Tax rules are not always clear-cut. Several recent rulings, including some victories for taxpayers and some defeats, help clarify the rules and provide lessons that could help you save money on taxes and/or avoid a fight with the IRS…
• Be careful how you pay your employees, especially your children. When Patricia Diane Ross asked her three children to handle chores such as filing, shredding and stuffing envelopes at her employment agency in Washington, DC, she figured that she could take a tax deduction for their wages as a business expense because she considered them to be employees. She prepared time sheets and W-2 forms for the children, ages 15, 11 and eight, but she never took any income tax withholding from their pay or issued them any paychecks. Instead, she used their salaries to pay for their pizza, tutoring and other things that she said they ”directed” her to spend the money on. She deducted these disbursements as wages on tax returns for her business and cited several IRS publications as backup.
IRS Position: The payments were not wages that she could deduct because what she gave the children were the kinds of things that all parents might normally provide—food and tutoring—rather than wages tied to work.
Tax Court Ruling: The deduction is not allowed because there was a lack of correlation between the dates and amounts of the payments and the hours supposedly worked by the children. Example: When the Tax Court divided the disbursements on behalf of the oldest child by the hours worked, in one month he was effectively paid $3.40 per hour while in another month he received $25 per hour. Also, the arrangement in which the children helped the mother in exchange for eating out and receiving tutoring seemed to be more in the nature of parental training and discipline than of services rendered for an employer by an employee. Ross had to pay a penalty and back taxes.
Lesson: While there’s no bar to employing one’s own minor children for nonhazardous work (within limits on hours), if you want to be able to deduct what you pay them as an expense of your business, it’s vital to keep a careful record of the time of work and work performed…issue paychecks for this work and withhold income taxes…and set the wages at a rate properly reflecting the work performed.
Patricia Diane Ross, Tax Court Summary Opinion 2014-68
• There can be slight leeway on personal use of a home office. Lauren Miller was the New York City account director for a public relations firm based in Los Angeles. Because she was the only employee in New York, the company didn’t provide her with office space and asked her to use part of her 700-square-foot studio apartment as an office that included her desk, two shelving units, a bookcase and a sofa. Her apartment’s address and phone number were listed as the company’s New York space on its website even though it did not reimburse her for this space.
She claimed a sizable home office tax deduction as an unreimbursed employee business expense.
IRS Position: The IRS denied her write-off, claiming that she violated the law’s requirement that a home office be used exclusively—meaning 100%—for business purposes. She admitted that she used portions of the office space for nonbusiness purposes.
Tax Court Ruling: Miller was eligible for the deduction because her personal use of the space was minimal and “wholly attributable to the practicalities of living in a studio apartment of such modest dimensions.”
Lesson: Although you need to clearly limit personal use of a home office in order to qualify for a tax deduction, minor unavoidable use of the space for personal use might not disqualify you.
Lauren Elizabeth Miller, Tax Court Summary Opinion 2014-74
• One IRA rollover per year means one per year. Alvan Bobrow, a tax attorney who lived in Short Hills, New Jersey, had two traditional (non-Roth) IRAs at Fidelity Investments. On April 14, 2008, he withdrew $65,064 from one of the accounts, and on June 6, 2008, he took the same amount from the other. On June 10, he redeposited the funds in the first IRA, which was within 60 days of that withdrawal—he did the same for the other IRA on August 4 (also within 60 days).
Each transaction was technically an IRA rollover—a withdrawal from an IRA that is redeposited into the same or another IRA (not to be confused with a 401(k) rollover, which does not fall under this rule). Bobrow did not report the rollovers as taxable because he understood the law to say that one such rollover can be made for each IRA in a 12-month period, which was the common interpretation of the law before his case.
IRS Position: A person can make a total of only one rollover from traditional IRAs in a 12-month period no matter how many separate IRAs there are. While the April distribution was not taxable, Bobrow’s other distribution was taxable because it was his second rollover within the same 12-month period.
Tax Court Ruling: Agreeing with the IRS, the Tax Court said that the tax law limits rollovers to one in a 12-month period regardless of the number of IRAs maintained by a taxpayer. The fact that IRS Publication 590 had an example showing one rollover per account per year does not mean that is allowable under the Tax Code.
Lesson: In the case of multiple IRAs, make sure that no more than one account is rolled over within a 12-month period—and only one time.
Because there has been confusion over the rule, the IRS says that it won’t start enforcing the rule with the new interpretation until 2015, meaning that you might be able to make more than one qualifying IRA rollover in 2014 without owing taxes. But the IRA owner in the above case is out of luck—the court’s decision is binding on his 2008 rollovers.
Alvan L. Bobrow, Tax Court Memo 2014-21