How the Tax Court Upholds IRS Employment Choices

In three previous columns, I discussed often-overlooked IRS tax breaks available in 2021 for freelancers, consultants and other self-employed individuals who pay their sons and daughters reasonable wages for work actually done by the children on behalf of their businesses. One discussed dealing with retirement benefits like Social Security taxes.

This column covers how the courts usually uphold IRS determinations that “wages” paid by parents to their children actually were nondeductible allowances or spending money.

First, though, let’s focus on what the IRS tells parents to do. Truly treat their children like employees; be able to document that the children actually perform the chores for which they’re paid; make sure that the work is necessary for the business; and pay only reasonable amounts for the jobs performed.

What can happen when parents are unaware of or ignore IRS admonitions not to blur the lines between business and family. Let’s start with a Tax Court decision that denied deductions for payments over a two-year period by an Indiana surveyor to his children, ages nine and eleven, for sweeping out his office and helping him with surveys. He kept no records of the time they worked. His case really went down the drain when the judge examined the children’s pay checks and found all of them had been redeposited in the father’s account.

The doctor doesn’t always know best. A 1974 Tax Court decision dealt with a disputed payment turned over by Dr. Anthony R. Furmanski, an Encino, California neurologist, to his teenage daughter. The court concluded it wasn’t a deductible salary, as he claimed, but merely a nondeductible allowance.

The doctor got exactly nowhere with his argument the payment compensated his daughter for regularly answering calls from patients at his home when his office’s answering service was off and he didn’t want to be disturbed. A dubious judge noted that children normally answer family phones.

Nor was the doctor’s case helped by his admission that he made the entire payment to his daughter in advance––and paid nothing to his son for answering calls. The clincher was his failure to keep any records showing when she worked for him or, in this particular situation, to withhold taxes on the payment.

All in the family. The Tax Court mostly sided with Walter and Dorothy Eller, who hired their three children, ages seven, eleven, and twelve, to work at their mobile home parks in California.

During a three-year period spanning 1972 to 1974, the capable kids, as the parents persuasively explained to the Tax Court, accomplished the following: cleaned the grounds and laundry rooms; performed landscape work; maintained the swimming pools; read gas meters; answered phones; delivered leaflets and messages; and made minor repairs.

Walter and Dorothy submitted 1040s on which they included deductions for nearly $18,000 of their payments to the children. Their ambiguous listing for the payments: “outside services.”

The IRS’s Stepford reaction was to invoke the “reasonableness” requirement, disallow about 90 percent of the payments as “unreasonable”, and send a bill for additional taxes, interest and penalties to the parents.

The IRS’s rebuff prompted them to ask the Tax Court to determine how much was reasonable, which turned out to be a smart decision, as the court focused on what would’ve happened had the children not done the work and concluded that the parents would’ve had to hire someone else to do it.

Because the children performed what the court characterized as “substantial services,” it approved more than $15,000 as allowable. The court attributed most of the disallowance to the seven-year-old, although it did allow around $4,000 of his earnings.

“Experience teaches that 11- and 12-year-old children can generally handle greater responsibility and perform greater services than seven-year-old children,” the judge explained.

With malice toward some. I’ll conclude with my reaction when judges approve deductions for wages paid to a seven-year-old.

“Really?”, like they say on Saturday Night Live’s “Weekend Update.” I’ve yet to encounter a seven-year-old who’s able to help operate a parent’s businesses.

Not even my two grandsons. They’re twins who awed me, because of what happened when they had yet to attain age five. Both read flawlessly from the Passover Haggadah, which recounts a story from the Book of Exodus about how God intervened to deliver the Israelites from several hundred years of slavery in Egypt.

While they read, it never entered my mind to remind them of how things would play out, were they to take care of some business chores for freelancer grandpa. He would garner a tax deduction for payment of reasonable wages to them for work they actually performed.

Why did I pass up a write-off? Because of my take on seven-year-olds, a take that, I prefer to believe, would’ve been shared by even Fred M. Rogers, creator and host of the preschool television series “Mister Rogers’ Neighborhood,” which ran from 1968 to 2001.

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 350 and counting).