ABC Taxes, Tips & Tools

On the advice of a CPA a farmer hired his wife who had worked on the fam­ily farm for years with­out pay.  All the farm and per­sonal expenses were paid from the same joint check­ing account (this is called co-mingling of funds).  The ratio­nal for sud­denly hir­ing his wife and pay­ing her a mod­est salary was so they could set up a plan to reim­burse the her as an employee for med­ical expenses.  The wife opened an account to receive her pay and to pay for the med­ical expenses.  The IRS denied the med­ical reim­burse­ments on the Sched­ule C and the tax court agreed (Shel­lito V Com­mis­sioner TC Memo 2010–41).

Why? The Eco­nomic Sub­stance Doc­trine.  The wife had work for years with no pay and the only rea­son to make the change was to receive a tax ben­e­fit.  The change in the farmer’s busi­ness prac­tice had no eco­nomic sub­stance other than the tax ben­e­fit so the ben­e­fit was denied.

Bot­tom Line: When related par­ties are involved employ­ers should fol­low all legal for­mal­i­ties and have an eco­nomic sub­stance behind them.  The farmer did not have a rea­son for sud­denly pay­ing for work that was pre­vi­ously unpaid, and did not estab­lish that the pay was rea­son­able for the work done.  Also since the farm and per­sonal expenses were paid from an account co-owned by the farmer’s wife she was essen­tially reim­burs­ing herself.

See Med­ical Insur­ance Plans for Small/Micro Busi­ness Own­ers about one way to do it properly.

See Tips to Avoid Get­ting Audited, and How to Make Your Audi­tor Drool for more infor­ma­tion about not co-mingling your funds and other ways to steer clear of an IRS audit.

As always, small busi­ness ser­vices and tax­a­tion are our busi­ness.  If you need help Please give Art & Busi­ness Con­sult­ing a call.  We would love to engage you as a client.

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