Creative accounting or tax fraud?

[Quixote]

From the Yahoo Answers tax questions:

Can I use the gift tax when employed by a parent?
I'll be working at my stepfather's law office. Can I deduct $12,000 from my taxable income (or perhaps $24,000 if I claim $12,000 from my mother as well) by claiming this amount was a gift?
13 minutes ago - 3 days left to answer.
Additional Details
4 minutes ago

Just to clarify, we haven't structured how I'd be payed yet, so I wouldn't be claiming income as a gift. My stepfather could easily give me a gift of $12,000, then pay me a reduced taxable salary. This doesn't strike me as fraud - just a more intelligent way to pay me.

Although the Barbie Twins case tells us that something everybody involved calls a "paycheck" can be a gift, I don't think the IRS would see things his way.

[Investor]

I have a feeling this would be counter productive, from an overall tax standpoint. I would venture to guess that Dad's marginal tax rate > than kid's marginal tax rate. Yes, there could be some savings in the form of payroll taxes, but if kid doesn't have income from wages (taxed at 10-15%) then dad is not going to have a deduction for wages paid (savings at 35%, probably). If the "reduced" wage can be defended as reasonable, I don't see why you can't do what they're attempting, with little static from the Feds. The truth is, any agent who audited this mess should be able to see that the tax revenues from leaving this alone would exceed any adjustments that could be made.

[Mr. Mephistopheles]

I have a feeling this would be counter productive, from an overall tax standpoint. I would venture to guess that Dad's marginal tax rate > than kid's marginal tax rate. Yes, there could be some savings in the form of payroll taxes, but if kid doesn't have income from wages (taxed at 10-15%) then dad is not going to have a deduction for wages paid (savings at 35%, probably). If the "reduced" wage can be defended as reasonable, I don't see why you can't do what they're attempting, with little static from the Feds. The truth is, any agent who audited this mess should be able to see that the tax revenues from leaving this alone would exceed any adjustments that could be made.

What if Dad paid the "gift" as other "pre-tax income", such as whole life insurance policy premiums, health insurance benefits, retirement bennies, supplemental disability insurance, commuting allowance, etc. that is a legitimate deductable expense but doesn't result in a tax liablity for the "kid"? Am I on the right track here, or would these items be taxable income if given in lieu of a portion of wages?

[Investor]

I don't think I follow, Mr. Meph. Are you suggesting that, instead of the dad personally giving a cash gift, that his business could pay for employee benefits under some sort of Section 125 Cafeteria plan and a qualified cash or deferral arrangement (401(k), etc.)? I don't see the game, in this case. If the kid is meeting the requirements of the plans, which are subject to anti-discrimination provisions, I don't see a problem with the dad providing those benefits, so long as the benefits are commensurate with the work being done by the kid. Where's the tax game in treating a child who is an employee the same as other employees?

It is clear to me, from the question posed, that the contemplated gift here would be from the dad, personally, in lieu of wages from his business. I don't think it's a coincidence that $12,000 was thrown out as the number, as that is the amount of a gift that can be made to any individual in a given year without triggering any transfer tax consequences. The game that is being played here is an attempt to keep the kid from owing income taxes. The more efficient game, if one were to play "a game" with these taxes, would be to do the opposite of what the poster is suggesting; pay an excessive wage to the kid, in lieu of what would otherwise be gifted from the dad, and then have the dad make a gift to the kid equal to the income tax liability generated from the wages. That way, the kid and the dad net a much smaller tax liability, while the kid is not out of pocket anything for the income taxes. I'm not suggesting that they engage in this type of income shifting scheme - I'm just pointing out that the person asking the question has a backwards way of looking at this. Tax rate arbitrage is not a new concept.

CLARIFICATION: I am assuming that the kid would be in a much lower tax bracket than the dad.

[Mr. Mephistopheles]

I don't think I follow, Mr. Meph. Are you suggesting that, instead of the dad personally giving a cash gift, that his business could pay for employee benefits under some sort of Section 125 Cafeteria plan and a qualified cash or deferral arrangement (401(k), etc.)? I don't see the game, in this case. If the kid is meeting the requirements of the plans, which are subject to anti-discrimination provisions, I don't see a problem with the dad providing those benefits, so long as the benefits are commensurate with the work being done by the kid. Where's the tax game in treating a child who is an employee the same as other employees?

I'm simply playing "what if" and under my hypothetical situation the other employees weren't necessarily receiving these benefits. Regarding the anti-discrimation provisions: are all employees legally due the same benefits, or can the employer give employee M a better benefits package than employee T?

... The game that is being played here is an attempt to keep the kid from owing income taxes. The more efficient game, if one were to play "a game" with these taxes, would be to do the opposite of what the poster is suggesting; pay an excessive wage to the kid, in lieu of what would otherwise be gifted from the dad, and then have the dad make a gift to the kid equal to the income tax liability generated from the wages. That way, the kid and the dad net a much smaller tax liability, while the kid is not out of pocket anything for the income taxes. I'm not suggesting that they engage in this type of income shifting scheme - I'm just pointing out that the person asking the question has a backwards way of looking at this.

Interesting.

[Investor]

Regarding the anti-discrimation provisions: are all employees legally due the same benefits, or can the employer give employee M a better benefits package than employee T?

The simple answer - generally speaking, for the plans to qualify for the pre-tax treatment you are suggesting, there cannot be benefits offered to the "highly compensated" that are not also offered to the others. The kid would meet the definition of "highly compensated" by virtue of his/her relationship with dad (attribution rules under IRC 416(i)(1) and IRC 318, if memory serves).

[Mr. Mephistopheles]

Regarding the anti-discrimation provisions: are all employees legally due the same benefits, or can the employer give employee M a better benefits package than employee T?

The simple answer - generally speaking, for the plans to qualify for the pre-tax treatment you are suggesting, there cannot be benefits offered to the "highly compensated" that are not also offered to the others. The kid would meet the definition of "highly compensated" by virtue of his/her relationship with dad (attribution rules under IRC 416(i)(1) and IRC 318, if memory serves).

Thanks again, but now I'm a little confused with "pre-tax". If the company provides health bennies, or life insurance bennies is it required that these benefits be shown as income to the employee? For example, if my employer pays 100% of my health insurance premium, do I have to claim that benefit as income?

What are the implications of being "highly compensated"?

[Investor]

Thanks again, but now I'm a little confused with "pre-tax". If the company provides health bennies, or life insurance bennies is it required that these benefits be shown as income to the employee? For example, if my employer pays 100% of my health insurance premium, do I have to claim that benefit as income?

What are the implications of being "highly compensated"?

Sorry for my use of the term "pre-tax", I was specifically thinking of the employee's portion of health benefits. But the concept still applies. If your employer pays 100% of your health insurance premiums, and you are not a "highly compensated" person, then there is no taxable income to you. Further, if your employer pays 100% of your healh insurance premiums and you are a "highly compensated" person, then you do not have taxable income, so long as the plan by which the premiums are paid meets certain requirements, and is not discriminatory towads highly compensated employees.

Highly Compensated is defined (if I remember correctly) as (1) anyone who owns more than 10% of the company; (2) the top 5 paid officers of the company; (3) the top 25% of all employees, in terms of salary; and (4) family members of 1-3.

Someone please update my info. if it's no longer accurate.

CAVEAT: It's been years since I dealt in any depth with employee benefit plans, but this is the rule as I remember it.

[Mr. Mephistopheles]

Sorry for my use of the term "pre-tax", I was specifically thinking of the employee's portion of health benefits. But the concept still applies. If your employer pays 100% of your health insurance premiums, and you are not a "highly compensated" person, then there is no taxable income to you. Further, if your employer pays 100% of your healh insurance premiums and you are a "highly compensated" person, then you do not have taxable income, so long as the plan by which the premiums are paid meets certain requirements, and is not discriminatory towads highly compensated employees.

Just to be sure, you're saying as long as it's not discriminatory in favor of highly compensated employees?

Highly Compensated is defined (if I remember correctly) as (1) anyone who owns more than 10% of the company; (2) the top 5 paid officers of the company; (3) the top 25% of all employees, in terms of salary; and (4) family members of 1-3.

Here's what gets me: "highly compensated" doesn't necessarily have anything to do with actual compensation. Either way, I qualify for reasons 2, 3, & 4.

Someone please update my info. if it's no longer accurate.

CAVEAT: It's been years since I dealt in any depth with employee benefit plans, but this is the rule as I remember it.

From what I read on the IRC's you gave, it looks like you're still pretty current.

I appreciate your information on this!

[Investor]

Just to be sure, you're saying as long as it's not discriminatory in favor of highly compensated employees?

Yes, and I used to know the tests to determine if the arrangement is considered discriminatory, but that was a different lifetime ago. The policy behind this is obvious. Congress wants to make sure the top brass at the company don't put a plan in place by which the premiums for the CEO, CFO and COO are paid, while the guys working on the factory floor (or other 'rank and file' employees) are left to fend for themselves.

Either way, I qualify for reasons 2, 3, & 4.

Me too, exactly for the same reasons (well, I'd have to do some research to see if #4 applied)

[Dezcad]

Highly Compensated is defined (if I remember correctly) as (1) anyone who owns more than 10% of the company; (2) the top 5 paid officers of the company; (3) the top 25% of all employees, in terms of salary; and (4) family members of 1-3.

Someone please update my info. if it's no longer accurate.

CAVEAT: It's been years since I dealt in any depth with employee benefit plans, but this is the rule as I remember it.

26 USC 414 (q) Highly compensated employee
(1) In general
The term “highly compensated employee” means any employee who—
(A) was a 5-percent owner at any time during the year or the preceding year, or
(B) for the preceding year—
(i) had compensation from the employer in excess of $80,000, and
(ii) if the employer elects the application of this clause for such preceding year, was in the top-paid group of employees for such preceding year.
The Secretary shall adjust the $80,000 amount under subparagraph (B) at the same time and in the same manner as under section 415 (d), except that the base period shall be the calendar quarter ending September 30, 1996.
(2) 5-percent owner
An employee shall be treated as a 5-percent owner for any year if at any time during such year such employee was a 5-percent owner (as defined in section 416(i)(1)) of the employer.
(3) Top-paid group
An employee is in the top-paid group of employees for any year if such employee is in the group consisting of the top 20 percent of the employees when ranked on the basis of compensation paid during such year.
(4) Compensation
For purposes of this subsection, the term “compensation” has the meaning given such term by section 415 (c)(3).
(5) Excluded employees
For purposes of subsection (r) and for purposes of determining the number of employees in the top-paid group, the following employees shall be excluded—
(A) employees who have not completed 6 months of service,
(B) employees who normally work less than 171/2 hours per week,
(C) employees who normally work during not more than 6 months during any year,
(D) employees who have not attained age 21, and
(E) except to the extent provided in regulations, employees who are included in a unit of employees covered by an agreement which the Secretary of Labor finds to be a collective bargaining agreement between employee representatives and the employer.

In 2008, the definition of highly compensated employee under Section 414(q)(1)(B) was increased from $100,000 to $105,000.

[Mr. Mephistopheles]

Yes, and I used to know the tests to determine if the arrangement is considered discriminatory, but that was a different lifetime ago. The policy behind this is obvious. Congress wants to make sure the top brass at the company don't put a plan in place by which the premiums for the CEO, CFO and COO are paid, while the guys working on the factory floor (or other 'rank and file' employees) are left to fend for themselves.

That makes perfect sense now. But I suppose other benefits, such as a company vehicle, fall into a different category. IMO, there is a broad gap in importance between Healthcare and Company Car.

Me too, exactly for the same reasons (well, I'd have to do some research to see if #4 applied)

I'm guilty of one count on 2, one count on 3, and two counts on 4. (I am a part of my parent's business of which they are co-owners.)