Tax planning often includes a recommendation to the small business owner that he or she pay wages to their minor children. Wages to the kids may mean (1) using the child’s standard deduction to provide some tax free money, (2) shifting income from the parent’s high tax bracket to the child’s lower bracket, (3) saving FICA/SE tax on wages paid by a parent to the minor child, and (4) allowing the parent (or child) to fund a Roth IRA.
The Tax Cuts and Jobs Act made paying kids a wage from the business even better when the new law doubled the standard deduction. The 2019 standard deduction for the earned income of a single taxpayer is $12,200. That means that a child can earn $12,200 and pay no income tax.
The Tax Cuts and Jobs Act added a qualified business income (QBI) deduction. W-2 wages are important in the calculation of the QBI deduction for those who have income above the thresholds imposed by §199A. If the business has no other employees, paying wages to the owner’s children may result in a QBI deduction — an extra tax benefit.
All of these are legitimate tax savings ideas as long as the parent follows some strict rules. Two tax court cases show what can go wrong even with good intentions.
YEAR-END BONUSES PAID TO CHILDREN WERE NOT REASONABLE
Brent and Lynette McMinn1 owned and operated a business that refurbished and resold large, commercial embroidery machines. The business was very successful and averaged $8,750,000 in sales per year. Advanced Embroidery Supply, a Schedule C business, was used to pay wages to the McMinns’ minor children. For the years at issue, the McMinns claimed deductions for total wages paid to their four children of $46,516, $50,913, and $64,650, respectively. Advanced Embroidery Supply issued Forms W-2 for the wages paid and the children reported the wages on their own tax returns. The children were paid by the job with each child receiving a large payment at year end. For example, in 2006, year-end bonuses represented $55,000 of the total wages of $64,650 paid to the children.
Wages must be reasonable. Section 162(a) requires not only that the wage deduction be ordinary and necessary but also that the amount paid be reasonable for personal services actually rendered to the payer. When an amount deducted as wages involves a familial relationship, the IRS and the courts closely scrutinize the transaction to determine whether there is a bona fide employer-employee relationship and whether payments were made for services actually performed for the business (see Denman v. Comm., 48 T.C. 439, 450 (1967)).
Court said December bonuses were not reasonable. Although work records were not complete, the court accepted the testimony of Mr. McMinn, three of the children and an unrelated third party that the children performed valuable work for the embroidery business. For their work, the children were generally paid small amounts throughout the year for the jobs that they completed, and were paid bonuses in December of each year. It appeared that the McMinns paid their children significant bonuses at year-end, partially on the basis of the performance of the embroidery business. The court was not convinced that unrelated parties would act similarly. Thus, the court found that the amounts paid throughout the first 11 months of the year were reasonable for the work each child completed. The court allowed the McMinns to deduct the average of each child’s other monthly payments in that year, and disallowed the remaining balance of the December payments as unreasonable.
WAGES WERE NOT REASONABLE AND NO FORMS W-2 WERE FILED
Lisa Fisher2, an attorney, claimed wage deductions for her three children, all of whom were under nine years old as of the close of year under audit. During summer school recesses, Mrs. Fisher often brought her children into her office, usually for two hours a day, two or three days a week. On the 2006, 2007, and 2008 Schedules C relating to Mrs. Fisher’s law practice, she deducted “wages to minor children” of $10,435, $10,313, and $8,022, respectively. Mrs. Fisher did not issue a Form W-2 to any of her children; no payroll records regarding their employment were kept, nor were any federal tax withholding payments made from any amounts that might have been paid to any of them. The court was unable to tell from what was presented how much was paid to each of Mrs. Fisher’s children. Nor could it tell how many hours each worked or what the hourly rate of pay might have been. Without records showing these details, the court could not tell whether the amounts deducted were “reasonable.” Taking into account their ages, generalized descriptions of their duties, generalized statements as to the time each spent in the office, and the lack of records, the court allowed a $250 deduction for wages paid to each child for each year.
- Brent and Lynette McMinn v. Comm., TCM 2016-136
- John and Lisa Fisher, pro sese, v. Comm., TCM 2016-10