Personal expenses in lieu of compensation

[DaveinTexas]

Here's the scenario:

Client lived alone until his ex-wife and daughter moved in due to lack of employment/cash flow. They worked out an arrangement to where his ex-wife would perform services for his self employed business; clerical duties, filing, answering phone calls etc. in exchange for his payment of her living expenses. He provides food, clothing, utilities, mortgage for his ex-wife and daughter and she provides these services for his company. His reasoning for not paying her directly is because she does not have a bank account.

He deducted these expenses he paid for his ex-wife and issued her a 1099 MISC. She filed a return and received EIC. Now the IRS is questioning the "arrangement", stating that the amounts he paid for her behalf, personal expenses, are not deductible as compensation.

Do any of you know of a ruling or court case that corresponds to this particular issue? His position is that the amounts paid for her expenses are deductible because if he would've just paid her first, this would be deductible anyway.

TIA

[MAMalody]

Here's the scenario:

Client lived alone until his ex-wife and daughter moved in due to lack of employment/cash flow. They worked out an arrangement to where his ex-wife would perform services for his self employed business; clerical duties, filing, answering phone calls etc. in exchange for his payment of her living expenses. He provides food, clothing, utilities, mortgage for his ex-wife and daughter and she provides these services for his company. His reasoning for not paying her directly is because she does not have a bank account.

He deducted these expenses he paid for his ex-wife and issued her a 1099 MISC. She filed a return and received EIC. Now the IRS is questioning the "arrangement", stating that the amounts he paid for her behalf, personal expenses, are not deductible as compensation.

Do any of you know of a ruling or court case that corresponds to this particular issue? His position is that the amounts paid for her expenses are deductible because if he would've just paid her first, this would be deductible anyway.

TIA

Did he count the "mortgage" relief or any of the other items as income?

[DaveinTexas]

No

He paid the mortgage and all other expenses directly. No expenses were paid by his ex-wife.

[MAMalody]

He paid the mortgage and all other expenses directly. No expenses were paid by his ex-wife.

That may be part of your problem. The IRS may be looking at the fact that he "received' a portion of a mortgage payment (called rent) in lieu of compensation he paid her. Did he include the income and appropriate expenses as if he was renting out a portion of his home? They may be thinking you can't have your cake and eat it too. I am assuming that she reported the income and paid the appropriate tax on her tax return and they have acknowledged this.

[newbie]

Did she keep any type of log of hours worked/duties performed? This however could also lead to problems with a 1099MISC reclassified as W-2 income and then you have the employment tax issues.

[Golden Rocket]

All Kinds of Problems

Dave,

There are likely chinks in the armor, and I would hesitate to even call it "armor."

The ex-wife could be more conjugal than anyone knows. We can't assume that, but that might arouse suspicion in the minds of IRS whether stated or not. The re-entry of the ex-wife and daughter into the home could more likely qualify them as dependents than recipients of compensation and EIC.

He is also providing the house, meaning his ex-wife could not be providing the house and cannot qualify for EIC. There IS the possibility that she did not live there more than six months but I don't believe that information was given in your original post.

There is certainly nothing wrong with this woman receiving compensation whether she is married to him or not for the value of services. But there is no exchange of money. I think the IRS would naturally question this arrangement, especially since there was an attempt to invoke EIC.

[DonPriebe]

Doesn't matter for EIC

He is also providing the house, meaning his ex-wife could not be providing the house and cannot qualify for EIC.

There is no requirement that mom must provide the house that she and the kids live in. Pub 17 still uses the "homeless shelter" as an example for EIC.

[Golden Rocket]

Clarification

Don, technically you are correct. "Support" and "Providing the home" are not EIC qualifiers. In Dave's case, the "other person" living in the home happens to be the child's own father, who would win a tie-breaker and could even claim the child as his own dependent, more than likely.

I did a poor job of presenting the support issue as germane to disqualifying the EIC. Support is not the culprit, and I appreciate your bringing this to my attention. I think my big problem is I'm sorta "married" to the idea of providing the home when interviewing clients who might qualify for EIC. It is my attempt at finding out if there is really someone else living there...

Thanks, Mr. Priebe. By the way, Syracuse is going to be better next year.

[DaveinTexas]

I'm thinking the same thing

Dave,

There are likely chinks in the armor, and I would hesitate to even call it "armor."

The ex-wife could be more conjugal than anyone knows. We can't assume that, but that might arouse suspicion in the minds of IRS whether stated or not. The re-entry of the ex-wife and daughter into the home could more likely qualify them as dependents than recipients of compensation and EIC.

He is also providing the house, meaning his ex-wife could not be providing the house and cannot qualify for EIC. There IS the possibility that she did not live there more than six months but I don't believe that information was given in your original post.

There is certainly nothing wrong with this woman receiving compensation whether she is married to him or not for the value of services. But there is no exchange of money. I think the IRS would naturally question this arrangement, especially since there was an attempt to invoke EIC.

This is a client of my colleague and we are racking our brains trying to come up with the magic answer. I agree that since no money was exchanged, the client has no basis to claim that he "paid" his ex-wife anything. I wonder where people receive this crazy advice.

Thanks to all.

[joanmcq]

So he provided support for his daughter...isn't that what a father is supposed to do? The daughter is his dependent. This looks like EIC fraud, and that is another reason why the IRS is upset, besides the fact that it appears he did not claim the 'rent' income.

[oceanlovin'ea]

Barter

This is kind of a case of barter, trading work for a place to live and food. That is taxable income to the recipient and a deduction to the business owner. I had a cowboy that worked on a ranch in exchange for bed and food.

BUT he should have been keeping accurate records of the time she worked, her duties, etc especially since she is an ex-wife. Time records would show she really worked. If she did office work, wouldn't paperwork, notes etc be in her handwriting? Seems like it should not be too hard to prove what she had been doing.

Linda

[DaveinTexas]

The IRS is requesting a log

This is kind of a case of barter, trading work for a place to live and food. That is taxable income to the recipient and a deduction to the business owner. I had a cowboy that worked on a ranch in exchange for bed and food.

BUT he should have been keeping accurate records of the time she worked, her duties, etc especially since she is an ex-wife. Time records would show she really worked. If she did office work, wouldn't paperwork, notes etc be in her handwriting? Seems like it should not be too hard to prove what she had been doing.

Linda

or some sort of paperwork that would document her services and time worked. The part I am having trouble with is: How is the rent, food and other living expenses that he paid for his ex-wife deductible as a business expense? These seem like personal expenses no matter how you slice it.

[oceanlovin'ea]

DaveinTexas,
She is living in his house. He is paying his mortgage and his bills that he would have even if she weren't there. There is extra food that is true.

So don't consider it paying her living expenses. Look at it as she works for him and he provides her a place to live and food, like the ranch hand.

If I'm off base, please say so.

Linda

[Zee]

Gosh, there are so many questions here about this transaction it's probably not possible to get a good answer without more details. The close relationship of the ex-wife and daughter including the EIC issues create a very questionable situation.

As such, it might be helpful to look at an example assume the person providing the secretarial services for food clothing and shelter isn't closely related in any way. As already indicated, the independent contractor situation needs to be addressed. Let's assume it's correct.

In this situation, I'd agree this is a "barter transaction". As such, INMHO each party should report as income the FMV of the benefit or services received. I suppose this can be an agreed-upon amount, but it should be reasonable. In addition to income taxes, the service provider would pay taxes on the net income (after subtracting expenses...if any). The party providing housing and food would report the housing portion as rental income on Schedule E, and the FMV or cost of the food and clothing on Schedule C (assuming it's a sole-proprietorship). The expenses related to rental include direct & indirect expenses similar to that of a daycare provider (a portion of the utilities, depreciation, insurance, mortgage interest, taxes).

However, because of the close relationship issue of the wife & daughter being the other parties to the transaction, I'd probably avoid any reporting of this transaction at all. My guess is this won't fly under audit. But, of course, I could be wrong.