Here is a surprising and concerning case. It appears by the summary that the farmer did everything right but did not convince the IRS or the Tax Court that the wife was a bonafide employee. This case proves that if you are paying your spouse a salary and have a medical plan, you must have good documentation. We will be watching this case closely.
Milo L. Shellito, TC Memo 2010-41
The Tax Court has held that a farmer could not deduct on Schedule F, Profit or Loss from Farming, as business expenses medical reimbursements paid to his wife whom he claimed was an employee of the farming business. It denied the deductions because it found that the wife was not an employee. However, because they acted in good faith on the advice of their CPA, the Tax Court refused to apply accuracy-related penalties.
Facts. Mr. Shellito was engaged in a farming business since about '78. In 2001 and 2002 (the years in issue) his farming operation covered about 2,300 acres.
Mrs. Shellito assisted on the farm since at least '82. The nature of her services has remained fairly constant over time. Before, during, and after the years at issue her services included: assisting with the planting and harvesting of crops; operating tractors and equipment; feeding and caring for cattle; building and repairing fencing; maintaining and performing basic equipment repairs; running various errands; and performing accounting and bookkeeping services. Before 2001, Mrs. Shellito received no compensation for these services.
In 2001, a CPA advised Mr. Shellito that he could qualify for an employee medical reimbursement plan if Mrs. Shellito were his employee. They went along with his advice. The CPA drafted an employment agreement under which Mrs. Shellito was to be Mr. Shellito's employee. The CPA help them set up a medical reimbursement plan on May 29, 2001.
Mrs. Shellito was the only eligible employee of Mr. Shellito. The plan qualified her for unlimited reimbursement of health insurance premiums for her and her family, reimbursement of up to $15,000 of out-of-pocket medical expenses for her and her family, and $50,000 of term life insurance.
An individual checking account was opened in Mrs. Shellito's name. On June 7, 2001, and each month thereafter in 2001 and 2002, Mr. Shellito wrote Mrs. Shellito a $100 check from their joint checking account, which she deposited into her individual checking account. The memo line on most of the checks and each accompanying deposit ticket stated that the check represented wages or salary. Mrs. Shellito used these funds to pay for medical care for herself, Mr. Shellito, and their dependent children.
For 2001 and 2002, on Schedule F, Mr. Shellito deducted wages and medical reimbursements provided to Mrs. Shellito, whose occupation was listed on their Forms 1040 for those years as housewife. IRS disallowed the reimbursements but made an adjustment for self-employed health insurance.
Tax Court disallows the deductions. IRS conceded that the Shellitos would be entitled to most of the claimed deductions for “Employee benefit programs” if Mrs. Shellito could properly be considered her husband's employee. IRS contended, however, that she was not a bonafide employee and the Tax Court agreed.
The Shellitos contended that they entered into an employment agreement on May 29, 2001, to “formalize” their preexisting employer-employee relationship. The Tax Court said there was no such preexisting agreement. According to their own testimony, before May 29, 2001, Mrs. Shellito received no remuneration for her services. Consequently, because this essential condition of an employment relationship was missing, Mrs. Shellito was not her husband's employee before 2001, irrespective of the degree of control he might have exercised over her.
The Tax Court was not convinced that anything happened in 2001 that materially changed the nature of the couple's economic relationship. Thus, it concluded that Mrs. Shellito received no remuneration under the purported employment arrangement and consequently during the years at issue, as in the preceding years, there was no bonafide employment relationship. As a result, Mr. Shellito was not entitled to any deduction for employee program benefits in excess of the amounts IRS allowed. However, taking into account all the facts and circumstances, including the Shellitos' lack of experience and knowledge regarding tax matters, the Court concluded that they reasonably relied on the CPA's advice in claiming the disputed deductions and thus were not subject to accuracy-related penalties.
