Were Children Really Employees? - Digit Payroll
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Were Children Really Employees?

The taxpayer operated a sole proprietor vending machine business, in which he deducted compensation paid to his two children. The IRS disallowed the education for amounts paid to his children after determining that the amounts were not ordinary and necessary expenses paid or incurred in a trade or business. The IRS also determined that the taxpayer was liable for the accuracy-related penalty in regard to the underpayment attributable to the disallowed deductions. The tax court ruled for the IRS on both issues.

The taxpayer testified that the services provided by his children, ages ten and five, included: riding along on a weekly route, putting candy bars into the machines, sorting the totes full of candy, and breaking down the cardboard and sorting recyclable products. He testified that the children worked about ten hours per week, but he did not know for sure how often his children worked every week and he did not keep any record of their hours. For these services, he wrote checks to each child for $4,200 each year at the end of December and deducted these amounts as labor expenses.

These checks were not cashed until at least two months later because the business had insufficient funds. Even after the checks were endorsed, the taxpayer retained control of the proceeds. He did not set up separate accounts for his children to deposit their alleged wages. Instead he kept the proceeds and either reinvested into the business or deposited the amounts into his own personal account. The taxpayer never established an hourly rate for the children’s services and paid a set amount for both years in question. The taxpayer testified that the payments to his children were based on what he believed the “law allowed for, so that they would not have to file taxes.” The taxpayer did not keep adequate books and records or otherwise substantiate the deductions reported on his Schedule C and the amount allegedly paid to the children remained in his control.

The IRS also assessed the penalty under ยง6662(a) based on the amount of the underpayment due to the disallowed deductions. This penalty is imposed on the portion of the underpayment attributable to any one of various factors, one of which is negligence or disregard of rules and regulations. Negligence includes any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code, including any failure to keep adequate books and records or to substantiate items properly.

This case does not state that children cannot be hired to work in a business. However, if children are hired, make it legitimate, substantiate the hours worked, and actually pay them a reasonable wage.

TC Summary Opinion 2005-11
December 2007 NATP Taxpro Monthly