Self-Employment for the Shareholders

A basic principle of taxation is that anyone who earns income should pay tax on it. “The existence of a validly organized and operated corporation does not preclude taxation of income to the service provider instead of the corporation.”

A taxpayer and his wife, who is a realtor, each owned S corporations. The taxpayer ran his construction business through one corporation while his wife runs her business through another corporation. The S corporations recognized the income and operating expenses of their businesses. Neither the taxpayer nor his wife received a salary from the S corporations. No payroll taxes were paid on moneys distributed to them. They did report income flowing through (pass-through income) to themselves from the corporations and paid income tax on the amounts, but no FICA or self-employment tax.

In this case, the IRS and the Tax Court has determined:
· The person providing the service is an employee of a corporation that has the right to instruct or control the employee in some meaningful sense.
· There exists a contract or similar arrangement between the corporation and the service provider that recognizes the right to instruct or control.

Both of these factors were absent in this case. Therefore, it has been upheld by the Tax Court to subject the taxpayers’ income from their S corporations to self-employment tax.

If you have an S corporation where the shareholder(s) are performing services for the S corporation, they should be drawing a reasonable salary and reporting it on IRS Form W-2.

Further reading:

Corporations

S Corporations

Tax Information for Corporations

Publication 542

Tax Help - "Do Your Children Work For You?"

Taxpayers who own small businesses such as paper route carriers and vending machine businesses sometimes have their children work with them. In some instances the owner (father/mother) will use their children’s help as a deduction.

If you do use your child to do minial tasks in your business, beware, the IRS has very specific regulations for claiming wages paid to a child.

In Tax Court Summary Opinion 2005-11, the IRS disallowed the deduction for amounts paid to children after determining that the amounts were not ordinary and necessary expenses paid or incurred in a trade or business.

The Tax Court also determined that a taxpayer is 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.

As an example, a taxpayer states that his children work about ten hours per week, but does not really keep good records on the exact time. For their services, the taxpayer writes checks to each child in the amount of $3,000 each year and deducted these amounts as labor expenses.
The parent does not set up separate accounts for his children to deposit their alleged wages. Without proper documentation, the IRS will assume that the parent kept the proceeds and either reinvested into busines or deposited the amounts into their own personal account. The parent also never establishes and hourly rate for the child’s services and pays the set amount.
Overall, the parent did not keep adequate books and records or otherwise substantiate the deductions reported on his Schedule C and the amount allegedly paid to the child remained in his control.

This particular case does not state that children cannot work for their parents. However, if children are hired, make it legitimate, substantiate the hours worked, and actually pay them a reasonable wage. But most of all, make the money earned theirs. Save for their education and financial future.

TAX TIP: Parents owning a sole proprietorship or a partnership with a spouse can hire their children and avoid withholding FICA as long as the children are under the age of 18. Your are not required to pay FUTA until your child reaches the age of 21. This exception from withholding does not apply if the parents own a corporation or if there are any partners in the partnership other than the child’s parents.