Archive for Employees

Hire Your Kid and Get a Tax Break

Do you want to find out a better way to teach your child about money than just giving an allowance? If you own your own business, you can pay your kid in a way that benefits both you and the child when it comes time for taxes. You see, it’s possible to get a deduction by hiring your child to work in your company, and your kid could get the money without paying any taxes! Compare that to paying taxes first (without the deduction) and then paying an allowance out of after-tax dollars.

A Precedent Case

Sally Wilson hired her 13-year-old to work in her proprietorship, and she paid the child $5,700. For doing so, she got back $2,600 from state and federal governments. If Wilson’s business functioned as a corporation, she still could have gotten back $644. This extra money comes from hiring-your-child tax breaks.

Additionally, Ms. Wilson’s child paid zero taxes. That’s because the child can take the standard deduction (instead of itemizing property taxes, mortgage interest, charitable donations, etc.). In 2009, the standard deduction was $5,700 (the total amount of the child’s income). The standard deduction is $6,200 for 2014 and $6,300 for 2015.

Why You Should Hire Your Child

Hiring your child is a great way to teach them about finances, as well as what it takes to work and earn money. Aside from that, your own child can make a terrific employee because you already know and trust them.

There’s an added benefit to this tactic if you plan to help your child pay for college. Legally, your child can put money into an IRA (traditional or Roth) to grow tax-free, and because your child is employed by a parent, they can take out that money penalty free to use for college. This is a big advantage for you and your child.

Considering the $6,200 standard deduction for 2014, let’s look at what would happen if your kid earned $11,200. Zero taxes are paid for the $6,200, and if your child puts the additional $5,000 in a traditional IRA, then zero tax dollars are paid for the entire earnings! That’s right—your kid could nearly double their income and still not pay a single penny in taxes.

The benefits are still impressive even when you pay your child even more throughout the course of the year. Let’s use Ms. Wilson’s example again. If she had paid her child $19,050, she would have received total benefits from state and federal deductions equaling $8,763 (saving 7 percent in state income tax, 14 percent in self-employment tax, and 25 percent in federal income tax). She would keep that money. The child has taxable income only on what’s left after the standard and IRA deductions. The tax would have equaled $1,035, and the child would have kept $18,015 (including what is in the IRA).

You may be wondering, “What about the payroll taxes?” Well, if your business is a sole proprietorship (or partnership owned only by the parents of a child), then payments to a child under 18 are not subject to Social Security or Medicare taxes.[1] Additionally, no unemployment taxes have to be paid by such an entity while the employed child is under 21.[2]

Other Considerations

Perhaps you’ve heard of the kiddie tax, which puts a limit on how much income an underage child can bring home without paying taxes. Don’t worry—it doesn’t apply to this situation. The kiddie tax applies only to net unearned income.[3]

As for age restrictions regarding hiring your child, tax law has none. In fact, in one case that the IRS acquiesced to, a couple hired all three of their children to work at their mobile home park operation.[4] The youngest was 7. What the IRS does care about is that you are paying the children fair wages for services rendered. In this case, it noted that compensation paid to children is only deductible if the amount is reasonable and paid for actual services rendered, and parents may deduct amounts paid to their minor children.[5] That means you’ll have to have documentation proving the wages were fair.

Of course, the IRS will be keeping a closer eye on you to make sure that the child actually is an employee and performing services for the business.[6][7] One way to provide documentation of this is to keep a timesheet for your child’s earned wages. And, here’s an extra tip: don’t try to deduct food and lodging expenses for your child employee. Parents are legally liable for the support and maintenance of their minor children.[8]

Maybe the IRS doesn’t mind, but what about child labor laws? For the most part, parents employing their own children are exempt from child labor laws. According to the Fair Labor Standard Act, parents can have their children under age 16 work for any number hours at any time of day in a business owned solely by the parents.[9] The Department of Labor, however, does have prohibitions about employing children in hazardous jobs.[10] Check their website for a list .

What About Corporations?

The rules for corporations differ, of course. As you saw in the numbers above, if Ms. Wilson had been the owner of a corporation, she would have gotten significantly less in tax benefits. That’s because a corporation is not the mother or father of a child. As a corporation, your business will have to pay unemployment taxes, and the corporation and your child will be responsible for Social Security and Medicare taxes.

If you’re going into business and already have children, you may want to consider the different outcomes of hiring your child when choosing an entity structure. When choosing, keep in mind that hiring your under-18 child for a proprietorship or partnership definitely pays off. But, hiring your under-18 child for an S corporation or C corporation may or may not. It’s important that you run the numbers in those situations.

Ensuring Against Audit

As with any tax strategy, the key to winning your child employee deductions with the IRS is to provide adequate documentation. Here are some tips for providing enough proof:

  • Have an Employer IDEven if your child is your only employee, you need to get an employer ID number in order to make the employer-employee relationship legitimate. You can do this online or call the IRS at 1-800-826-4933.
  • Track Work with a Time SheetHaving your child fill out a time sheet is a great way to keep proof of the time they worked and the wages they earned. In one case, Vernon E. Martens hired his four children, but failed to require time sheets and lost out on 80 percent of his deductions.[11]
  • Have Support for Your Pay Scale—If you want to pay your child more than minimum wage, you’ll need documentation supporting the wage. One way to do this is to determine how much it would cost if you hired someone outside the family, and adjust for variables such as skill level and whether it takes your child longer to complete the task than it might take someone else. However, if you’re just paying minimum wage, there’s no need to document your reasoning.
  • Always Use Payroll ChecksChecks maintain a clear trail from your business account to your kid’s checking or savings account. There’s no question left about the amount paid or whether it was paid by the business. When you hire your child, the money you pay is theirs, and you must be able to show that the pay went to a separate account, not one of your own. Also, be sure to check the payment if you use a payroll service; they may mistakenly take out Medicare and FICA, which is unnecessary for a minor.
  • Fill Out Payroll Forms (Both State and Federal)These are the documents you have to fill out to set up your child as an official employee of your business and properly prove the child’s earnings and any taxes due. The federal forms include IRS Form W-4, IRS Form W-2, IRS Form 941, and IRS Form 940. Even though your minor is exempt from withholding for FICA, Medicare, and unemployment taxes, you’ll still need to turn in those forms. You can find all the forms at the IRS Forms and Instructions page.

Now that you’ve learned all the advantages of hiring your child as an employee for your proprietorship or partnership, it’s time to teach your child the value of money. You’re giving your kid a wonderful opportunity to begin investing early. As mentioned above, your kid can even save up for college with an IRA, which stretches the tax savings even further.

  1. IRC Section 3121(b)(3)(A); Reg. Section 31.3121(b)(3)-1.
  2. IRC Section 3306(c)(5).
  3. IRC Section 1(g).
  4. Eller v Commr., 77 TC 934; Acq. 1984-2 CB 1.
  5. AOD 1985-004.
  6. Gerald W. Jordan v Commr., T.C. Memo. 1991-50.
  7. Denman v Commr., 48 T.C. 439, 450 (196).
  8. Rev. Rul. 73-393.
  11. Vernon E. Martens v Commr., No. 90-3104, May 91 (4th Cir.).

You Can Make the Most of Tax Deductions on Employee Parties

If you’re going to throw an employee party, know that you are entitled to a tax deduction for this business expense. However, be careful in how you go about it. It turns out that there are two different kinds of deductions for business-related entertainment expenses—50 percent deductible or 100 percent deductible.

When tracking entertainment deductions, it’s best to keep these two types separate from the beginning. That means keeping two separate accounts for them. So, what is the difference?

50 Percent Deductible Entertainment

Most expenses for entertaining employees or other business contacts will fall into the 50 percent deductible category. You can consider this your usual account for these types of expenses. Here’s an example. Let’s say you take a team out to lunch following a training session. The lunch tab falls into the 50 percent deductible classification.

The Employee Party and 100 Percent Deductible Entertainment

Unlike business lunches, other expenses are exempt from that 50 percent cut, meaning they are 100 percent deductible[1]. The primary example of this is the employee party. When an entertainment expense is chiefly for the benefit of your employees, it may qualify as 100 percent deductible entertainment. Read on to determine whether your party qualifies:

  • Which Activities Qualify—According to the IRS, qualifying activities include holiday parties, annual picnics, and summer group outings. You can also deduct the cost of maintenance for employee benefit, such as keeping up a golf course, swimming pool, bowling alley, or baseball diamond. The important thing to remember about this is that in order to qualify, the IRS must deem that these expenses are primarily for the benefit of your employees[2].
  • What the Law States about BenefitHow do you know if your use of time or facilities meets the definition of employee benefit? A sample case may make the term clearer. During one year, American Business Service Corporation rented a powerboat at a rate of $1,000 per day on forty-one separate days. The boat was used for single-day recreational cruises both for employees and their guests. Any employee was eligible to sign up in advance, and the choices were made on a first-come, first-served basis. The court’s decision indicated that the full $41,000 was deductible. Here’s why[3]:
  1. The cruises were primarily for employees.
  2. The decision on who participated did not favor owners or other highly-compensated employees over other employees.
  3. Documentation was kept that recorded who participated and when.
  4. And, the activities sufficed for the “ordinary and necessary” business purpose test.

How Does This Fit into Your Business?

For tax law purposes, the term “primarily” means greater than 50 percent[4]. So, if you take two employees (who are not your family members) on a recreational cruise, then that activity is more than 50 percent for the benefit of employees because employees make up two-thirds of the group.

This definition does not only apply to numbers of people participating. For instance, if you own a vacation home, and you allow your employees to use it more days out of the year than you do, your vacation home now qualifies for an entertainment deduction! You simply make clear that the home was used for an ordinary business-use reason.

Normally, recreational expenses are not something we think of in terms of business expenditures. Unlike, for instance, traveling for a conference, your employee entertainment[5] does not need to fit any definitions for being directly related to business. The terms for employee entertainment are a bit looser. You simply need to pass the “ordinary and necessary” business purpose test[6]. All this means is the expense should be appropriate to and helpful for your business[7]. Keeping your employees motivated and making your business a competitive employer are perfectly sound reasons for providing employee entertainment.

Exceptions to Watch Out For

You must keep in mind that these activities and facilities must primarily benefit employees. Given this stipulation, you need to understand that certain individuals are considered a part of “tainted groups”. Tainted groups[8] include highly compensated employees (those who earned more than $115,000 in 2014[9]), any person who owns 10 percent interest or more in your business (called a 10 percent owner), or any family member of a 10 percent owner[10]. This includes siblings (full and half), ancestors, spouses, and descendants (biological and adopted).

Obviously, you as the business owner are a member of the tainted group. This does not mean you can’t party with the employees; it just means you have to make sure the partying is mostly for the employees, and watch out for the greater than 50 percent rule. Participants should be more than 50 percent from outside the tainted group for your activity or facilities use to qualify.

Keeping Records

Important: Make sure you document the facility usage or activity attendance[11]. You can use any reasonable measurement, such as the number of days of use, the number of times used, or the number of employees participating. The most important aspect of these measurements is that your records prove the uses.

Here are a couple of tips for making sure your documentation meets IRS standards:

  • Always note the business reason for any entertainment expenditures, whether it’s an annual morale-booster or a celebration for a newly acquired contract. Write this down and keep it with your other account documentation.
  • Let the person who prepares your taxes know that you have two separate categories of entertainment expenses, 50 percent deductible and 100 percent deductible. You can make the whole process easier by keeping separate accountings of each from the outset.

With this advice, you’ll keep your employees pleased and your accounts squared away without much difficulty. Don’t be afraid to join in the fun yourself! Tax-deductible employee entertainment is fairly simple to keep straight as a business expense when you understand what qualifies as 100 percent deductible.

  1. Reg. Section 1.274-2(f)(2)(v).
  2. IRC Sections 274(n)(2); 274(e)(4).
  3. American Business Service Corp. v. Commr., 93 TC 449.
  4. For example, see Rev. Rul. 63-144, Questions and Answers 60 through 66.
  5. Reg. Section 1.274-2(f)(2)(v).
  6. IRC Section 162(a).
  7. E.g., Capital Video Corporation v Commr., 90 AFTR 2d 2002-7429 (CA1) November 27, 2002.
  8. IRC Section 274(e).
  10. IRC Sections 274(e)(4); 267(c)(4).
  11. Reg. Section 1.274-5T(a)(2), referring to items in IRC Section 274(e), which includes employee entertainment expenses.

How Commissioned Employees Have Vanquished the AMT and You Can, Too

When it comes time to prepare your taxes, you may have an unpleasant surprise waiting in the alternative minimum tax (AMT). Despite its intention of ensuring that top earners pay their fair share of taxes, the AMT really can be a kick in the pants for employees, who cannot deduct their business expenses. Particularly in the case of commissioned employees, this creates a huge difference in the amount of taxes they pay.

What You Need to Know about the AMT

The AMT was created during the 1986 tax reform, and it basically taxes income that is deductible under the regular tax, such as employee business expenses. Here are just a few of the types of employees who pay their own work expenses:

  • Mortgage brokers and bankers,
  • Insurance sales professionals,
  • Traveling sales professionals,
  • Real estate sales professionals, and
  • Emergency room physicians.

Why are commissioned employees particularly burdened by this tax? It’s because they often have a slew of business-related expenses that they pay out of pocket. Then, here comes the AMT to tell them they are not allowed to deduct any of those expenses. However, independent contractors performing the exact same duties as those commissioned employees can deduct many of their expenses.

What Employees Can Do about It

If your income level boxes you into the AMT, you don’t have to give up and lose thousands of dollars to additional taxes. And yes, it is potentially thousands. Take, for instance, the case of Dan Butts, an Allstate insurance agent. In one year, he paid about $10,000 more in federal income taxes than agents at State Farm.

What did Butts do wrong? Nothing—the difference lay in how he was designated by his employer. Butts was considered a W-2 employee, but the State Farm agents were independent contractors with 1099’s. Look at that scenario again. Butts did the same job, at the same pay, and with the same deductions as the agents at another company, but because of his designation, he paid $10,000 more in taxes.

That is a ridiculous situation for an employee to be in simply because the AMT does not permit deductions for business expenses! Fortunately, if you’re in a commissioned position, like Butts, you can do something about this unfair situation. He simply amended his tax return to put his W-2 employee commission earnings on the Schedule C form that self-employed individuals (including contractors) use. He deducted his expenses and saved that $10,000.

Of course, the IRS noticed that he used the wrong form, and he ended up going to court over the issue. . . and winning! Of note in this case is that the court granted Butts independent contractor status even though he had been employed as an employee with Allstate for years and enjoyed employee benefits[1]. The ruling went his way because he carried a “risk of loss”, just like the agents who were independent contractors.

However, you should keep in mind that using the Schedule C to avoid the AMT may work differently in various fields. For instance, a mortgage loan officer named Dan Cibotti worked for Liberty Trust Mortgage, Inc. as a commission-only W-2 employee. More and more commissioned employees are filing on Schedule C, and Cibotti was one of them. In his case, the court ruled that he was considered an independent contractor, despite having a W-2 that reported his income as an employee, because[2]:

  • He set his own hours and chose his own work location and method of finding clients;
  • His employer did not provide him an office;
  • He claimed a home-office deduction;
  • He was paid 100% on commission;
  • He had the possibility of gain or loss on his business activities; and
  • He received no employee benefits, such as a retirement plan or health insurance.

As you can see, the two situations were quite different, but each involved a commissioned employee who fought for his right to file as an independent contractor and won.

Going Forward

Now that other cases have set the precedent, it is becoming easier for insurance agents and other commissioned employees to avoid the AMT. In fact, the IRS, in chief counsel notice N(35)000-141(a), ordered its lawyers not to challenge individuals who claimed independent contractor status under the Butts precedent, but the IRS can be a stubborn entity. The notice that allowed independent contractor status also instructed the lawyers to:

  • Calculate self-employment tax on the agent’s net income and allow a credit just for the employee share of FICA and Medicare (i.e., employer payments are not included);
  • Calculate taxes on employee benefits, like employer-paid medical insurance and Section 125 contributions;
  • Calculate taxes on 401(k) contributions and make the taxpayer aware that they may not fall back on the Lozon decision, which concluded that such contributions were not taxable until withdrawn[3].

This notice has since expired, but if you plan to pursue independent contractor status, it would be wise to compare AMT savings with the potential tax disbursement outlined in the above IRS strategy.

Other Cases

Several other cases for independent contractor status have gone to court with varying results. Wesley Wickum, a district manager for Combined Insurance Co. of America, amended three years of tax returns and reclaimed $27,000. His salary included commission from his sales, bonuses, and override commissions based on the salespeople he recruited and supervised. In a funny twist, his company had previously considered the salespeople and managers to be independent contractors, but had changed the status out of fear of IRS penalties for wrongly classifying employees as contractors!

You can see the repercussions on business. The AMT hurts a company’s best salespeople—those who make the most commissions. When such a worker is classified as employee instead of contractor, the AMT comes into play, and may cause the best salespeople to leave the company.

A sales agent named Paul Hathaway also amended three years of tax returns after learning of the Butts case[4]. He was a commissioned employee, and although his company provided a W-2 each year and gave him benefits, he paid his own expenses for food, samples, travel, telephone, stationary, and business cards.

William Johnson and Barbara Lewis, on the other hand, lost each of their cases for independent contractor status. Johnson was a full-time hospital equipment salesperson who worked on commission, but the court ruled that he was an employee because his employer 1) restricted him from hiring employees and 2) required that he file daily call reports[5]. Lewis sold hair care products to salons and also made commissions. The court ruled her an employee by status because 1) her employer required her to file daily sales activity reports, 2) her employer supplied her with leads, which she was expected to follow up on, and 3) she had a negligible “risk of loss”[6].

AMT Tax Savings

If you’re going to claim independent contractor status for your commissioned income, take these cases as examples what kind of evidence you need. Remember, your savings could be thousands of dollars. Need an example? Let’s say you’re a mortgage loan officer, like Wickum in the case above. If you made $200,000 and spent $125,000 in business expenses, you have a net income of $75,000.

With regular taxes, those business expenses are reduced by 2 percent, leaving a regular taxable income of $79,000 (.02 x $200,000 = $4,000; $125,000 – $4,000 = $121,000; $200,000 – $121,000 = $79,000). But, for AMT purposes, this employee gets no deductions on those expenses. That means the taxable income is the full $200,000. That’s a huge difference!

So, if the employee files taxes on Schedule A, the amount owed is $45,000. On Schedule C (as an independent contractor), it would only be $15,000. You can see why commissioned employees argue for their contractor status.

If your work situation involves unreimbursed business expenses and a status as employee, you have options to establish your status as an independent contractor for tax purposes. Since the IRS has established a position on this issue, you can start by discussing your status with the local IRS district director. If necessary, you can escalate the situation by requesting a private letter ruling from the IRS. This route does cost money, but it will likely be less costly than going to court. Litigation like the Butts case has not happened in years, so you have a good chance of a ruling in your favor if your circumstances and evidence are sufficient. The AMT seems to be here to stay for the present, so don’t let thousands of dollars slip away from you every year.

  1. Butts v. Commissioner, TC Memo 1993 478, affd. per curiam 49 F.3d 713 (11th Cir. 1995).
  2. Dean Cibotti v Commr., TC Summary Opinion 2012-21.
  3. Lozon v. Commr., TC Memo 1997-250.
  4. Paul E. Hathaway v. Commr., TC Memo 1996-389.
  5. William O. Johnson v. Commr., TC Memo 1993-530.
  6. Donald J. Lewis, Jr., v. Commr., TC Memo 1993-635.