Taxpayer Fails to Prove Compensation Deduction

It may often be a good idea for a small business owner to have
children and other relatives on the company payroll. However, a new
Tax Court case put a spotlight on what truly qualifies for the tax
deductibility of compensation to that employed relative, and what does

Certainly, small business clients may know the tax benefits of having
family members on the payroll, but a new Tax Court case, Wolpert, TC
Memo 2022-70, 7/7/22,  found that the payments must be for actual
services rendered.

Background: Hiring your child to work for your company can turn into a
tax bonanza. Although the wages are taxable to your child, they will
often qualify for tax-free fringe benefits, including health
insurance. In addition, the child may participate in the company’s
401(k) or another qualified retirement plan. And there may be payroll
savings for a young child employed by an unincorporated business.

To top things off, the business can deduct the amounts paid to the
child as long as they are reasonable for the services they
legitimately provide. But the burden of proof is on the business if
the IRS contests the deduction. That was the rub in the new case.

Key facts: The taxpayer, a resident of Pennsylvania, is a former
professor of public affairs and urban planning. His academic career
included posts at the Wharton School of the University of Pennsylvania
and Princeton University.

During the two tax years in question—2016 and 2017—the taxpayer
engaged in various consulting activities focusing on civic engagement.
He didn’t maintain a separate checking or credit card account for his
consulting activities. Instead, he made payments from personal
checking accounts.

The IRS disputed a number of deductions claimed for business expenses,
including vehicle and travel expenses. For this purpose, we will focus
on the taxpayer’s claims regarding various checks issued to his three
children and one grandchild for work as his “assistants.”

School’s out: After examining the facts and the testimony at trial,
the Tax Court concluded that the taxpayer failed to properly
substantiate the payments as compensation or reimbursement amounts.
Thus, they are treated as being purely personal and nondeductible.

To summarize, the taxpayer didn’t maintain bank accounts to be used
for payment of compensation by his business. Notably, there wasn’t any
documentary evidence presenting payments being made for services, nor
were there any copies of negotiated checks to assistants.

The payments from the personal accounts didn’t bear any notation as to
the purpose of payment. Also, the taxpayer failed to provide any
evidence substantiating the expenses of one child who was purportedly
being reimbursed. Ultimately, there was no proof that the child worked
for her father.

Finally, the taxpayer’s contention that a child inadvertently threw
out business records stored in their residence following her mother’s
death wasn’t supported. This closed the book on the taxpayer’s case.

Reminder: A taxpayer’s company can deduct payments to a child, or
another relative if the compensation is reasonable in amount. If a
client has a bona fide business relationship that can be
substantiated, make sure they don’t go overboard and pay the child an
excessive salary. Some common sense can go a long way.

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