ELITE ADVISOR BEST PRACTICES
Helping Clients Save on Taxes by Hiring Their Kids - Part One
Seven ways to ensure that wage deductions are legitimate
By Glenn Demby
- The tax code allows your small-business owner clients (and you) to deduct ordinary and necessary business expenses.
- Deductible expenses include wages paid to employees as long as compensation is reasonable in amount, based on services actually rendered, and actually paid or incurred.
- Wage deductions are allowed even if the employee happens to be the business owner’s minor, dependent child, and even if the child uses those wages for his own support.
- The catch: To make such deductions, the business owner must be able to prove that the child works under a “bona fide employment” arrangement.
Here are seven things that you and your business owner clients can do to pass the bona fide employment test.
Chances are that some of your clients have hired, or are thinking about hiring, their minor kids to help out around the office during the summer. In addition to keeping the kids out of trouble and taking care of those chores that just never seem to get done, putting the kids to work can generate tax savings for your clients’ businesses.
While it may sound like a boondoggle, you can assure your clients that it is all perfectly legal, but it does require careful planning. Luckily, you can show your clients what to do, and you might consider using the same arrangement for your own practice.
The Bona Fide Employment Rule
Employing one’s own children is an ancient practice. And it can also be a perfectly legitimate way to carry on a small business and generate wage deductions.
The IRS says. “Reasonable wages paid by a father to his child for services rendered as a bona fide employee in his trade or business are deductible business expenses.”
This quote comes from a 1973 IRS Revenue Ruling upholding a father’s right to withhold wages paid to his minor son even though the son actually used some of that money for his own support. And it still represents the state of the law today.
Of course, the IRS isn’t stupid. The agency recognizes that taxpayers may try to make bogus employment schemes with their kids to pass along money to them tax-free. To prevent this, the IRS imposes a strict rule: To deduct wages paid to their minor, dependent children, small-business owners must prove both that:
- The employment is bona fide; AND
- The wage amount paid is reasonable.
Because of the potential for abuse, employment of dependent children is a tempting target for IRS auditors. Your clients also need to understand that if they ever end up fighting it out with the IRS in court, they bear the burden of proving that employment is bona fide. In other words, courts will presume the arrangement is not bona fide and clients must rebut the presumption.
When is hiring one’s own kids deemed bona fide employment?
Unfortunately, the IRS doesn’t provide a definition of “bona fide employment.” It decides the issue case by case. So the best—and maybe the only—way to figure out what bona fide employment means is to look at how the IRS and tax courts have interpreted the term in actual cases over the years. Of the 18 cases we found, only four ruled the employment of a child (or dependent spouse) to be “bona fide.” (Note: The same bona fide employment rules also apply to spouses.)
Seven key lessons from the cases
Most important are the lessons that the cases offer about what constitutes bona fide employment. Based on these rulings, there are seven things you can advise your clients to do to make their kids’ employment bona fide.
1. Get an Employer Identification Number
For tax purposes, being a bona fide employer means having an employer identification number (EIN). This is probably a moot point for any of your clients who have other employees. But if the kids are the clients’ only employees, they may not have EINs. Let them know they can get one from the IRS:
- Online at www.irs.gov;
- By calling (800) 829-4933; or
- By completing IRS Form SS-4.
2. Keep detailed records of services kids perform
Make sure clients understand that they need the right employment records to meet the burden of proving that their children’s employment is bona fide, including records showing that the kids actually performed services for them.
Strategy. Tell clients to have their kids fill out time sheets showing they did the work and how long the work took and to collect completed sheets daily or at least once a week.
3. Pay by check to show wages were actually paid
Clients must also show that they actually paid their kids the wages they earned. Although it sounds obvious, not documenting wage payments is a common way that deductions get killed.
Strategy. Advise clients to pay their kids’ wages by check on a regular schedule as they would with any other employee. In addition to being a hallmark of normal employment, paying by check creates an audit trail running from their business checkbooks to the kids’ savings or money market accounts.
4. Create a formal employment agreement
There are hallmarks of an employment relationship that the IRS and tax courts look for in judging whether employment of a child is bona fide. One of them is whether there is a valid employment contract, i.e., one that specifically defines and holds the child-employee accountable for performing duties in consideration for a stated rate of compensation.
Strategy. Again, counsel your clients to treat their kids the way they treat their other employees. Have them sign the same employment agreement, and actually implement the terms of the agreement for as long as the children remain in their employment.
5. Do the payroll paperwork and withholding
Failure to complete payroll paperwork and withholding is one of the factors that courts and the IRS cite most often cite in denying deductions for wages of minor children.
Example. A small publisher’s failure to withhold income tax and Social Security FICA taxes from his kids’ wages is evidence that their part-time employment wasn’t bona fide.
Strategy. Make sure your clients withhold and complete the payroll paperwork for their hired children, including:
- IRS Form W-4: So the children can claim exemptions and allowances.
- IRS Form W-2: If the clients pay the children more than $600 each in wages (file IRS Form W-3 and copies of W-2s with the Social Security Administration).
- IRS Form 941: Each quarter if they pay periodically. (If the children are the only employees, tell the clients to enter zero as the amount subject to Social Security tax. If they pay wages once a year, they should file Form 941 once a year on a “seasonal” basis.)
- IRS Form 940: Clients must file this form even though the wages they pay their under-age-21 children are exempt from unemployment taxes. (If the children are their only employees, they should enter the amounts paid to their children as both (1) gross pay, and (2) exempt pay, making a net pay of zero subject to federal unemployment tax.)
Clients will also have to withhold federal income taxes from their kids’ wages unless the kids can claim exempt employee status because they had no federal income tax liability for the previous year and expect to have none for the current year.
6. Make sure kids’ services legitimately help the business
Make sure clients understand that they can’t just hire their kids to do household chores that aren’t related to their business. These are considered personal services for which wages are not deductible. To be bona fide employment, the children’s services must contribute to the conduct of the business or production of income. Unfortunately, it’s not always simple to distinguish between personal and business-related services and nearly identical jobs may fall into different categories depending on the circumstances:
Strategy. Advise clients to document in the employment agreements the specific jobs they expect their kids to do in exchange for their wages and, if it’s not self-evident, how the kids’ services help clients conduct their business or earn income.
7. Make sure the wage amounts paid are reasonable
Finally, clients must be able to prove that the wages they pay their kids are commensurate with what they’d pay third parties for the same services. If they don’t use any third parties, the IRS and tax courts will compare the wage amount to minimum wages, industry rates, and other benchmarks.
Example. A CPA’s 14-year-old daughter has no training, skills, or experience in bookkeeping. There’s no justification for paying her above minimum wage for her bookkeeping services.
Strategy. Clients should establish an objective method for measuring the value of the wages they pay and use that method not only to set fair wages, but to document that the amount paid is reasonable. If the wage rate is either above or below a relevant benchmark, they need to be able to justify the discrepancy.
One more important point: Bona fide employment is based on how kids earn their wages, not on how they spend them. Thus, the fact that kids spend some or all of the money they earn on their own support doesn’t undermine the bona fide nature of the employment relationship, even though parents are legally responsible for supporting their minor children.
But there are a couple of caveats for your clients to keep in mind:
Caveat 1. If kids spend too much of their wages on their own support, clients could end up losing the right to claim them as dependents.
Caveat 2. Clients aren’t allowed to deduct the value of meals and lodging they furnish to their kids the way they can with other employees.* * * * * * *
Next week, in Part Two of this series, we’ll take a closer look at the income tax savings that your clients can accrue by entering into bona fide employment arrangements with their minor, dependent children.
This article was adapted with permission from MurrayBradfordTaxInstitute.com, a site dedicated to helping self-employed taxpayers and one-owner businesses save on taxes.