Tax Court Rejects IRS Position; Medical Premiums for Spouse Are Deductible

When a taxpayer with a Schedule C business seeks to deduct medical premiums for an employee-spouse, a number of factors come into play. For example, the spouse must be a legitimate employee and the employment agreement must be properly structured. Otherwise, the business can’t deduct the expense and the benefits are includible in the spouse’s gross income.

The importance of these factors is illustrated in Speltz v. Commissioner, <1> where the IRS disallowed a deduction to the taxpayer’s day care center for medical benefits paid to an employee-spouse. However, because (1) the employer-spouse set up a proper medical plan; (2) there was a legitimate employer-employee relationship; and (3) the employee-spouse met the hourly requirements under the plan; the Tax Court held that the day care business could deduct the medical benefits and the employee-spouse did not have to include such benefits in income. The case provides a roadmap for others on how to properly structure such transactions in order to obtain a deduction.

Facts:

Maureen Speltz operated a licensed day care business in her house. She hired her husband, Peter, to assist her in the business. In 2000, Maureen established an employer-provided accident and health plan for employees. <2> She executed three documents in 2000, an employment contract, a salary redirection document, and a client data sheet. With respect to Peter, the employment contract described Peter’s job duties and he and Maureen signed the contract. Peter’s duties included childcare, lawn care, chopping firewood, and repairing toys and sundry items.

The employee salary redirection document provided that $542 per month would be directed to a flexible spending account on Peter’s behalf to pay for his insured and uninsured healthcare costs. Peter signed the employee salary redirection document as an “employee” and Maureen as his “employer.” In addition, Maureen signed a client data sheet requiring Peter to work a “minimum” of 12.5 hours a week and a “minimum” of seven months a year. The client data sheet also stated that Peter’s medical reimbursement was limited to $6,500 per year. Medical benefits, according to the contract, included deductibles, insurance premiums, and medical costs not covered by insurance.

Maureen substantiated that Peter worked 525.25 hours in 2000 and 735 hours in 2001, an average of 12.84 hours a week in 2000 and 14.13 hours a week in 2001.

The Issues Raised:

The Tax Court was presented with two issues: (1) the excludability of medical premiums and reimbursements from the Speltzes’ gross income; and (2) the deductibility of those same amounts from the day care business income.

Regarding the excludability issue, the court was asked to decide whether Maureen and Peter entered into a valid arrangement for the payment of health benefits under Code Section 105(b) and whether Peter was a bona fide employee of the day care. Regarding the deductibility issue, the court had to determine whether the deduction amount was an ordinary and necessary business expense of the day care.

Among other things, the IRS argued that the Speltzes’ Code Section 105(b) plan was improper and/or failed on its own terms, that Peter was not a bona fide employee of the day care, that Peter worked less than the minimal hourly requirement and, consequently, failed to fulfill his contractual obligations under the accident and health plan. More specifically, the IRS cited Maureen’s “client data sheet,” which states that employees are to work a “minimum” of 12.5 hours a week and a minimum of seven months a year. According to the IRS, the term “minimum” should be interpreted as requiring Peter to work 12.5 hours “every” week, rather than an average of 12.5 hours a week.

The Speltzes countered that the medical premiums and reimbursements should be excluded from Peter’s gross income because Maureen set up a proper Code Section 105(b) plan for day care employees and Peter was a bona fide employee. The Speltzes also contended that the medical premiums and reimbursements are deductible from the day care business income because they are ordinary and necessary business expenses of the day care.

The Tax Court’s Decision:

The Tax Court looked at the day care’s documentation relating to the accident and health plan detailed in Maureen’s “client data sheet.” That document stated that the medical benefits plan would be effective in March 2000, that employees were eligible to receive up to $6,500 a year in reimbursements, and those employees had to work a minimum of 12.5 hours a week to be eligible to receive benefits. On those facts, the court found that the day care established a proper accident and health plan.

The court also rejected the IRS’s argument that Peter worked less than the minimal hourly requirement and, consequently, failed to fulfill his contractual obligations under the accident and health plan. According to the court, interpreting the client data sheet to require Peter to work 12.5 hours every week would render the seven month a year minimum requirement superfluous – Peter would by definition have to work twelve months a year.

With respect to whether Peter was an actual employee, the court concluded that Maureen provided a sufficient level of direction and control for Peter to perform his required duties. Based on the facts, the court concluded that Maureen had the right to control Peter as far as the day care business was concerned. In addition to the control factor, other factors supported Maureen’s employer-employee characterization. For instance, Maureen’s calendar notations during the years at issue confirmed that Peter consistently worked for the day care, Maureen paid Peter in employee benefits, Peter’s work was integral to the day care’s operation, Peter was trained to work in childcare, and Maureen and Peter’s employment contract evidenced an intent to create an employer-employee arrangement.

Finally, the court rejected the IRS’s argument that the medical plan expenses were not ordinary and necessary business expenses because some of Peter’s activities were not sufficiently business oriented. The court found that Peter completed a substantial number of hours of business-oriented services for the day care that Maureen credibly substantiated.

References:

1/ T.C. Summary 2006-25 (2/14/06).

2/ Maureen set up the plan in accordance with IRS Coordinated Issue Paper “Health Insurance Deductibility for Self-Employed Individuals,” and Rev. Rul. 71-588, 1971-2 C.B. 91.

Posted: 02-28-06

Tax Court Says Gambler Entitled to Business Deductions for Horse Betting Activity

A taxpayer’s gambling activity was a trade or business and his wagering losses could be deducted from adjusted gross income and not as an itemized deduction. Castagnetta v. Commissioner, T.C. Summary 2006-24 (2/13/06).

James Castagnetta is employed as a part-time truck driver delivering produce to area restaurants. He typically worked three days a week from early morning till noon. His 2001 wages were approximately $18,000. In his spare time, James bet on horse races. He was introduced to that activity by a relative at an early age. James has been seriously handicapping horse races for more than eleven years. In 2001, he spent more than 250 days handicapping races and betting at Yonkers Raceway.

James kept a detailed account of his daily gambling transactions. The records he maintained included his daily wagers and winnings, as well as a cumulative total of his yearly winnings and losses. He also spent a considerable amount of time studying racing programs and other materials. He also kept racing forms, racing programs, and betting tickets as part of his recordkeeping, but did not maintain a separate checking account with respect to his gambling activity.

James funded his gambling activity with a bankroll that consisted of his cumulative winnings at the racetrack. Generally, James bet 2.5 percent of his bankroll at each race. In 2001, James earned a 4 percent return on each dollar bet he placed. James timely filed his 2001 returns. He included with his return a Schedule C, Profit or Loss From Business, which lists his principal business activity as parimutuel wagering. On his Schedule C, James reported a net profit of $234 from wagering.

According to the IRS, the gambling activity did not constitute a trade or business during 2001. The IRS recharacterized the income reported on the Schedule C as “other income,” and the wagering losses were allowed as a miscellaneous itemized deduction. This change resulted in a deficiency of $863.

At Tax Court, James argued that his gambling activity was a trade or business and, therefore, his wagering losses were deductible from adjusted gross income.

The Tax Court held that James’s gambling activity was engaged in for profit and that it constituted a trade or business in 2001. According to the court, James’s gambling activity was conducted with the required continuity and regularity during the tax year. Turning to the determination of whether the activity was conducted with a profit objective, the Tax Court noted that the gambling activity was conducted in a business-like manner. James regularly attended the Yonkers Raceway, kept copies of betting records and slips, racing forms, and programs as well as a detailed record of his activity. Although he kept only one checking account, his gambling winnings and losses were accounted for separately. While James was knowledgeable about the activity, he consulted frequently with other individuals who gambled. Thus, the court concluded that James engaged in the gambling activity with an intent to make a profit and, as a result, his gambling expenses were deductible under Code Section 162(a).

Ed Note: Remember, documentation was the key in this case!

Dance Teachers Weren’t Employees; Studio Wins Litigation Costs

A dance studio was entitled to attorneys’ fees and costs in a case where the IRS conceded it erroneously classified the taxpayer’s dance instructors as employees rather than independent contractors. Images in Motion of El Paso, Inc. v. Commissioner, T.C. Memo. 2006-19 (2/7/06).

In 2001, the IRS began an audit of a dance studio, Images in Motion of El Paso (Images), to determine if the studio had properly classified its dance instructors as independent contractors. The information obtained from an informant indicated that the instructors were issued employee manuals and were required to follow the directives set out in those manuals and that the instructors could be fired if they failed to attend work.

In IRS interviews with four instructors, three acknowledged they were given manuals, but none of them believed the directives were mandatory. Two of the three who received the manuals specifically stated they were not mandatory. The fourth instructor denied that any manual was issued. The documents in question were not titled as manuals but rather were guidelines for conducting dance classes, instructions in first aid, and an employee code of conduct.

The IRS concluded that Images owed over $33,000 in employment taxes because the studio: (1) exercised sufficient behavioral and financial control over its instructors to classify them as employees; (2) had an arrangement with its instructors that strongly evidenced the existence of an employer-employee relationship; and (3) did not qualify for Section 530 relief as provided in the Revenue Act of 1978.

After Images petitioned the Tax Court, an Appeals officer determined that Images had a significant chance of prevailing on the worker classification issue and conceded the issue. Images then filed a motion for reasonable litigation costs. The IRS argued that its position was substantially justified because the facts gathered during the examination and the law, taken together, indicated Images had improperly classified its instructors as independent contractors.

The Tax Court held that the IRS’s litigating position wasn’t substantially justified and Images was thus entitled to litigation costs, attorneys’ fees, and expenses. The court said that the examining agent’s analysis demonstrated that she failed to consider many facts that contradicted her conclusions, failed to consider the facts mitigating an inference that the instructors were employees, and failed to give such facts the appropriate amount of weight they deserved. The court further held that it was unreasonable for the examining agent to conclude that Images did not qualify for Section 530 relief.

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