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June 2007 Attention to detail in employing family members The IRS and the courts apply a high standard of evidence to establish the legitimacy of the employment arrangement Many small businesses do not use formal written employment agreements, particularly for part-time workers. But a recent Tax Court case suggests that, if the occasional-duty employee is a close relative of the owner, the formalities can be very important. Further, the tax consequences can be significant, because it is usually not only a wage that it is in question, but also one or more tax-deductible employee fringe benefits such as health insurance or a medical reimbursement plan. The Francis Case. A recent Tax Court case, Ronald Francis et ux. (T.C. Memo 2007-33), involved a full-time business owner whose wife was engaged by the business for part-time duties (maintaining books and records, occasional errands for the business, telephone services, etc.). A written employment agreement specified that she would receive annual compensation of approximately $2,000, plus a fringe benefit health plan that covered the family health insurance costs and reimbursements of up to $8,000 annually for out-of-pocket medical expenses. These spousal employment and fringe benefit plans can be very tax-efficient. If done properly, the employer-employee relationship allows the business to deduct the health insurance and other medical benefit payments as a direct business expense, often saving both income tax and self-employment Social Security tax. And the value of those benefits is tax-free to the family employee. In this case, the Tax Court was wary of the reality of the arrangement, applying “close scrutiny to the facts in a family situation.” Based on the IRS examination, the court noted that the taxpayers had failed to prove that the total compensation paid to the spouse was reasonable. For the year under consideration by the court, the direct wages plus fringe benefits amounted to about $12,000 in value. But the court noted that the couple had failed to document the actual services performed by the spouse for the business. There was no record of the dates nor the hours that the employee had worked; no established hourly rate of pay established; and no evidence that the compensation package was comparable to similar employment by similar small businesses in their area. Lessons. The Francis case emphasizes the importance of documenting the nature and extent of services of an employed spouse or other family member. The employment agreement should refer to the required hours of work by the employee and the hourly rate of pay used to arrive at the total compensation package. Additionally, the family member should complete some type of time record, similar to other employees, detailing the hours worked and the services performed. Family employment accompanied by fringe benefit plans can be both very tax-efficient and lucrative. But, given the benefits involved, the IRS and the courts apply a high standard of evidence to establish the legitimacy of the arrangement. If you have family employment arrangements that should be reviewed, or are interested in considering whether your facts may present an opportunity in this area, please contact your Schmidt Westergard & Company professional. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |