mployees can exclude reimbursement they receive from their employers for medical expenses—and employers can deduct payments made to employees—only under certain conditions. There must be a bona fide employer-employee relationship and a proper plan, even if unwritten, that conforms to IRS guidelines for medical reimbursement plans. And covered employees must know about or have notice of the plan. The IRS looks even more closely when the employer and employee are husband and wife.
Maureen Speltz was a licensed day care provider who operated a sole proprietorship in Minnesota. Her husband, who also had a full-time job, was her only part-time employee. Mrs. Speltz established a medical reimbursement plan for her employee-husband with the help of a tax adviser. An employment contract specified his duties and minimum work requirements to qualify for the plan. Mrs. Speltz deposited his salary, which was used to reimburse him for health insurance premiums and any uninsured medical costs, into a flexible spending account.
In the years 2000 and 2001 Mrs. Speltz deducted the reimbursements on her schedule C as a business expense and the couple excluded the payments on their joint tax returns. The IRS disallowed the deductions and assessed a deficiency. The taxpayers petitioned the Tax Court for relief.
Result . For the taxpayer. The IRS argued that the couple could not exclude the reimbursements to the husband because no proper plan existed. And, even if it did, the husband was not a bona fide employee and the plan was not sufficiently available to him. The service further contended Mrs. Speltz could not deduct the amounts on her schedule C since they were not business expenses. The Tax Court rejected all of these arguments.
First, the court found that a proper plan existed. Mrs. Speltz had prepared a document that explained employees were eligible to receive up to $6,500 a year in medical expense reimbursements and specified the number of hours they must work to receive them. The Tax Court concluded the employee-husband knew of the plan because he had signed a document stating his annual compensation consisted entirely of medical reimbursements up to the $6,500 limit. In addition, during the years in question, he had submitted claims for reimbursement under the plan.
The court also said Mr. Speltz was a bona fide employee because Mrs. Speltz could control his work activities—the “fundamental” test used to determine whether an employer-employee relationship exists. In addition the court held that Mr. Speltz performed activities essential to operating the day care business. Thus his salary was compensation for work he had actually performed and it did not result from his spousal relationship.
The Tax Court also found that payments for personal services are ordinary and necessary business expenses; the taxpayers in this case had to demonstrate only that the payments were reasonable. To ascertain this the court used a log maintained by Mrs. Speltz and divided her husband’s total compensation by his total work hours. It then held the payments were reasonable because his hourly rate was much less than the salary she would have had to pay to another employee.
This case demonstrates how a sole proprietorship can both obtain tax benefits and provide health benefits for family members. It also illustrates the importance of carefully researching the issue and implementing a well-documented plan.
Peter F. and Maureen L. Speltz v. Commissioner, TC Summary Opinion 2006-23.
Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.