Can a farmer take a business deduction for medical expenses paid for his wife?
Taxpayer Says: His wife was an employee of the farming business and the medical expenses were paid under an established medical reimbursement plan. The expenses are deductible.
Internal Revenue Service Says: There was no bona fide employment relationship. The expenses are not deductible.
From Internal Revenue Code Section 162(a)(1): Provides that a taxpayer may deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered.
From Internal Revenue Code Section 262(a): Except as otherwise provided, no deduction shall be allowed for personal, living, or family expense.
From Federal Tax Regulation 1.162-10(a): Allows a deduction for “salaries or other compensation for personal services actually rendered”, such as any amount paid to an employee pursuant to an employee benefit plan for an expense that the employee pays or incurs if they are ordinary and necessary expenses of the trade or business.
From Revenue Ruling 71-588: Amounts reimbursed under an accident and health plan covering all bona fide employees, including the owner’s spouse, and their families are not includible in the employee’s gross income and are deductible by the owner as business expenses.
THE CAUSE OF THE DISPUTE
As a sole proprietor, you can provide deductible fringe benefits such as a medical reimbursement plan for your employees, including your spouse. As long as your spouse is a bona-fide employee under common law rules, these plans let you deduct the cost of medical insurance and medical expenses for you and your family on your business tax return. In addition, the cost of the fringe benefits is excluded from your spouse’s gross income.
Disputes arise when these plans do not follow the guidance set out in Coordinated Issue Papers on this issue published by the IRS in March 1999.
In this case, the taxpayer, a farmer, set up an employment agreement and a medical reimbursement plan for his wife in 2001. Throughout 2001 and 2002, he paid his wife $100 a month in salary, and issued a W-2 for the amount paid to her. During each of those years he took a deduction for employee fringe benefits related to medical reimbursements ($15,593 in 2001 and $20,897 in 2002). The taxpayer believes these are deductible because the employment agreement and wage payments prove his wife was his employee.
The IRS says the taxpayer’s wife had worked at the farm since 1982 with no pay and that the employment agreement did not make her a bona fide employee nor create a true employment relationship. Since the taxpayer’s wife was not a bona fide employee, no deduction for employee benefits is allowed.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
**UPDATE: In August 2011, the 10th Circuit Court of Appeals sent the case back to the tax court for further consideration. The 10th Circuit felt the arguments of the IRS were inconsistent with prior rulings and cases, and ordered the tax court to avoid using doctrines such as substance over form and economic substance in re-evaluating the case. Instead, the tax court should begin its analysis of whether or not the taxpayer’s spouse was a bona fide employee by applying the common law agency doctrine.**
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.