Small businesses often rely on family members to help with the work. When a family member is also an employee, complicated tax and benefits issues can arise. The Court of Appeals for the Tenth Circuit recently reversed the Tax Court’s decision that the wife of a small business owner was not an employee of the business. Treating the wife as an employee allowed the business to deduct as an expense the cost of reimbursing her for medical expenses.

Family farm
In this case, the husband began farming in 1978. He operated his farming business as a sole proprietorship. His wife started working on the farm in 1982. Typically, she worked 40 hours each week engaged in activities such as planting and harvesting crops, feeding farm animals, doing maintenance and repairs, and some bookkeeping. Her husband directed all of her work activities.

Beginning in 2001, the husband reimbursed his wife for out-of-pocket medical expenses and health insurance premiums under a medical reimbursement plan. The husband also began paying her $100 monthly; previously, she apparently received no compensation. In 2001, the husband also purchased a pre-packaged medical reimbursement plan for small farms.

On their joint federal returns, the couple deducted medical expenses not covered by insurance as ordinary business expenses for the employee benefit program. According to the couple, the business expenses were justified by designating the wife as her husband’s employee for the work she did on the farm. The IRS disagreed. The Tax Court also ruled against the couple, finding that the wife was not a bona fide employee.

Spouse-employee
The appeals court looked to a similar IRS decision from 40 years ago. In Rev. Rul. 71-588, the taxpayer operated a small business as a sole proprietorship and employed his wife in the business. The IRS determined that amounts reimbursed under a health plan covering all bona fide employees, including the owner’s wife were excluded from employees’ gross incomes and were deductible by the owner as business expenses. The court noted that the Tax Court had decided similar cases in favor of taxpayers (Speltz, TC Summ. Op. 2006-25; Fraham, TC Memo. 2007-351).

The court also found that the couple had “cross all the Ts and dotted all the Is” in maintaining very good records. The wife kept a daily log of her farm activities. The husband paid payroll taxes on the monthly amounts issued to his wife. The court found no problem with the monthly payments coming from the couple’s joint checking account. Opening another account would merely create another layer of business complexity, the court observed.

The court also noted the wife’s testimony at trial. The wife testified she never identified herself as her husband’s business partner. Rather, she represented herself as an employee.

The court remanded the case to the Tax Court. The court instructed the Tax Court to take a fresh look at whether the wife was an employee.

Many small businesses use pre-packaged benefits plans like the farmer in this case. If you have any questions about employing a family member in your business or using a pre-package plan, please contact our office.