Hire Your Children and Save Thousands In Taxes (If You Do It Right)

Episode Transcript

(00:00):
A business owner tried claiming6, 315 in wages for having his

(00:04):
10 year old take out the trash.
The IRS wasn't impressed.
But here's the twist.
Paying your kids to work in yourbusiness isn't just legal.
It's a powerful tax strategywhen done correctly.
In these next few moments, we'regoing to break down three court
cases and highlight IRS methodsused when conducting an audit.
What the IRS allows when payingyour kids as employees.

(00:27):
And how some business owners arelegally paying up to nearly 14,
000 per child in a 0 percent taxbracket, while others are losing
thousands of dollars and wastinghours of time.
The difference it's all in thedetails.
Really quickly.
My name is Davion.
I'm a licensed certified publicaccountant.
I formerly worked with the IRSin the European stock market and

(00:47):
with over 70 differentbusinesses spanning over 17
different industries.
My ultimate goal is to help yousave time and money while
building wealth and legacy.
So don't wait and procrastinateuntil the end of the tax season.
Click the link in the bio so wecan get you from where you're at
to where you want to be.
And let's jump back into thevideo.

(01:08):
If you're a business owner and aparent, you probably already
spend money on your kids, thingslike school supplies, sports
fees, clothes or extracurricularactivities.
Normally, those expenses areconsidered personal, which means
you can't deduct them.
On your tax return, but there'sa legal way to pay your
children, reduce your tax bill,and still cover those expenses.

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Here's how it works.
When you earn income throughyour business, it could be taxed
in several ways, federal incometaxes, state income taxes, self
employment taxes, andpotentially other taxes like
sales tax.
Once you've paid all thosetaxes, the remaining money is
what you use to cover.
Personal expenses, like payingfor your kids needs.

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Not only are those expenses nondeductible, but you've also lost
a big chunk of your income totaxes before you even pay for
those personal expenses.
Instead of paying those expensesyourself, you could hire your
children to work for yourbusiness and pay them wages.
Here's the strategy in anutshell.
Number one, your businessdeducts the wages.

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You see, if your child works foryour business, the wages you pay
them are deductible businessexpense.
That means you reduce yourtaxable income by the amount you
pay them.
Number two is your child'sincome is tax free.
If your child earns up to thestandard deduction limit, they
don't owe any federal income taxon those wages.

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Since they're likely minors andyou own the business.
You also won't owe payroll taxeson their wages if your business
is a sole proprietorship, an LLCtaxes one, or a partnership with
both parents as owners.
And the last thing, your childuses their earnings to pay for
their own expenses.
You see, your child can use thewages you've paid them to cover

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some of the same expenses youare already going to pay for
anyway.
The key difference is that thesepayments are no longer coming
out of your post tax income.
By using this strategy, you onaverage save 37.
30 in taxes when paying yourchild a 10, 000 salary.
That same 10, 000 in expenses iscovered, but instead of coming

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from taxed income, it's paidusing your child's untaxed
wages.
Your child benefits by havingearned income, which can also
help with future financial goalslike starting a Roth IRA.
Now, the IRS allows this becausethe wages are legitimate
business expense and your childis treated like any other
employee as long as the workthey do and the wages they earn

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are reasonable and necessary.
By taking advantage of the taxrules, you effectively turn
personal expenses intodeductible business expenses.
legally and strategically.
This strategy is a win win foryour family and for your
business, but it's important tofollow all the IRS guidelines to
avoid issues during an audit.
So let's break down some courtcases and learn how the IRS

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views this tax strategy.
The Fisher v.
Commissioner case provides acritical lesson for business
owners considering the taxstrategy of paying their
children.
Fisher attempted to deduct wagespaid to her three minor children
as business expenses for her lawpractice.
While the concept itself islegal, her execution failed to

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meet IRS standards.
The tax court's decisionhighlights the consequences of
inadequate documentation.
Improper payment methods andoverstated deductions.
You see Fisher operated her lawpractice out of a rented office
in New York and occasionallybrought her children to work
during the summer.
She claimed that the childrenperformed various tasks to

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assist in her law practice, suchas shredding documents,
answering phones, greetingclients, and escorting them to
designated areas.
photocopying documents andhelping move files during office
relocations and cleanup afterfloods.
For this work, official deductedwages paid to our Children on a

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schedule C for three tax years.
The deductions were substantial10, 435.
10, 313 and 8, 022 respectfully.
However, the IRS disallowedthese deductions leading to
litigation and tax court.
The issues identified by the IRSwere absence of payroll records,

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improper payment methods, andunreasonable compensation.
You see Fisher did not issue W 2forms for her children.
She also failed to maintainpayroll records or provide
evidence of tax withholding.
The IRS requires clear recordsto establish an employer
employee relationship and tosubstantiate wages paid.

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Payments were also not madethrough traditional payroll
systems.
Instead, Fisher claimed thatwages were paid partly in cash
for the children to use onpersonal items like books and
souvenirs and partly ascontributions to five twenty
nine college savings plans.
The court emphasized thatcontributions to 529 plans do

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not qualify as wages foremployment tax purposes.
And then the court closelyscrutinized the amounts deducted
in light of the children's ages,which are all under nine and a
task performed.
The lack of documentationregarding hours worth of
specific duties made itimpossible to determine whether
the wages were reasonable.
Ultimately, the court deemed theamount excessive.

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The court acknowledged thatFisher's children performed some
services for the law practice.
However, due to the lack ofevidence, it allowed only a
nominal deduction of 250 perchild per year.
Here's why she had lack ofdocumentation.
Fisher did not providecontemporaneous records such as
time sheets or logs detailingthe work performed by her

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children.
She also had vague paymentpractices, so her payments were
inconsistent and lackedtraceability.
For example, Fisher's testimonyabout payments made in cash and
through the 529 contributionswas unsupported by bank
statements, counsel checks, orother evidence.
She also had no withholding orreporting.

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So the absence of W 2 forms andpayroll tax compliance further
undermined the validity of theclaim deductions.
Consequences of hernoncompliance included
disallowed deductions.
So Fisher's failure to meet theIRS's substantiation
requirements resorted in thedisallowance of nearly all the
deductions for wages.

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Paid to her children.
She also incurred an accuracyrelated penalty.
So the court upheld a 20 percentpenalty under section 66, 62 for
negligence and substantialunderstatement of income tax.
This penalty was based onFisher's failure to maintain
adequate records and herimproper reporting of wages.
Lastly, she's had financial andtime costs.

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Fisher faced not only theadditional tax liability, but
also penalties and the time andexpense associated with
litigating the case in taxcourt.
So you can see the benefit ofbecoming familiar with these
court cases because it providesthe do's and don'ts other
business owners have tried.
So let's dive into case numbertwo in Alexander versus

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commissioner, Alexanderattempted to claim a 6, 315
deduction for wages.
He allegedly paid his 10 yearold stepson for work related to
his network marketing business.
This case provides a vividexample of how failing to meet
IRS standards for documentation,task legitimacy and reasonable
compensation can lead todisallowed deductions and other

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financial consequences.
Alexander operated a networkmarketing business, which he
supported through meetings,presentations and other
promotional activities.
He claimed on his tax returnthat he paid a step son wages
for tasks such as taking out thetrash, vacuuming, setting up
chairs for meetings and cleaningthe pool.

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Alexander argued that thesepayments were necessary labor
expenses for his business anddust deductible on schedule C.
The IRS and tax court thoroughlyexamined Alexander's claims and
documentation.
Several critical deficiencies inhis approach led to the denial
of the deduction.
He had a lack of contemporaneousrecords, so Alexander provided a

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handwritten ledger and acomputer generated list of tasks
performed by Stepson.
However, These records werecreated years later and were not
contemporaneous with the workperformed.
The court deemed them unreliableand insufficient to substantiate
the claim payments.
He also had questionable taxlegitimacy.
So some of the tasks listed,such as help with new baby, were

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clearly personal or householdrelated and unrelated to the
operation of a business.
The IRS in court emphasized thatonly tasks directly tied to the
business were considered.
Qualify for deductible wages.
He had no payroll or taxreporting compliance.
So Alexander also failed toissue a w two or 10 99 form for
a stepson.

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Additionally, he did notwithhold or pay appointment
taxes on the reported wages.
There's a lack of compliancewith payroll requirements,
significantly weakened hisclaim, and he also had
unsubstantiated payments.
Although Alexander testifiedthat he paid his stepson in
cash, he provided nocorroborating evidence such as
council checks or bankstatements.

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The court found no proof thatthe payments were ever made.
The task court disallowed the 6,315 wage deduction entirely,
concluding that Alexander failedto demonstrate that his stepson
performed legitimate.
Ordinary and necessary servicesfor the business.
Additionally, the court notedthe task listed were often

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personal in nature and notordinary and necessary business
expenses as required by section1 62 A of the Internal Revenue
Code.
Alexander's failure to complywith basic payroll and tax
reporting requirements furtherjustified the denial of the
deduction.
So the consequences he had to gothrough were the disallowed

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deduction The accuracy relatedpenalties.
So the court did impose thepenalties under section 6662 for
negligence and substantialunderstatement of income tax.
And then he also had areputational and time cost.
So beyond that monetary loss,Alexander had to invest
significant time defending hisclaims in tax court.

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The final court case we're goingto discuss is the biggest of
them all.
Embroidery Express LLC versusCommissioner provides a deep
look into how wages paid tochildren by a family business.
can go wrong when not properlysubstantiated or justified.
The McMinn family operatingadvanced embroidery supply
claimed significant deductionsfor wages paid to their

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children, including tasksranging from cleaning offices to
transporting embroiderymachines.
However, a lack ofdocumentation, excessive bonuses
and questionable wage practicesled to substantial disallowances
by the IRS and the tax court.
So let's look at the story.
The McMinn couple owned multipleentities under their embroidery

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business umbrella, includingadvanced embroidery supply
through which they employedtheir minor children.
Now, during the three years inquestion, the McMinn's paid
their children 46, 516.
50, 913 and 64, 650,respectfully.

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The children received thesepayments through a combination
of small periodic payments andlarge year end bonuses.
The McMins deducted these wagesas business expenses issued W 2
forms, and the children reportedtheir income on their tax
return.
Sounds legit, right?
The IRS challenged thedeductions asserting that the
amounts were unreasonable,inadequately substantiated, and

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partially served as familysupport rather than legitimate
wages.
The children were involved invarious roles within the family
business, including, but notlimited to cleaning the office,
including bathrooms and thebreak room, assisting with
inventory, helping cleanembroidery machines, assisting
with transporting embroiderymachines, Often out of state,

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helping with repairs to themachines and providing lawn care
for the business properties,handling mail, phone calls and
appointments, and preparingdocuments related to machine
transportation.
The work performed by thechildren vary significantly
based on their age and skilllevel.
For example, the older childresponsibilities as a full time

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employee were much moresophisticated compared to the
younger children's tasks.
The men's failed to providesufficient records such as time
logs or job specific taskdocumentation to substantiate
the wages paid to the Children.
Payments were madeinconsistently, often in large
lump sums at the end of theyear, with no clear link to

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specific work completed.
They also had unreasonablecompensation.
The large year end bonuses,particularly for the younger
children, were disproportionateto the task performed.
For example, the eight year oldreceived eleven thousand fifty
dollars, an amount the courtdeemed excessive given her age
and the nature of her work.

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The tax court ruled against theMcMinn's on several key points.
The payments to the youngerchildren was one.
So the court acknowledged thatthe younger children performed
some work for the business, butfound that the large bonuses
paid at year end were notreflective of a bonafide
employer employee relationship.
The court allowed deductionsonly for small periodic

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payments, which it deemedreasonable for the task
performed.
Okay.
The large bonuses weredisallowed.
They also had payments to theolder children.
So unlike the younger children,the older child's work as a full
time receptionist was welldocumented and aligned with
industry standards for similarroles.
So the court allowed deductionsfor her wages in full.

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The last was overall deductiondisallowance.
So a significant portion of theclaim deductions was disallowed,
particularly the year endbonuses as they were determined
to be unreasonable andunsupported by adequate records.
The consequences for theMcMinn's were just like the
others disallowed deductions.
So the court disallowed themajority of wages paid to the

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younger Children, reducing theallowable deductions to amounts
deemed reasonable for the taskperformed the accuracy related
penalty.
So the I.
R.
S.
Imposed that penalty undersection 66 62 for negligence and
substantial understatement ofincome tax and being the
financial and time loss beyondthe disallowed deductions.

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And penalties, the McMeansincurred significant costs,
defending their position incourt, a burden that could have
been avoided with propercompliance.
Now, do you want to use thisstrategy for yourself?
Here's your checklist.
First things first, real work,real documentation, create
detailed job descriptions, trackhours worked and tasks

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completed, document how the workbenefits your business and keep
all records contemporaneously.
That means as the work happens,not during an audit.
Next, I want you to make sureyou have age appropriate tasks.
So follow federal and statechild labor laws.
Ensure tasks match the child'scapabilities.
Consider digital tasks foryounger children like social

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media and basic data entry anddocument training and
supervision.
Next, reasonable compensation.
So make sure you pay marketrates for the work performed.
Keep compensation consistentwith experience, avoid large
unexplained bonuses, anddocument how you determine your
pay rates.
Lastly, proper paperwork.
So issue W 2s, not 1099s,maintain agreements, keep

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timesheets and payment records,and file all required payroll
tax returns.
When done correctly, thisstrategy can save your family
thousands in taxes whileteaching your kids valuable
business skills.
But remember what the tax courtrepeatedly emphasizes.
Substance over form.
The work must be real, thecompensation must be reasonable,

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and the documentation must besolid.
This article provides thegeneral information, not
individual tax advice.
Tax situations vary.
Consult with a qualified taxprofessional for advice specific
to your circumstances to consultwith me for your specific tax
situation.
Click the link in the bio andthanks for watching the video.