The daughter of the taxpayers in the case of Lopez v. Commissioner, TC Memo 2017-171 competed in several beauty pageants beginning at the age of nine. She won several events and received cash prizes, totaling $1,325 and $1,850 in the two years at issue in the case and her parents deposited her winnings in a savings account for her future college education expenses.
Competing in such contests require incurring many expenses, as the parents discovered. The taxpayers paid $21,732 and $15,445 of such expenses in the two years under examination. The parents did not take reimbursement for any of the expenses from their daughter’s savings accounts.
When it came time to have their tax return prepared for the years in question, the taxpayers filled out an organizer provided to them by an enrolled agent (EA) who had over 40 years of experience preparing returns. The EA, based on his understanding of Indiana’s child labor laws, determined that the income and expenses were allocable to the parents rather than their daughter and reported the income and expenses on the parents’ return.
The EA may have been right about Indiana law treating such income as that of the parents—but, unfortunately, the analysis does stop there. The Internal Revenue Code has a provision that deals with income for the services a child. IRC §73(a) provides:
(a) Treatment of amounts received
Amounts received in respect of the services of a child shall be included in his gross income and not in the gross income of the parent, even though such amounts are not received by the child.
The provision goes on to deal with expenses incurred that are attributable to those expenses as well:
(b) Treatment of expenditures
All expenditures by the parent or the child attributable to amounts which are includible in the gross income of the child (and not of the parent) solely by reason of subsection (a) shall be treated as paid or incurred by the child.
The opinion begins by noting that the Tax Court has previously ruled that pageant-related income is income for services:
In the past, we have specifically treated pageant-related remunerations — even those named as scholarships — as compensation for services. See Miss Ga. Scholarship Fund, Inc. v. Commissioner, 72 T.C. 267, 269-271 (1979) (holding that a pageant’s “scholarship award” was compensation because it was a payment for the contestant’s agreement to perform the requirements of the pageant contract).
In this case the child received payments related to the pageants she competed in. As such, the Court held:
The record reflects that the gross receipts reported on petitioners’ Schedules C relate solely to C.P.’s pageant winnings. These winnings were clearly earned by C.P.9 It was C.P. who performed in the pageants, and C.P. was the direct recipient of the pageant winnings. See Fritschle v. Commissioner, 79 T.C. at 156. Because prize winnings earned by C.P. are compensation for her services in the pageant, see Robertson v. United States, 343 U.S. at 713-714, they are includable in her gross income under section 73(a). Accordingly, only C.P. may deduct petitioners’ pageant-related expenses. See sec. 73(b). We therefore sustain respondent’s disallowance of petitioners’ Schedule C loss deductions pertaining to C.P.’s pageant expenses.
One item of good news was that the parents were not subject to penalties on this underpayment. They had sought the advice of an experienced tax professional on whom they had relied for tax advice for years without incident and provided him with all of the relevant information. Despite the fact that his advice was ultimately found to be in error, the taxpayers had acted reasonably to attempt to determine the proper amount of tax due and thus were not held subject to penalty under IRC §6662.
From a practical standpoint, this is one major advantage to taxpayers of using an experienced and licensed tax professional. Other cases suggest that had the taxpayers claimed these losses on a self-prepared return, the penalties likely would not have been so easily escaped. The seeking of professional advice in good faith was key in this case to the taxpayer’s ability to avoid having to pay penalties on top of the tax assessed.