Small business owners often look for ways to reduce their taxes. With family businesses, these plans often involve employing the owner’s children. This raises the question of whether a small business owner employ their children as independent contractors and deduct seemingly personal expenses for the children as fringe benefits if the children did in fact provide legitimate services for the business? The court recently addressed this in Wax v. Commissioner, T.C. Memo. 2018-63.
The Facts & Procedural History
The facts and procedural history for the case are as follows:
The taxpayer operated a business. It was taxed as a sole proprietorship. The business reported $710,027 in gross receipts and $712,487 for business expenses in 2014.
The expenses included contract labor for payments made to her son and daughter. The taxpayer claimed both children as dependents on her 2014 tax return.
The expenses also included expenses relating to four or five family vehicles, travel expenses, monthly dry cleaning bills, meals and entertainment expenses, etc. These expenses were incurred for the taxpayer or her children.
On audit, the IRS disallowed the deductions for contract expenses and the other expenses. Litigation ensued. The IRS conceded the contract labor expense deduction, leaving only the other expenses incurred for the taxpayer and/or her children.
For the expenses attributable to her children, the taxpayer took the position that the expenses were deductible as fringe benefits for her children workers.
Section 262 and 132 Expenses
Personal expenses are not deductible. This rule is set out in Section 262. Section 262 says “[e]xcept as otherwise expressly provided in this chapter, no deduction shall be allowed for personal, living, or family expenses.”
The law also allows taxpayers to deduct certain fringe benefits. This rule is set out in Section 132. Section 132 says that the following fringe benefits paid to workers are excluded from gross income:
- no-additional-cost service,
- qualified employee discount,
- working condition fringe,
- de minimis fringe,
- qualified transportation fringe,
- qualified moving expense reimbursement,
- qualified retirement planning services, or
- qualified military base realignment and closure fringe.
Disguised Personal & Family Expenses
The court was asked to reconcile these two rules. It concluded that the expenses were disguised family and personal expenses and not employee fringe benefits. It did so without providing much detail given that it did not believe the taxpayer provided sufficient records to determine which expenses could have been employee fringe benefits and it did not accept her explanations for the business purpose for some of the expenses.
About Family Fringe Benefits
Had the taxpayer provided sufficient records and separated out non-deductible personal expenses for herself, she may have been entitled to deduct some of the balance of the expenses.
Most deductible fringe benefits are limited to those amounts paid to employees. This is set out in Section 132 itself. There are exception for working condition fringe benefits and certain other expenses. This is also in Section 132 and/or the regulations for Section 132. Costs incurred by the contractor for travel, transportation, etc. are also deductible by the business under Section 162 and, if they meet the accountable plan requirements described in Section 62, excluded from the workers income.
The taxpayer paid her children as independent contractors and not as workers, so the Section 132 benefits would generally be limited to working condition fringe benefits. There are rules that determine what is deductible as a working condition fringe, but these benefits can even include education-related expenses, such as tuition.
This provides the framework for fringe benefits that are deductible for family members.
These type of expenses are frequently challenged by the IRS. They often result in tax disputes. To avoid these disputes, small business owners should take the time to keep records for these type of expenses and structure their affairs so that only qualifying expenses are deducted.
This issue is even more relevant given the recent TCJA changes that prevent workers from being able to deduct unreimbursed employee expenses. Now that workers cannot deduct these expenses themselves, taxpayers will want to shift more of these expenses to their business rather than to their workers.