Don't Pay Children Large Bonuses in Your Family Business

If you run a family business, employing your children is a good way for them to earn money while effectively "shifting" income from your high bracket to the children's lower bracket.

However, the work must be "real", recorded, and at a reasonable pay rate.

In the case of Embroidery Express, LLC vs. Commissioner, Internal Revenue (T.C. Memo. 2016-136), the business owners paid their children relatively small wages during the year, but then gave the children very large bonuses at year end.

The Tax Court found that such large bonuses would not be paid to unrelated employees, and disallowed the bonuses as deductible business expenses.

The children were generally paid small amounts throughout the year for the
jobs that they completed, and bonuses in December of each year. Petitioners
placed little economic value on the jobs their children completed throughout the
year but paid them significant bonuses at yearend, partially on the basis of the
performance of petitioners’ embroidery business. Although Mr. McMinn testified
that he paid the children on the basis of what he would pay an unrelated party,
petitioners introduced no evidence proving that an unrelated party would receive a
similar bonus for the same work. The bonuses were the largest part of the
children’s wages and were paid at yearend after petitioners had the opportunity to
determine the financial status of the business. The Court is therefore not
convinced that unrelated parties would act similarly.

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