intentional disregard of the rules) unless the taxpayer can demonstrate reasonable cause.
Besides the legal filing requirement, there are two other protective reasons to file the Form W-2. First, if the child will use the earned income to contribute to a Roth IRA, the earned income amount should be documented. Second, if the IRS examines the taxpayer and questions the child’s wage deduction, the Form W-2 issuance will assist in substantiating the business expense, as discussed above.
Forms 941 and 940. A business must file Form 941 if it pays wages subject to federal income tax withholding or Social Security and Medicare taxes. See Instructions for Form 941 (Rev. 3-2023), p. 4. A child’s wages remain subject to federal income tax withholding even if they are exempt from Social Security and Medicare taxes.
A business must file Form 940 if the business either (1) paid wages of $1,500 or more to employees in any calendar quarter during 2021 or 2022 or (2) had one or more employees for at least some part of a day in any 20 or more different weeks in 2021 or 20 or more different weeks in 2022. See Instructions for Form 940 (2022), p. 3.
In many cases, Forms 941 and 940 will be required to be filed but will have no tax liability with respect to the business owner’s child. If the business is filing these forms anyway, the additional compliance cost is minimal; if the child is the business’s only employee, the compliance cost must be factored into the decision to hire the child.
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