If a minor child earns income, is the income taxable to the parent or the child? There have been quite a few tax disputes involving this question. The Ray v. Commissioner, T.C. Memo. 2018-160 court case provides an opportunity to consider these rules.
The Facts & Procedural History
Mr. Ray the financial officer for a non-profit he co-founded. He took the position that five of his children worked for the non-profit as office assistants. This included answering telephone calls and emails, handling the mailing duties, and filling orders. He did not require his children to fill out timesheets or document their hours. He also did not file Forms W-2 to report wages paid to the children.
While the non-profit did not make enough to pay Mr. Ray for his services, it paid $260,120 to his children for their services. The non-profit paid the children by check, which Mr. Ray signed as the financial officer for the non-profit. The children then deposited most of the checks into their education savings accounts.
On audit, the IRS determined that the $260,120 was income taxable to Mr. Ray. Litigation ensued.
Taxed for the Parent or Child?
The Code includes rules that subject a child’s investment income to the parents higher income tax rate. These rules are generally referred to as the “kiddie tax.” These rules are intended to prevent parents from shifting investment income to their children. But these rules do not apply to the child’s earned income.
The Code specifically addresses whether the child or the parent are liable for income tax on the child’s earnings. Section 73(a) provides that:
Amounts received in respect of the services of a child shall be included in his gross income and not in the gross income of the parent, even though such amounts are not received by the child.
This makes it clear that the child is to be taxed on their earnings. But the Code does not stop there. Section 6201(c) provides that:
Any income tax under chapter 1 assessed against a child, to the extent attributable to amounts includible in the gross income of the child, and not of the parent, solely by reason of section 73(a), shall, if not paid by the child, for all purposes be considered as having also been properly assessed against the parent.
This means that the income may be taxable to the child, but can be assessed against the parent if the child does not pay the tax.
Before getting to Section 6201, one has to determine whether the parent or the child actually earned the income. There are a number of fact patterns where the child receives earned income, but still may not trigger Section 73 or 6201. There are several recurring fact patterns that provide examples.
The courts in these cases generally look to (1) whether services were actually provided and (2) to who the true earner is, which turns on who had the ultimate direction and control over the earning of the income.
The Child Child Services Fact Pattern
The easiest fact pattern is where a child provides services for a third party. The Lopez v. Commissioner, T.C. Memo 2017-171 court case provides an example. It involves a minor child who competed in beauty pageants. The child’s winnings were deposited into her college savings account. The taxpayers reported this income and the corresponding expenses, which netted to a loss, on their income tax returns. The court concludes that the winnings were compensation for the child and belonged to the child for income tax purposes.
The Plausible Child Services Fact Pattern
There have been a number of disputes involving a taxpayer who owns a business and the business pays the child for services rendered for the business. The Roundtree v. Commissioner, T.C. Memo 1980-117 case provides an example. It involves a solo attorney who paid wages to his two sons and daughter. The sons were attending community college and came home on weekends to do odd-jobs for their father. This included car washing and waxing, xeroxing, cleaning and furniture moving at the law office and serve process, perform clerical duties, conduct record searches, file documents at the local courthouse and do some investigative work. The attorney’s daughter provided bookkeeping services. The attorney-father did not keep timesheets for his children’s services, but he did report some portion of the income on Forms W-2 for the children. The court concludes that the children did provide services given their testimony and that the amounts reported on the Forms W-2 were compensation.
The Child Services Facilitated by the Parent Fact Pattern
There are also court cases where the child received income, but the parent provided substantial services that facilitated the receipt of the income. Allen v. Commissioner, 50 T.C. 466 (1968), provides an example. It involves a bonus for signing a professional baseball player contract. The player was a minor at the time the contract was entered into. The player’s mother had spent considerable time and effort negotiating the contract and, given that her son was a minor, she consented to the son signing the contract. The son took the position that the signing bonus was compensation earned by his mother for these services. There was no evidence suggesting an oral or written contract between the son and mother. As such, the court determines that the signing bonus was to secure the son’s services to play baseball and the income belongs to the son rather than the mother.
The Parent-Child Services Fact Pattern
There are other cases where the child provides services along side of the child, but the parent is paid for the child. The Fritschle v. Commissioner, 79 T.C. 152 (1982) case provides an example. It involves a printing company that sold ribbons that had rosettes affixed to them. The taxpayer-husband was an employee of the company. He agreed to have his wife and eight minor children assemble the rosettes to the ribbons at his personal residence. The work involved cutting, shaping, and stapling of things like streamers, bezels, and ribbons to form the final product. The company paid the wife on a piecemeal basis at 3 cents per ribbon and 15 cents to 25 cents per rosette. The company knew that the children were performing some of the work, but the payment for the services were made by check directly to the taxpayer-wife. The court concludes that the taxpayer-wife managed, supervised, and otherwise exercised total control over the entire operation. Because she controlled the capacity to earn the income, the court concludes that the income belongs to her and not her children.
The Business Transfer, Child Services Fact Pattern
There are also cases where the parent transfers a business to the child, thereby shifting earned income from the business to the child. The DeKorse v. Commissioner, 5 T.C. 94 (1945) court case provides an example. It involves a tool and die company. The two partners admitted their wives and one of the son’s minor children as a partner. The roles of the two original partners, their wives, and the minor son with respect to the business did not change after the business structure was changed. The wives were paid their allocable share of the profits after the change. The mother of the minor son who was now a partner kept the son’s allocable share of the profits. The minor son was also paid for his work hours, which consisted of occasionally being around the shop as an apprentice. The court concludes that all of the profits were allocable to the original two partners. The rationale is that the partners intended to assign the income from the business, rather than gift a capital interest in the business.
The Paycheck Transfer, Child Services Fact Pattern in the Ray Case
The court in Ray, did not question whether Mr. Ray’s children provided services for the non-profit that Mr. Ray controlled. Rather, the court focuses on who earned the income. The court concludes that Mr. Ray earned the income–not his children. As a result, Section 73 did not apply and the income is taxable to Mr. Ray.
The fact pattern in Ray is slightly different than the “business transfer, child services fact pattern,” as the business was not transferred to the children. Instead, Mr. Ray’s compensation was transferred to the children.
The result is consistent with the other fact patterns. The outcome may have been different if the non-profit paid Mr. Ray for his services, filed employment taxes for the children, and the children filed returns to report their own income.