Employees don’t generally have to include in their income amounts received from either health insurance that the employer pays for or amounts the employer pays for directly. Medical reimbursement plans don’t generally work for sole proprietors, but IRS issued a Revenue Ruling in 1971 providing a chance for sole proprietors to use medical reimbursement plans where the spouse of the sole proprietor works for the business. However, the spouse must be a bona fide employee of the business and receive reasonable compensation (including the medical reimbursement) for the services actually rendered. In a 2006 case, the taxpayer prevailed against an IRS attack on the medical reimbursement plan the taxpayer had adopted that covered her spouse/employee. The Tax Court ruled in that case that the spouse was truly an employee of the enterprise and that a proper plan existed. The court was impressed with the quality of the records the taxpayers retained on the work the husband performed - that was the key to the case. But, IRS has prevailed in two recent cases due largely to lack of substantiation.
Both cases involved medical reimbursement plans administered by AgriPlan/BizPlan. In the one case, the taxpayer adopted a plan that provided reimbursement of all health insurance premiums and up to $3,000 in other medical expenses to eligible employees for themselves and their immediate family. The taxpayer executed an employment agreement with her husband late in 2000 where she agreed to pay him $480 in wages annually and made him an eligible employee under the plan. During the tax year at issue, the husband was paid $480 in wages and received benefits under the plan of $10,355, of which $3,906 represented health insurance premiums under a policy for the taxpayer. The IRS took the position that the taxpayer failed to show that the husband actually paid those premiums or that he was reimbursed by the business if he did. IRS took the position that those premiums were deductible to the extent of 60 percent - the amount allowed for self-employed persons in 2000 (the deduction was an “above-the-line” deduction and would also not count as a deduction against self-employment tax). The court agreed with the IRS. The taxpayer didn’t produce any cancelled checks, receipts or premium statement showing that the husband actually paid or had the obligation to pay the premium (which would have made the premium fully deductible). That’s a tough outcome. The form of the transaction must be correct, not just the substance. Here, all the couple had to do was have the husband pay the premium and then get reimbursed by the wife’s business. They tried to short-circuit the process and lost some of the tax benefit as a result.
In the other case, the husband had been a sole proprietor farmer for 40 years. His wife helped him by doing chores and other miscellaneous odd jobs around the farm, but had never received any compensation for those tasks. The husband adopted a medical reimbursement plan in 1991 that allowed health insurance costs to be paid for eligible employees, and provided for additional reimbursement for up to $8,000 of other medical expenses. In 1997, the wife signed an employment agreement. She kept the farm’s books, ran errands for the farm and answered telephone calls. He annual salary was $2,004, and she participated in the medical reimbursement plan. Her employment agreement did not, however, set forth the number of hours of work or establish the days or times she would be available to work. In the year at issue (2001), the wife performed services for the farm, but there was no documentation of hours worked or what she had actually done. She was reimbursed $9,502 for the year in question, with $5,571 being paid on a joint health insurance policy and a Medicare supplement for the husband. So, her total compensation for 2001 was $11,500. The husband deducted the entire amount of the medical reimbursement on Schedule F. IRS denied the $9,502 deduction for reimbursed medical expenses and the court agreed. While the court was troubled as to whether there was proof of a bona fide employment relationship, that wasn’t determinative of the outcome. Instead, the court held that the couple failed to establish whether any compensation paid to the wife in excess of the $1,988 actually paid (IRS conceded that amount was deductible) was reasonable insomuch as the couple failed to document any hours or times the wife may have performed services for the farm. So, a full deduction would have been available if the couple had kept records.
The bottom line for self-employed persons using “boilerplate” medical reimbursement plans - pay attention to the details. There is more to the matter than simply adopting a plan and forgetting about it. Snorek v. Comr, T.C. Memo. 2007-34; Francis v. Comr., T.C. Memo. 2007-33.
The Tax Court has decided four additional cases involving Agriplan/Bizplan. In the first case, the court denied a deduction for “employee benefit program” payments. The husband farmed and set up a medical reimbursement plan for his wife. The question in the case was whether the couple could deduct as a business expense the $8,216 claimed for “employee benefit programs” on their Schedule F. The court determined that the taxpayers failed to establish that the husband paid to his wife, either directly or indirectly under the medical reimbursement plan, the claimed $3,586 of health insurance premiums and the claimed $4,630 of medical and dental expenses to reimburse her for expenses that she incurred or paid. The court also held that the taxpayers failed to establish that any portion of the claimed premiums and expenses was an ordinary and necessary business expense. Again, the case points out that attention to details is critical with medical reimbursement plans. Albers v. Comr., T.C. Memo. 2007-144.
In the second case, IRS disallowed the taxpayers' deduction of health insurance premiums paid by the husband as an employer for the wife as the husband's sole employee. The couple claimed that the amount paid for the premiums was a deductible expense of the husband's employee benefit program under I.R.C. Sec. 162(a), and that the premiums were excludible from the wife's income as expenses incurred for medical care and as employer-provided health insurance coverage. The court held, however, that the claimed deduction was properly disallowed since the taxpayer's failed to produce business records or canceled checks drawn on the business checking account establishing that the husband paid the premiums as the wife's employer rather than as the primary individual insured under the husband's health insurance policy which also covered the wife as spouse. Eyler v. Comr., T.C. Memo. 2007- 350.
In the third case, IRS denied deductions under I.R.C. Sec. 162(a) for payments made pursuant to a medical reimbursement plan. The husband owned and operated a farming business, in which he employed his wife. The husband, as the employer, provided a medical reimbursement plan for his wife. During the years at issue, pursuant to the plan, the husband (as the employer) paid, either directly or indirectly, the wife amounts for premiums for various policies covering herself, her husband, and/or both of them. IRS claimed that any payments for medical expenses made for the husband's benefit were not payments made pursuant to an employee benefit plan. But, the court disagred with the IRS position. Instead, the court held that the payments were ordinary and necessary business expenses of the farming operation. So, the couple was able to deduct amounts paid by the farming operation through the medical reimbursement plan. Frahm v. Comr., T.C. Memo. 2007-351.
In the fourth case, the court agreed with IRS in disallowing a deduction on the taxpayers' Schedule F for health insurance and medical expenses of the wife who was paid $2,000 per year under a the medical reimbursement plan. The court held that the payment was not an ordinary and necessary business expense, was paid out of a joint account and was not a reimbursement. As a result, the amount was deductible only as an above-the-line deduction (60 percent for tax year 2001 and 70 percent for tax year 2002). Stephens v. Comr., T.C. Summary Op. 2008-18.