Archives for July 2013

Small business owners can have family members such as their children who work for the business.  Many times, parents will pay their children for the work they perform but will not take a tax deduction for amounts paid to their children.  This is a mistake.

The Income Tax Break

Parents are able to claim a tax deduction for compensation paid to their children.  While the children will have to claim this compensation as income, the income will be taxed at the child’s lower tax rate.  Additionally, the child will be able to shelter up to $6,100 of income with the standard deduction.  This income tax deduction strategy works for all types of business entities (proprietorship, partnership, corporation, and LLC).

The Payroll Tax Break

Children under age 18 who work for their parents sole proprietorships or partnerships/LLCs (if the parents are the sole partners/LLC members) are not subject to FICA taxes on their payroll.  Additionally, the proprietorship or partnership/LLC will not be subject to the employer portion of FICA or FUTA.  This payroll tax benefit is only available for proprietorships and partnerships/LLCs in which the parents are the only partners.  If a child works for his parent’s corporation, the exemption from payroll tax is not available.

The Self-Employment Tax Break

An additional benefit for proprietorships and partnerships (including LLCs) is that the deduction for compensation also reduces the business owner’s self-employment income, which is subject to the 15.3% self-employment tax.

Example

Example:  Tim is an attorney.  He operates as a proprietorship.  His 16 year old son, Jimmy, does administrative work for him such as filing documents, shredding documents, scheduling appointments, and other clerical work.  Based on the work his son performs, it is reasonable for Tim to pay Jimmy $10,000 per year.  Tim is in the 25% tax bracket.

By claiming a $10,000 compensation deduction, Tim’s income tax is reduced by $2,500 ($10,000 deduction times 25% tax rate).  Additionally, the $10,000 compensation deduction reduces Tim’s self-employment income by $10,000, saving him an additional $1,530 ($10,000 deduction from self-employment income times 15.3% self-employment tax rate).

Jimmy has to claim the $10,000 as income.  This is his only income for the year.  Jimmy is able to claim a standard deduction of $6,100 which reduces his taxable income to $3,900.  Jimmy is in the 10% tax bracket, so his tax will be $390.

The total tax benefit is:

Tim’s income tax reduction:                        $2,500

Tim’s self-employment tax reduction:           $1,530

Less: Jimmy’s income tax:                           ($390)

Total tax benefit:                                      $3,640

Since Tim operates as a proprietorship, he will not have to pay FICA or FUTA taxes on Jimmy’s compensation and Jimmy will not have to pay FICA taxes on his compensation.  Additionally, Jimmy now has earned income that allows him to make IRA contributions which can further lower income taxes owed.

Make Sure the Compensation is Reasonable and Well Documented

The IRS will not allow this strategy if the compensation paid to children is unreasonably high.  Factors that determine reasonableness include:

• The hours worked
• The nature of the work involved
• The expertise required to perform the work
• The typical compensation paid to others performing the same work

It is especially important to ensure that basic business practices such as keeping time reports, filing payroll tax returns, and basing pay on worked performed (not on a relationship to the employer) are followed.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

In celebration of the illegal fireworks many of us will be firing off this weekend, I will use this blog post to explain the rules for deducting expenses related to illegal activities.Now don’t you go and take this too seriously—I’m not advocating illegal business activity; the point of this is to have a little fun with some of the absurdity in the tax law.Plus, my brain is already on vacation and I don’t have it in me to write too heady of an article.

In 1969, Congress added language to the tax law that explicitly denied deductions for the following expenses:

• Bribes and kickbacks.  IRC §162(c)
• Fines and penalties.  IRC §162(f)
• Punitive damages portions of criminal antitrust violations.  IRC §162 (g)

The legislative history of these provisions indicate that this list is all inclusive—thus, expenses of illegal activities are deductible against federal income tax unless Section 162 explicitly provides that the expenses are not deductible (as it does in the above list).  However, Section 280E provides that expenses incurred in drug trafficking are not deductible (oh, man!).

Let’s run through some examples:

John runs an illegal bookie operation out of his home office.  To make sure he collects from his clientele, he hires goons to break legs. Are John’s home office and goon expenditures deductible?

The answer is yes!  Since Section 162 does not prohibit deductions for illegal gambling and goon services, John can take the deductions.  As a practical matter, John is still violating several laws that could subject him to criminal prosecution.  On his tax return, John can label these deductions as “Fifth Amendment Expenditures,” to help prevent discovery of his heinous activities.  But guess what, labeling an expense as a Fifth Amendment Expenditure is a red flag.  Expect a call from law enforcement.

Example the Second:

Jane runs a pizza parlor that delivers.  Jane has $2,000 in parking tickets she got by parking in front of fire hydrants.  Can Jane deduct her parking tickets?  Nope.Section 162(f) disallows deductions for fines and penalties (such as parking tickets).  Apparently, Jane doesn’t have her act together like John.

Example the Third:

Tina runs a moonshining operation and pays bribes to the coppers (“5-0” in early-90s street parlance).  Tina gets pinched and has to pay criminal defense attorney fees.Riddle me this:  Are these expenses deductible?

The bribes are not deductible under Section 162(c).  The costs of defending herself against criminal charges related to her illegal business activity are deductible!!!  Commissioner v. Tellier, 383 U.S. 687 (1966).

So, there you have it. Have a happy 4th of July weekend!

This posting contains general tax information that may or may not apply in your specific tax situation. Before starting up your own illegal business operation, please consult a tax professional (other than us) before relying on any information contained in this post.

Interest due and paid on qualified education loans for qualified higher education expenses can be claimed as a tax deduction.  The deduction is an above-the-line deduction so it can be claimed regardless of whether the taxpayer itemizes.  Married taxpayers must file a joint return to claim the deduction and no deduction is allowed to a taxpayer if he or she is being claimed as a dependent by another taxpayer.

The maximum amount of student loan interest that a taxpayer can deduct is $2,500 per year.  The limitation is the same regardless of how many students are in the taxpayer’s family.  There is an income phaseout on the student loan interest deduction.  For 2013, the deduction phases out when modified Adjusted Gross Income moves from $125,000 to $155,000 for joint filers and $60,000 to $75,000 for single and head of household filers.

What is a Qualified Education Loan?

A qualified education loan is any loan incurred solely to pay for the qualified higher education expenses of the taxpayer, the taxpayer’s spouse, or any dependent of the taxpayer at the time the loan was taken out to attend an eligible education institution (generally a college or university) or an institution conducting internship or residency programs leading to a degree or certificate from an institution of higher education, a hospital, or a health care facility conducting postgraduate training.

What are Qualified Higher Education Expenses?

Qualified higher education expenses for purposes of the student loan interest deduction are generally the student’s cost of attending the educational institution.  These costs include tuition, fees, room and board, books, equipment, and related expenses.

The amount of qualified higher education expenses must be reduced by the following:

• The exclusion from gross income for employer provided education assistance under Section 127 plans
• The exclusion of income from U.S. savings bonds used to pay higher education expenses
• The exclusion from income for distributions from Educational Savings Accounts and Qualified Tuition Programs
• The amount of any scholarship, veteran’s educational assistance, or any other nontaxable payment received for educational purposes

It must be noted that only the taxpayer that is legally obligated to make interest payments under the loan’s terms may claim the student loan interest deduction.  Therefore, parents cannot claim interest deductions on payments they make on loans in which their children are borrowers.

Where a parent cosigns a loan, the IRS will allow the parent to claim a student loan interest deduction because the parents and children are now jointly liable on the loan and the parents are deemed to be legally obligated to make the interest payments.  In this case, parents must realize that they are exposing themselves to a substantial liability in exchange for an annual $2,500 tax deduction.  A deduction will not be allowed when a parent guarantees the student loan.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.