The Tenth Circuit Court of Appeals vacated the Tax Court’s decision that denied a farmer’s business deduction for reimbursements made to his wife under an employee medical expense and health insurance reimbursement plan. The appellate court held that the Tax Court should have applied the common-law agency doctrine to determine if the wife was a bona fide employee and thus remanded the case to the Tax Court to reconsider its decision using that analysis.
Sec. 162(a)(1) permits a deduction for compensation paid for personal services, which Regs. Sec. 1.162-7 interprets as reasonable amounts paid solely for services rendered. Regs. Sec. 1.162-10 further states that amounts paid under a medical expense plan may be deducted, while Rev. Rul. 71-588 states, “Amounts reimbursed under an accident and health plan covering all bona fide employees, including the owner’s wife, and their families are not includible in the employee’s gross income and are deductible by the owner as business expenses.”
Milo L. Shellito began farming operations in 1978 in Kansas, where he leased approximately 2,300 acres of farmland. Since 1982 his wife, Sharlyn Shellito, had assisted him on the farm, working 40 hours a week and performing mostly the same duties each year; however, she was not paid for her services before 2001. That year, Milo Shellito began paying his wife $100 per month and, with the advice of a CPA, established a medical reimbursement plan called AgriPlan/BizPlan. Under the plan, Sharlyn Shellito, as his only employee, was reimbursed for amounts she paid for family health insurance premiums and up to $15,000 of out-of-pocket family medical expenses. On his Schedule F for 2001 and 2002, Milo Shellito deducted $15,593 and $20,897, respectively, for reimbursements to his wife under the plan (reimbursements made from their joint checking account), while the couple excluded the amounts from income on their joint returns for those years.
The IRS disallowed all but $689 of each year’s deduction and assessed deficiencies of $3,995 and $6,947 for 2001 and 2002, respectively. The Shellitos petitioned the Tax Court for relief; however, the court ruled in favor of the IRS. It held that Sharlyn was not Milo’s employee before 2001, since she was never paid for her work, and nothing happened in 2001 that materially altered their economic relationship. Therefore, the court held, she was not her husband’s employee in either 2001 or 2002.
The court opined that the $100 in wages paid every month were merely a component of the medical expense reimbursements. Furthermore, according to the court, Sharlyn received no economic benefit from the reimbursement arrangement, since amounts she received from the joint checking account were considered half to be from her own funds and half offset by her assuming and paying her husband’s liability for the family medical expenses, which he was legally obligated to pay under Kansas law (the doctrine of necessaries).
On appeal, the Shellitos argued that the Tax Court should have used the common-law doctrine of agency to determine whether an employer-employee relationship existed. The Tenth Circuit agreed and directed the Tax Court to begin with a common-law agency doctrine analysis of whether Sharlyn Shellito was an employee, which would then help determine whether the amounts she received were compensation for services rendered.
The court also held that the Tax Court erred in relying on the Kansas doctrine of necessaries to hold that Sharlyn Shellito received no economic benefit, since that doctrine applies only when one spouse is unable to provide for himself or herself. The Tenth Circuit also rejected the IRS’ argument that Sharlyn Shellito’s payments of the medical expenses should be disregarded because they would convert a legal support obligation into a deductible expense. The court cited Rev. Rul. 73-393, concerning wages paid by a taxpayer to his or her child, where the IRS held, “[T]he fact that there may be a legal obligation to support the child is not determinative of the deductibility of such wages as a business expense.” The Tenth Circuit held that the same logic should apply to a spouse-employee.
Finally, the Tenth Circuit noted that in six prior Tax Court cases involving employee-spouses the IRS had taken inconsistent positions compared with the Shellitos’ case and that those cases helped the couple’s argument.
By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.
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