This is a great deduction for parents of minor children who have a net income-generating Schedule C business. For 2007 a dependent can earn up to $5,350.00 in wages (or a combination of wages and up to $300.00 in “unearned income” – i.e. interest, dividends, capital gains) and pay no federal, and probably no state, income taxes. Contributions to a traditional IRA can add another $4,000.00 to that figure (however, in the long run, it is probably better to contribute to a ROTH IRA in such a situation).
However, to be deductible the wages must be for actual legitimate services to the business as an employee, the child must actually be paid the wages, and the amount of wages paid must be reasonable for the type of services provided. Routine family chores (see the Court’s discussion below) will not qualify, you cannot just claim a deduction and not actually give the money to the child (or deposit the money in the child’s IRA account), and you are not allowed to pay your 10 year old son $50.00 an hour for sweeping up your office.
In the case discussed in the newsletter the parents had three home-based businesses – a tree farm, a tailoring business, and a beagle-breeding business.
Their son, a 21-year old college student, helped with his mother’s tailoring business during summer break. His jobs included getting supplies at a fabric store, general cleaning and shampooing the rug in the sewing room, and accompanying his mother to the store.
Their two minor daughters worked in the beagle-breeding business walking the dogs, cleaning and cutting the grass in the beagle yard, hauling garbage, bleaching dog bowls, treating dogs for fleas, clipping nails and hosing kennels.
None of the children received an actual pay check. The son received $4,000.00 over the course of the year, most before he actually began work. A type of “drawing account” was kept for each of the daughters. Earnings were accumulated, and the girls were given money as they needed it, or the parents would purchase items for the girls and deduct the amount from their “account”. No quarterly (941) or annual (940, W-3, W-2) payroll tax returns were prepared for any of the wages claimed as a deduction.
The Court felt that “many of the tasks [the son] performed were in the nature of routine family chores such as cleaning, vacuuming, taking out garbage, and accompanying [his mother] on shopping trips. Such chores are part of parental training and discipline rather than the services rendered by an employee for an employer.” This, plus the fact that the son’s wages were not paid as earned and there were no payroll tax returns filed, caused the Court to conclude that the payments made to the son were not deductible as wages.
While I agree with the Court on the son, I felt that the daughters could have qualified as true employees. However, the Court disallowed the deduction for their wages as well.
It is very important that you “cross your t’s and dot your i’s” when it comes to documenting a deduction for dependent wages. You must make sure you pass the “duck test” (if it waddles like a duck and quacks like a duck…). Forget that these are your kids and treat them as you would any other employee.
· Create a written job description for each “position” outlining the duties and responsibilities involved.
· Pay the kids on an hourly basis.
· Use a time card to document hours worked and work performed.
· Write a company check as payment each week or every-other week.
· Even though the wages are not subject to FICA and FUTA tax and probably also state unemployment and disability contributions, file all appropriate quarterly payroll tax returns, such as the federal Form 941 (you can indicate that the wages are exempt from FICA on the form), submit an annual federal Form 940 or 940EZ indicating the amounts paid as “exempt”, and issue a W-2 in January to report the wages paid.
· If you have other employees make sure the kids’ wages are included on the quarterly and annual payroll tax returns.
If you send me an email with “THE WANDERING TAX PRO FORM REQUEST” in the “Subject Line” I will send you, as a “pdf” attachment, an Employee Time Card form you can use for your kids.