Hiring your children to work as employees in your business can be a great tax savings strategy. The money you pay them is a tax deductible business expense; and, since they are likely in a much lower tax bracket than you are, the tax due on the amount you pay will be much lower. In fact, they won’t have to pay any tax on their income at all unless it exceeds the IRS standard deduction.
Patricia Ross, a parent of three who ran a consulting and tax preparation business out of her home, was apparently fully aware of these benefits. She hired her children to work in her business and deducted what she paid them as wage expenses on her Schedule C. However, she was later audited by the IRS and denied her deduction. She lost her appeal to the tax court. (Ross v. Comm’r, T.C. Summ. Op. 2014-68.)
What went wrong?
Naturally, the IRS is suspicious whenever you hire a relative, particularly a child, to work in your business and claim a deduction for their compensation. As with any other employee, a child’s compensation is deductible as a business expense only if it is: (1) reasonable in amount, (2) based on services actually rendered, and (3) actually paid or incurred. Presence of the following factors will lead the IRS to conclude that payments to a child are not deductible:
Ross’s children were ages 15, 11, and 8. Their work included shredding, stuffing envelopes, copying, sorting checks, filing, “pulling" trash, carrying equipment, and helping to shop for supplies. The tax court found that most of this work consisted of parental training and discipline rather than the services rendered by an employee for an employer.
Moreover, there was no clear correlation between the amount of “work” the children performed and how much they were compensated. For example, in January 2008 the oldest child was “paid” $132.27 and worked, according to Ross’s time sheets, 39 hours, a rate of about $3.40 an hour. The same child was “paid” $515.21 for 20.5 hours of work in May 2008, a rate of about $25 an hour.
Ross kept timesheets showing how much each child worked and listing their compensation. Two of the children had recorded earnings exceeding $3,000 in 2007, and all three had recorded earnings exceeding $3,000 in 2008. However, Ross never actually paid her children with money—whether by cash or check. Instead, she bought things for them that they wanted, matched the amount against their “earnings,” and then made the appropriate charges against them in her records. The items she purchased and then charged against their earnings consisted primarily of pizza and other food, and fees for tutoring services.
Under longstanding tax rules, the value of meals and education furnished by a parent to a minor child is not income to the child nor a deduction allowable to the parent—a parent has a legal duty to support his or her children if able to do so. Wages paid by a parent to a minor child for services actually performed, however, may be a deductible business expense regardless of the parent’s legal obligation to support the child. The use to which the child puts the wages does not affect their deductibility. Thus, had Ross paid her children with money, they could have purchased pizza themselves, and she could have deducted the payments.
You can’t hire your children and pay them an exorbitant amount for their services in order to obtain the largest tax deduction you can. Their compensation must be reasonable under the circumstances to be deductible. Ross told the tax court that she paid her office workers $15 to $20 an hour to do some of the same types of work as her children performed. However, her records showed she "paid" her oldest child almost $30 an hour during one year.