This weeks’ tax puzzler involves a mom and her kids.
We again are talking about attorneys. Both mom and dad are attorneys, and mom is self-employed.
Sometimes she brought her children to the office, where they helped her with the following:
- answering the telephone
- greeting clients
- shredding unneeded documents
- moving files
Mom believed that having her children work would help them understand the value of money and lay the foundations for a lifelong work ethic.
She had three kids, and for 2006, 2007 and 2008 she deducted wages of $5,500, $10,953 and $12,273, respectively.
There are tax advantages to hiring a minor child. For example, if the child is age 17 or younger, there are no social security (that is, FICA) taxes. In addition, there is no federal unemployment tax for a child under age 21, but that savings pales in comparison to the FICA savings.
Then you have other options, such as having the child fund an IRA. All IRAs require income subject to social security tax. It doesn’t matter if one is an employee (FICA tax) or is self-employed (self-employment taxes), but social security is the price of admission.
Her children were all under the age of ten. Can you imagine what those IRAs would be worth 50 years from now?
The IRS disagreed with her deducting payroll, and they wound up in Tax Court.
Your puzzler question is: why?
(1) You: The Court did not believe that the kids really did anything. Maybe she was just trying to deduct their allowances.
Me: The tax law becomes skeptical when related parties are involved, and you cannot get much more related than a mother and her children. It was heightened in this case as the children were so young. For the most part, though, the Court believed her when she described what the children did.
(2) You: Mom used the money she “paid” the kids for their support – like paying their school tuition, for example.
Me: The tax law disallows a deduction if the money is disguised support, which tax law expects to be provided a dependent child. In this case, the Court saw the children buying books, games and normal kid items; some money also went to Section 529 plans. The Court did not believe that mom was trying to deduct support expenses.
(3) You: She could not provide paperwork to back-up her deductions. What if she paid the kids in cash, for example?
Me: Good job. One reads that the Court wanted to believe her, but she presented no records. She did not provide bank statements showing the kids depositing their paychecks, presumably because the children did not have bank accounts.
She did not provide copies of the Section 529 plans. That was so easy to do that I found the failure odd.
At least she could show the Court a Form W-2.
Mom had not even issued W-2s.
The Court was exasperated.
It allowed her a deduction of $250 per child, as it believed that the kids worked. It could not do more in the absence of any documentation.
And there is the answer to the puzzler.
Too often it is not mind-numbing tax details that trip-up a taxpayer. Sometimes there is just a lapse of common sense.
Like issuing a W-2 if you want the IRS to believe you paid wages to somebody.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.