Medical Expense Reimbursement Plan: Implementation Guide

Responsible:

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Action Steps:

Prepare corporate resolution

Determine eligible employees and expenses

Determine plan start date

Draft plan documents

Submit plan documents to employees

Complete employee enrollment forms

Per Plan: Reimburse employee expenses

Yearly: Report reimbursements on business return

Yearly: Prepare Form 720 to report and pay “PCORI” fee

This checklist and plan template are intended for use by a self-employed professional or business owner adopting a plan for a single family employee only. If your plan is intended to cover two or more employees, you’ll need a more detailed document that qualifies under the “market reform provisions” and other provisions of the Affordable Care Act. However, the classic one-employee “hire yourself in your C corporation” and “hire your spouse” arrangements remain unaffected by the ACA.

Employment Agreement This Agreement is entered into on ___/___/___ between ________________________________ (“Employer”), and ______________________________ (“Employee”). References to Employee using the masculine gender shall be deemed to include the feminine gender and vice versa. In consideration of the promises, mutual covenants, and conditions set forth herein, and for other good and valuable consideration, the parties hereby agree as follows: 1. Employment. Employer hereby employs Employee as ___________________________, to perform all services reasonable and customary to that position, as well as any other duties that may be assigned by Employer. 2. Term. Employee’s employment shall begin on ___/___/___ and shall continue at the will of both parties. Employer and Employee may terminate this Agreement, at any time, by giving fourteen (14) days written notice to the other party. In such event, Employee shall continue to perform the duties specified in this Agreement and shall be paid regular compensation and benefits through the date of termination. 3. Compensation. Employer shall pay Employee such salary, bonus, and benefits as Employer and Employee shall negotiate from time to time. Benefits are subject to change at any time with such notice to Employees as may be required by applicable employee benefit plans and laws governing them. 4. Expenses. Employee is expected to promote Employer’s business as an integral part of his service. Employee may incur reasonable expenses for travel and lodging, meals and entertainment, club and organizational dues, education, and similar expenses on behalf of Employer’s business. Employee shall document all such expenses and submit records and receipts for reimbursement. In the event that Employer advances cash for Employee’s expenses, Employee shall document such expenses and return any undocumented cash advances at least quarterly. 5. Confidentiality. Employee hereby acknowledges he will be exposed to Employer’s confidential business information, including, without limitation, research, marketing and customer information, business information, and other confidential information. Employee further acknowledges that any information received from third parties must be treated confidentially. Employee covenants and agrees that he shall not, at any time during and following his term of employment, disclose any research, marketing and customer information, business information, or other confidential information disclosed to him as a result of his employment. In witness whereof, the parties have executed this Agreement on ______/______/______: ______________________________ ______________________________ Employer Employee ______________________________ ______________________________ Print Name Print Name

User’s Guide First, fill in the effective date of the contract. Next, fill in the legal name of your business. Use your own name if you operate as a sole proprietor. Then fill in your employee’s name. 1. Employment. You can choose whatever title accurately describes your spouse’s duties. If you’re incorporated, think carefully before making your spouse a corporate officer (Vice-President, Treasurer, or Secretary) unless you want them to assume specific legal liabilities for those positions. Generally, “Administrative Assistant,” “Marketing Assistant,” or something similar will do. Marketing positions logically involve more deductible travel, meals, and entertainment, so that may be the best strategy. 2. Term: Your employee/spouse’s term of employment can start as early as the contract effective date. The rest of this provision specifies employment “at will.” Either of you may cancel this contract at any time after giving 14 days written notice. 3. Compensation : There’s no “ideal” salary to pay your spouse. In fact, you don’t have to pay a salary at all. You can pay your spouse solely in benefits so long as those benefits are reasonable compensation for the service they perform. This avoids having to file quarterly or annual payroll returns or issue an annual W-2. If you want to include your spouse in your retirement plan, you’ll need to pay at least some salary. But your best bet is to leave the amount unspecified so you can raise or lower it as you please. That’s why the contract specifies no specific salary.

It’s important that plan benefits be “reasonable compensation” for the work your spouse does. Let’s say your spouse stuffs envelopes a couple of hours per week. If that work is worth $10 per hour, it might justify $1,000 in medical reimbursements per year. But it won’t legitimately justify braces for your kid’s teeth, LASIK, and a year’s worth of expensive prescriptions. Keep a timesheet or other record showing your employee-spouse’s hours, dates, and duties performed. This may seem like a mere formality – but it documents your spouse’s employment to audit-proof your return. For more information, see the Tax Court’s opinion in Francis v. Commissioner, TC Memo 2007-33. 4. Expenses : This provision serves two purposes. First, it authorizes your spouse to write off legitimate business expenses that he or she is probably already incurs as he or she promotes your business. Second, requiring them to document expenses and return any undocumented cash advances creates an “accountable” plan. Obviously, documenting expenses helps audit-proof your return. But, if the IRS concludes you have a “nonaccountable” plan, they can reclassify reimbursements as wages and impose payroll taxes, and force you to deduct reimbursements as miscellaneous itemized deductions, deductible only to the extent that they exceed 2% of your AGI. You and your spouse both sign as Employer and Employee. Congratulations! Now you’ve established an employer relationship to start taking advantage of the Section 105 plan!

Employee Timesheet

Employee: __________________________ Month: _________ Year: ________

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Medical Expense Reimbursement Plan ______________________________________________ (“Employer”) hereby establishes this Medical Expense Reimbursement Plan (the “Plan”) for the exclusive benefit of its employees. 1. Medical Expense Reimbursement. Effective as of __________ _____, _____, Employer

shall reimburse all eligible employees on a monthly basis for medical expenses included in Paragraph 3, below, that they incur on behalf of themselves, their spouses, and their dependents (as defined in Internal Revenue Code Section 152).

2. Eligibility. All employees shall be eligible except: � Those who work less than 25 hours per week. � Those who work less than seven months per year � Those under age 25 � Those who have worked for employer for less than three years � Those who are covered by a collective bargaining agreement

3. Qualifying Benefits. “Medical expenses” shall include any expense qualifying under Internal Revenue Code Section 213(d).

4. Maximum Benefits. Employer shall limit reimbursement to any employee to ____________ per calendar year.

5. Reimbursement. Employer may reimburse employee for eligible expenses or pay medical providers directly. Employees applying for reimbursement shall submit all premium notices and eligible bills not more than 30 days after the end of the month in which they are paid. Failure to comply with this requirement may terminate employees’ right to reimbursement for expenses not timely submitted.

6. Unfunded Plan. This plan shall be unfunded for purposes of the Employee Retirement Income Security Act (ERISA). Plan benefits shall be paid out of Employer’s general assets.

7. Coordination with Insurance. Employer shall reimburse employee only in the event and to the extent that such expenses are not covered by any insurance policy, policies, or benefits, whether owned by Employer or employee, provided under any other accident or health insurance plan, or provided by federal or state governments or agencies.

8. Amendment and Termination. Employer reserves the right to amend or terminate the Plan at any time. Such action shall not deny any employee’s right to claim reimbursement for expenses incurred before such amendment or termination. Employer shall give employees written notice of amendment or termination not more than 60 days before such termination.

9. Notice. Employer shall provide all eligible employees with a copy of this Plan within 90 days of eligibility.

10. Exclusions. Employer intends that this Plan and all benefits payable under this Plan shall qualify for exclusion from eligible employees’ gross income under Internal Revenue Code Sections 105 and 106. Employer reserves the right to amend or terminate this Plan in the event that such benefits no longer qualify for such exclusion.

In witness whereof, Employer adopts this plan as of the date specified in Paragraph One. ______________________________________________ Signature _____________________________________________ Print Name and Title

User’s Guide First, fill in the employer name. As with the employment contract, you’ll use your own name if you operate as a sole proprietor. You’ll use your entity’s legal name if you operate as a partnership, corporation, or limited liability company. 1. Medical Expense Reimbursement : This section establishes the plan. Insert the effective date on the first line. You can date it as early as the start of your business’s current pay period. IRS rules explicitly prohibit you from reimbursing expenses incurred before the plan effective date. 2. Eligibility: This section defines eligibility for the plan. If your spouse is your only employee, there’s no need to limit eligibility. If you have non-family employees, however, you may want to exclude them as listed in the template. 3. Qualifying Benefits : The plan lets you reimburse employees for any qualifying expense under Internal Revenue Code Section 213(d). Plan benefits can include: • Major medical, Medicare, “Medigap”

and long-term care insurance • Co-pays, deductibles, prescriptions • Dental, vision, and chiropractic • Braces, fertility treatments, special

schools • Nonprescription medications and

supplies (when prescribed by physician) The plan works with any insurance coverage. If your spouse has coverage through an outside employer, you can use this plan to write off expenses not covered by that plan. 4. Maximum Benefit : You can specify a maximum annual benefit, or you can put

“N/A” in this line. Just remember, benefits should be “reasonable compensation” for the service your employee/spouse provides. 5. Reimbursement : You can choose to reimburse your employees, or pay their health-care providers directly. It may be easiest for your spouse to use a business check or credit card to pay for services. Alternatively, you can use the reimburse-ment form provided on the next page. Either way, be sure to document payments from the business! It’s not enough just to pay bills out of personal funds and deduct them through the business. For more information, see the Tax Court’s opinion in Snorek v. Comm, TC Memo 2007-34. 6. Unfunded Plan : Cafeteria plans and health savings accounts let you deduct unreimbursed health care costs you pay through the plan. But both of these require you to set aside money today for expenses you may not incur for quite some time. The 105 plan requires no pre-funding. This means you pay nothing unless and until your employee incurs a covered cost. 7. Coordination with Insurance : The plan is designed to cover unreimbursed expenses. There’s no double-dipping allowed for expenses your insurance covers. 9. Notice : IRS rules require you to give eligible employees a copy of the plan (or summary plan description) within 90 days. Sign the plan at the bottom, and print your name and title (proprietor, partner, member, or President) on the line below. Now you’re ready to start saving!

Employee Medical Expense Reimbursement

Employee: __________________________ Month: _________ Year: ________

DATE EXPENSE COST

Total

105 Plan Employee Enrollment

Employer

Phone Email

Employee Soc. Sec.#

Address Entry Date

City/State/Zip Max. Benefit

Spouse SS#

Dependent 1 SS#

Dependent 2 SS#

Dependent 3 SS#

Dependent 4 SS#

Dependent 5 SS#

Dependent 6 SS#

I hereby enroll for coverage under my employer’s Section 105 Plan and authorize my employer or the administrator designated above to gather any information reasonably necessary to determine and administer my benefit under the plan. I understand that my benefit under the plan is limited to the amount indicated in "Plan Benefit," above. I also understand that if I exit the plan before the end of the calendar year, my benefit will be limited according to the number of months of employment I complete during the year. I further understand that if I exit the plan before the end of the year and my total reimbursements received during the year exceed my pro-rata share, my employer may withhold any excess from my final paycheck.

Signature Print Name

Date

CODE Sec. 105. Amounts received under accident and health plans (a) Amounts attributable to employer contributions Except as otherwise provided in this section, amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer. (b) Amounts expended for medical care Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include amounts referred to in subsection (a) if such amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by him for the medical care (as defined in section 213(d)) of the taxpayer, his spouse, and his dependents (as defined in section 152). Any child to whom section 152(e) applies shall be treated as a dependent of both parents for purposes of this subsection. (c) Payments unrelated to absence from work Gross income does not include amounts referred to in subsection (a) to the extent such amounts - (1) constitute payment for the permanent loss or loss of use of a member or function of the body, or the permanent disfigurement, of the taxpayer, his spouse, or a dependent (as defined in section 152), and (2) are computed with reference to the nature of the injury without regard to the period the employee is absent from work. (e) Accident and health plans For purposes of this section and section 104 - (1) amounts received under an accident or health plan for employees, and (2) amounts received from a sickness and disability fund for employees maintained under the law of a State or the District of Columbia, shall be treated as amounts received through accident or health insurance. (f) Rules for application of section 213 For purposes of section 213(a) (relating to medical, dental, etc., expenses) amounts excluded from gross income under subsection (c) or (d) shall not be considered as compensation (by insurance or otherwise) for expenses paid for medical care. (g) Self-employed individual not considered an employee For purposes of this section, the term ''employee'' does not include an individual who is an employee within the meaning of section 401(c)(1) (relating to self-employed individuals). (h) Amount paid to highly compensated individuals under a discriminatory self-insured medical expense reimbursement plan

(1) In general In the case of amounts paid to a highly compensated individual under a self-insured medical reimbursement plan which does not satisfy the requirements of paragraph (2) for a plan year, subsection (b) shall not apply to such amounts to the extent they constitute an excess reimbursement of such highly compensated individual. (2) Prohibition of discrimination A self-insured medical reimbursement plan satisfies the requirements of this paragraph only if - (A) the plan does not discriminate in favor of highly compensated individuals as to eligibility to participate; and (B) the benefits provided under the plan do not discriminate in favor of participants who are highly compensated individuals. (3) Nondiscriminatory eligibility classifications (A) In general A self-insured medical reimbursement plan does not satisfy the requirements of subparagraph (A) of paragraph (2) unless such plan benefits - (i) 70 percent or more of all employees, or 80 percent or more of all the employees who are eligible to benefit under the plan if 70 percent or more of all employees are eligible to benefit under the plan; or (ii) such employees as qualify under a classification set up by the employer and found by the Secretary not to be discriminatory in favor of highly compensated individuals. (B) Exclusion of certain employees For purposes of subparagraph (A), there may be excluded from consideration - (i) employees who have not completed 3 years of service; (ii) employees who have not attained age 25; (iii) part-time or seasonal employees; (iv) employees not included in the plan who are included in a unit of employees covered by an agreement between employee representatives and one or more employers which the Secretary finds to be a collective bargaining agreement, if accident and health benefits were the subject of good faith bargaining between such employee representatives and such employer or employers; and (v) employees who are nonresident aliens and who receive no earned income (within the meaning of section 911(d)(2)) from the employer which constitutes income from sources within the United States (within the meaning of section 861(a)(3)). (4) Nondiscriminatory benefits

A self-insured medical reimbursement plan does not meet the requirements of subparagraph (B) of paragraph (2) unless all benefits provided for participants who are highly compensated individuals are provided for all other participants. (5) Highly compensated individual defined For purposes of this subsection, the term ''highly compensated individual'' means an individual who is (A) one of the 5 highest paid officers, (B) a shareholder who owns (with the application of section 318) more than 10 percent in value of the stock of the employer, or (C) among the highest paid 25 percent of all employees (other than employees described in paragraph (3)(B) who are not participants). (6) Self-insured medical reimbursement plan The term ''self-insured medical reimbursement plan'' means a plan of an employer to reimburse employees for expenses referred to in subsection (b) for which reimbursement is not provided under a policy of accident and health insurance. (7) Excess reimbursement of highly compensated individual For purposes of this section, the excess reimbursement of a highly compensated individual which is attributable to a self-insured medical reimbursement plan is - (A) in the case of a benefit available to highly compensated individuals but not to all other participants (or which otherwise fails to satisfy the requirements of paragraph (2)(B)), the amount reimbursed under the plan to the employee with respect to such benefit, and (B) in the case of benefits (other than benefits described in subparagraph (A) paid to a highly compensated individual by a plan which fails to satisfy the requirements of paragraph (2), the total amount reimbursed to the highly compensated individual for the plan year multiplied by a fraction - (i) the numerator of which is the total amount reimbursed to all participants who are highly compensated individuals under the plan for the plan year, and (ii) the denominator of which is the total amount reimbursed to all employees under the plan for such plan year. In determining the fraction under subparagraph (B), there shall not be taken into account any reimbursement which is attributable to a benefit described in subparagraph (A). (8) Certain controlled groups, etc. All employees who are treated as employed by a single employer under subsection (b), (c), or (m) of section 414 shall be treated as employed by a single employer for purposes of this section. (9) Regulations

The Secretary shall prescribe such regulations as may be necessary to carry out the provisions of this section. (10) Time of inclusion Any amount paid for a plan year that is included in income by reason of this subsection shall be treated as received or accrued in the taxable year of the participant in which the plan year ends. TREASURY REGULATIONS Sec. 1.105-11 Self-insured medical reimbursement plan. (a) In general. Under section 105(a), amounts received by an employee through a self-insured medical reimbursement plan which are attributable to contributions of the employer, or are paid by the employer, are included in the employee's gross income unless such amounts are excludable under section 105(b). For amounts reimbursed to a highly compensated individual to be fully excludable from such individual's gross income under section 105(b), the plan must satisfy the requirements of section 105(h) and this section. Section 105(h) is not satisfied if the plan discriminates in favor of highly compensated individuals as to eligibility to participate or benefits. All or a portion of the reimbursements or payments on behalf of such individuals under a discriminatory plan are not excludable from gross income under section 105(b). However, benefits paid to participants who are not highly compensated individuals may be excluded from gross income if the requirements of section 105(b) are satisfied, even if the plan is discriminatory. (b) Self-insured medical reimbursement plan

(1) General rule (i) Definition. A self-insured medical reimbursement plan is a separate written plan for the benefit of employees which provides for reimbursement of employee medical expenses referred to in section 105(b). A plan or arrangement is self-insured unless reimbursement is provided under an individual or group policy of accident or health insurance issued by a licensed insurance company or under an arrangement in the nature of a prepaid health care plan that is regulated under federal or state law in a manner similar to the regulation of insurance companies. Thus, for example, a plan of a health maintenance organization, established under the Health Maintenance Organization Act of 1973, would qualify as a prepaid health care plan. In addition, this section applies to a self-insured medical reimbursement plan, determined in accordance with the rules of this section, maintained by an employee organization described in section 501(c)(9). (ii) Shifting of risk. A plan underwritten by a policy of insurance or a prepaid health care plan that does not involve the shifting of risk to an unrelated third party is considered self-insured for purposes of this section. Accordingly, a cost-plus policy or a policy which in effect merely provides administrative or bookkeeping services is considered self-insured for purposes of this section. However, a plan is not considered self-insured merely because one factor the insurer uses in determining the premium is the employer's prior claims experience. (iii) Captive insurance company. A plan underwritten by a policy of insurance issued by a captive insurance company is not considered self-insured for purposes of this section if for the plan year the premiums paid by

companies unrelated to the captive insurance company equal or exceed 50 percent of the total premiums received and the policy of insurance is similar to policies sold to such unrelated companies. (2) Other rules. The rules of this section apply to a self-insured portion of an employer's medical plan or arrangement even if the plan is in part underwritten by insurance. For example, if an employer's medical plan reimburses employees for benefits not covered under the insured portion of an overall plan, or for deductible amounts under the insured portions, such reimbursement is subject to the rules of this section. However, a plan which reimburses employees for premiums paid under an insured plan is not subject to this section. In addition, medical expense reimbursements not described in the plan are not paid pursuant to a plan for the benefit of employees, and therefore are not excludable from gross income under section 105(b). Such reimbursements will not affect the determination of whether or not a plan is discriminatory. (c) Prohibited discrimination (1) In general. A self-insured medical reimbursement plan does not satisfy the requirements of section 105(h) and this paragraph for a plan year unless the plan satisfies subparagraphs (2) and (3) of this paragraph. However, a plan does not fail to satisfy the requirements of this paragraph merely because benefits under the plan are offset by benefits paid under a self-insured or insured plan of the employer or another employer, or by benefits paid under Medicare or other Federal or State law or similar foreign law. A self-insured plan may take into account the benefits provided under another plan only to the extent that the type of benefit subject to reimbursement is the same under both plans. For example, an amount reimbursed to an employee for a hospital expense under a medical plan maintained by the employer of the employee's spouse may be offset against the self-insured benefit where the self-insured plan covering the employee provides the same type of hospital benefit.

(2) Eligibility to participate (i) Percentage test. A plan satisfies the requirements of this subparagraph if it benefits-- (A) Seventy percent or more of all employees, or (B) Eighty percent or more of all the employees who are eligible to benefit under the plan if 70 percent or more of all employees are eligible to benefit under the plan. (ii) Classification test. A plan satisfies the requirements of this subparagraph if it benefits such employees as qualify under a classification of employees set up by the employer which is found by the Internal Revenue Service not to be discriminatory in favor of highly compensated individuals. In general, this determination will be made based upon the facts and circumstances of each case, applying the same standards as are applied under section 410(b)(1)(B) (relating to qualified pension, profit-sharing and stock bonus plans), without regard to the special rules in section 401(a)(5) concerning eligibility to participate. (iii) Exclusion of certain employees. Under section 105(h)(3), for purposes of this subparagraph (2), there may be excluded from consideration: (A) Employees who have not completed 3 years of service prior to the beginning of the plan year. For purposes

of this section years of service may be determined by any method that is reasonable and consistent. A determination made in the same manner as (and not requiring service in excess of how) a year of service is determined under section 410(a)(3) shall be deemed to be reasonable. For purposes of the 3-year rule, all of an employee's years of service with the employer prior to a separation from service are not taken into account. For purposes of the 3-year rule, an employee's years of service prior to age 25, as a part-time or seasonal employee, as a member of a collective bargaining unit, or as a nonresident alien, as each is described in this subdivision, are not excluded by reason of being so described from counting towards satisfaction of the rule. In addition, if the employer is a predecessor employer (determined in a manner consistent with section 414(a)), service for such predecessor is treated as service for the employer. (B) Employees who have not attained age 25 prior to the beginning of the plan year. (C) Part-time employees whose customary weekly employment is less than 35 hours, if other employees in similar work with the same employer (or, if no employees of the employer are in similar work, in similar work in the same industry and location) have substantially more hours, and seasonal employees whose customary annual employment is less than 9 months, if other employees in similar work with the same employer (or, if no employees of the employer are in similar work, in similar work in the same industry and location) have substantially more months. Notwithstanding the preceding sentence, any employee whose customary weekly employment is less than 25 hours or any employee whose customary annual employment is less than 7 months may be considered as a part-time or seasonal employee. (D) Employees who are included in a unit of employees covered by an agreement between employee representatives and one or more employers which the Commissioner finds to be a collective bargaining agreement, if accident and health benefits were the subject of good faith bargaining between such employee representatives and such employer or employers. For purposes of determining whether such bargaining occurred, it is not material that such employees are not covered by another medical plan or that the plan was not considered in such bargaining. (E) Employees who are nonresident aliens and who receive no earned income (within the meaning of section 911(b) and the regulations thereunder) from the employer which constitutes income from sources within the United States (within the meaning of section 861(a)(3) and the regulations thereunder).

(3) Nondiscriminatory benefits (i) In general. In general, benefits subject to reimbursement under a plan must not discriminate in favor of highly compensated individuals. Plan benefits will not satisfy the requirements of this subparagraph unless all the benefits provided for participants who are highly compensated individuals are provided for all other participants. In addition, all the benefits available for the dependents of employees who are highly compensated individuals must also be available on the same basis for the dependents of all other employees who are participants. A plan that provides optional benefits to participants will be treated as providing a single benefit with respect to the benefits covered by the option provided that (A) all eligible participants may elect any of the benefits covered by the option and (B) there are either no required employee contributions or the required employee contributions are the same amount. This test is applied to the benefits subject to reimbursement under the plan rather than the actual benefit payments or claims under the plan. The presence or absence of

such discrimination will be determined by considering the type of benefit subject to reimbursement provided highly compensated individuals, as well as the amount of the benefit subject to reimbursement. A plan may establish a maximum limit for the amount of reimbursement which may be paid a participant for any single benefit, or combination of benefits. However, any maximum limit attributable to employer contributions must be uniform for all participants and for all dependents of employees who are participants and may not be modified by reason of a participant's age or years of service. In addition, if a plan covers employees who are highly compensated individuals, and the type or the amount of benefits subject to reimbursement under the plan are in proportion to employee compensation, the plan discriminates as to benefits. (ii) Discriminatory operation. Not only must a plan not discriminate on its face in providing benefits in favor of highly compensated individuals, the plan also must not discriminate in favor of such employees in actual operation. The determination of whether plan benefits discriminate in operation in favor of highly compensated individuals is made on the basis of the facts and circumstances of each case. A plan is not considered discriminatory merely because highly compensated individuals participating in the plan utilize a broad range of plan benefits to a greater extent than do other employees participating in the plan. In addition, if a plan (or a particular benefit provided by a plan) is terminated, the termination would cause the plan benefits to be discriminatory if the duration of the plan (or benefit) has the effect of discriminating in favor of highly compensated individuals. Accordingly, the prohibited discrimination may occur where the duration of a particular benefit coincides with the period during which a highly compensated individual utilizes the benefit. (iii) Retired employees. To the extent that an employer provides benefits under a self-insured medical reimbursement plan to a retired employee that would otherwise be excludible from gross income under section 105(b), determined without regard to section 105(h), such benefits shall not be considered a discriminatory benefit under this paragraph (c). The preceding sentence shall not apply to a retired employee who was a highly compensated individual unless the type, and the dollar limitations, of benefits provided retired employees who were highly compensated individuals are the same for all other retired participants. If this subdivision applies to a retired participant, that individual is not considered an employee for purposes of determining the highest paid 25 percent of all employees under paragraph (d) of this section solely by reason of receiving such plan benefits.

(4) Multiple plans, etc. (i) General rule. An employer may designate two or more plans as constituting a single plan that is intended to satisfy the requirements of section 105(h)(2) and paragraph (c) of this section, in which case all plans so designated shall be considered as a single plan in determining whether the requirements of such section are satisfied by each of the separate plans. A determination that the combination of plans so designated does not satisfy such requirements does not preclude a determination that one or more of such plans, considered separately, satisfies such requirements. A single plan document may be utilized by an employer for two or more separate plans provided that the employer designates the plans that are to be considered separately and the applicable provisions of each separate plan.

(ii) Other rules. If the designated combined plan discriminates as to eligibility to participate or benefits, the amount of excess reimbursement will be determined under the rules of section 105(h)(7) and paragraph (e) of this section by taking into account all reimbursements made under the combined plan. (iii) H.M.O. participants. For purposes of section 105(h)(2)(A) and paragraph (c)(2) of this section, a self-insured plan will be deemed to benefit an employee who has enrolled in a health maintenance organization (HMO) that is offered on an optional basis by the employer in lieu of coverage under the self-insured plan if, with respect to that employee, the employer's contributions to the HMO plan equal or exceed those that would be made to the self-insured plan, and if the HMO plan is designated in accordance with subdivision (i) with the self-insured plan as a single plan. For purposes of section 105(h) and this section, except as provided in the preceding sentence, employees covered by, and benefits under, the HMO plan are not treated as part of the self-insured plan. (d) Highly compensated individuals defined. For purposes of section 105(h) and this section, the term ``highly compensated individual'' means an individual who is-- (1) One of the 5 highest paid officers, (2) A shareholder who owns (with the application of section 318) more than 10 percent in value of the stock of the employer, or (3) Among the highest paid 25 percent of all employees (including the 5 highest paid officers, but not including employees excludable under paragraph (c)(2)(iii) of this section who are not participants in any self-insured medical reimbursement plan of the employer, whether or not designated as a single plan under paragraph (c)(4) of this section, or in a health maintenance organization plan). The status of an employee as an officer or stockholder is determined with respect to a particular benefit on the basis of the employee's officer status or stock ownership at the time during the plan year at which the benefit is provided. In calculating the highest paid 25 percent of all employees, the number of employees included will be rounded to the next highest number. For example, if there are 5 employees, the top two are in the highest paid 25 percent. The level of an employee's compensation is determined on the basis of the employee's compensation for the plan year. For purposes of the preceding sentence, fiscal year plans may determine employee compensation on the basis of the calendar year ending within the plan year. (e) Excess reimbursement of highly compensated individual (1) In general. For purposes of section 105(h) and this section, a reimbursement paid to a highly compensated individual is an excess reimbursement if it is paid pursuant to a plan that fails to satisfy the requirements of paragraph (c)(2) or (c)(3) for the plan year. The amount reimbursed to a highly compensated individual which constitutes an excess reimbursement is not excludable from such individual's gross income under section 105(b). (2) Discriminatory benefit. In the case of a benefit available to highly compensated individuals but not to all other participants (or which otherwise discriminates in favor of highly compensated individuals as opposed to other participants), the amount of excess reimbursement equals the total amount reimbursed to the highly compensated individual with respect to the benefit.

(3) Discriminatory coverage. In the case of benefits (other than discriminatory benefits described in subparagraph (2)) paid to a highly compensated individual under a plan which fails to satisfy the requirements of paragraph (c)(2) relating to nondiscrimination in eligibility to participate, the amount of excess reimbursement is determined by multiplying the total amount reimbursed to the individual by a fraction. The numerator of the fraction is the total amount reimbursed during that plan year to all highly compensated individuals. The denominator of the fraction is the total amount reimbursed during that plan year to all participants. In computing the fraction and the total amount reimbursed to the individual, discriminatory benefits described in subparagraph (2) are not taken into account. Accordingly, any amount which is included in income by reason of the benefit's not being available to all other participants will not be taken into account. (4) Examples. The provisions of this paragraph are illustrated by the following examples: Example (1). Corporation M maintains a self-insured medical reimbursement plan which covers all employees. The plan provides the following maximum limits on the amount of benefits subject to reimbursement: $5,000 for officers and $1,000 for all other participants. During a plan year Employee A, one of the 5 highest paid officers, received reimbursements in the amount of $4,000. Because the amount of benefits provided for highly compensated individuals is not provided for all other participants, the plan benefits are discriminatory. Accordingly, Employee A received an excess reimbursement of $3,000 ($4,000-$1,000) which constitutes a benefit available to highly compensated individuals, but not to all other participants. Example (2). Corporation N maintains a self-insured medical reimbursement plan which covers all employees. The plan provides a broad range of medical benefits subject to reimbursement for all participants. However, only the 5 highest paid officers are entitled to dental benefits. During the plan year Employee B, one of the 5 highest paid officers, received dental payments under the plan in the amount of $300. Because dental benefits are provided for highly compensated individuals, and not for all other participants, the plan discriminates as to benefits. Accordingly, Employee B received an excess reimbursement in the amount of $300. Example (3). Corporation O maintains a self-insured medical reimbursement plan which discriminates as to eligibility by covering only the highest paid 40% of all employees. Benefits subject to reimbursement under the plan are the same for all participants. During a plan year Employee C, a highly compensated individual, received benefits in the amount of $1,000. The amount of excess reimbursement paid Employee C during the plan year will be calculated by multiplying the $1,000 by a fraction determined under subparagraph (3). Example (4). Corporation P maintains a self-insured medical reimbursement plan for its employees. Benefits subject to reimbursement under the plan are the same for all plan participants. However, the plan fails the eligibility tests of section 105(h)(3)(A) and thereby discriminates as to eligibility. During the 1980 plan year Employee D, a highly compensated individual, was hospitalized for surgery and incurred medical expenses of $4,500 which were reimbursed to D under the plan. During that plan year the Corporation P medical plan paid $50,000 in benefits under the plan, $30,000

of which constituted benefits paid to highly compensated individuals. The amount of excess reimbursement not excludable by D under section 105(b) is $2,700 ($4500 x $30,000/$50,000) Example (5). Corporation Q maintains a self-insured medical reimbursement plan for its employees. The plan provides a broad range of medical benefits subject to reimbursement for participants. However, only the five highest paid officers are entitled to dental benefits. In addition, the plan fails the eligibility test of section 105(h)(3)(A) and thereby discriminates as to eligibility. During the calendar 1981 plan year, Employee E, a highly compensated individual, received dental benefits under the plan in the amount of $300, and no other employee received dental benefits. In addition, Employee E was hospitalized for surgery and incurred medical expenses, reimbursement for which was available to all participants, of $4,500 which were reimbursed to E under the plan. Because dental benefits are only provided for highly compensated individuals, Employee E received an excess reimbursement under paragraph (e)(2) above in the amount of $300. For the 1981 plan year, the Corporation Q medical plan paid $50,300 in total benefits under the plan, $30,300 of which constituted benefits paid to highly compensated individuals. In computing the fraction under paragraph (e)(3), discriminatory benefits described in paragraph (e)(2) are not taken into account. Therefore, the amount of excess reimbursement not excludable to Employee E with respect to the $4,500 of medical expenses incurred is $2,700 ($4,500 x $30,000/$50,000) and the total amount of excess reimbursements includable in E's income for 1981 is $3,000. Example (6) Corporation R maintains a calendar year self-insured medical reimbursement plan which covers all employees. The type of benefits subject to reimbursement under the plan include all medical care expenses as defined in section 213(e). The amount of reimbursement available to any employee for any calendar year is limited to 5 percent of the compensation paid to each employee during the calendar year. The amount of compensation and reimbursement paid to Employees A-F for the calendar year is as follows: ------------------------------------------------------------------------ Reimbursable Employee Compensation amount paid ------------------------------------------------------------------------ A....................................... $100,000 $5,000 B....................................... 25,000 1,250 C....................................... 15,000 750 D....................................... 10,000 500 E....................................... 10,000 500 F....................................... 8,000 400 ----------------- 8,400 ------------------------------------------------------------------------ (ii) Because the amount of benefits subject to reimbursement under the plan is in proportion to employee compensation the plan discriminates as to benefits. In addition, Employees A and B are highly compensated individuals. The amount of excess reimbursement paid Employees A and B during the plan year will be determined under paragraph (e)(2). Because benefits in excess of $400 (Employee F's maximum benefit) are provided for highly compensated individuals and not for all other participants, Employees A and B received, respectively, an excess reimbursement of $4,600 and $850. (f) Certain controlled groups. For purposes of applying the provisions of section 105(h) and this section, all employees

who are treated as employed by a single employer under section 414 (b) and (c), and the regulations thereunder (relating to special rules for qualified pension, profit-sharing and stock bonus plans), shall be treated as employed by a single employer. (g) Exception for medical diagnostic procedures (1) In general. For purposes of applying section 105(h) and this section, reimbursements paid under a plan for medical diagnostic procedures for an employee, but not a dependent, are not considered to be a part of a plan described in this section. The medical diagnostic procedures include routine medical examinations, blood tests, and X-rays. Such procedures do not include expenses incurred for the treatment, cure or testing of a known illness or disability, or treatment or testing for a physical injury, complaint or specific symptom of a bodily malfunction. For example, a routine dental examination with X-rays is a medical diagnostic procedure, but X-rays and treatment for a specific complaint are not. In addition, such procedures do not include any activity undertaken for exercise, fitness, nutrition, recreation, or the general improvement of health unless they are for medical care as defined in section 213(e). The diagnostic procedures must be performed at a facility which provides no services (directly or indirectly) other than medical, and ancillary, services. For purposes of the preceding sentence, physical proximity between a medical facility and nonmedical facilities will not for that reason alone cause the medical facility not to qualify. For example, an employee's annual physical examination conducted at the employee's personal physician's office is not considered a part of the medical reimbursement plan and therefore is not subject to the nondiscrimination requirements. Accordingly, the amount reimbursed may be excludable from the employee's income if the requirements of section 105(b) are satisfied. (2) Transportation, etc. expenses. Transportation expenses primarily for an allowable diagnostic procedure are included within the exception described in this paragraph, but only to the extent they are ordinary and necessary. Transporta-tion undertaken merely for the general improvement of health, or in connection with a vacation, is not within the scope of this exception, nor are any incidental expenses for food or lodging; therefore, amounts reimbursed for such expenses may be excess reimbursements under paragraph (e). (h) Time of inclusion. Excess reimbursements (determined under paragraph (e)) paid to a highly compensated individual for a plan year will be considered as received in the taxable year of the individual in which (or with which) the plan year ends. The particular plan year to which reimbursements relate shall be determined under the plan provisions. In the absence of plan provisions reimbursements shall be attributed to the plan year in which payment is made. For example, under a calendar year plan an excess reimbursement paid to A in 1981 on account of an expense incurred and subject to reimbursement for the 1980 plan year under the terms of the plan will be considered as received in 1980 by A. (i) Self-insured contributory plan. A medical plan subject to this section may provide for employer and employee contributions. See Sec. 1.105-1(c). The tax treatment of reimbursements attributable to employee contributions is determined under section 104(a)(3). The tax treatment of reimbursements attributable to employer contributions is determined under section 105. The amount of reimbursements which are attributable to contributions of the employer shall be determined in accordance with Sec. 1.105-1(e).

(j) Effective date. Section 105(h) and this section are effective for taxable years beginning after December 31, 1979 and for amounts reimbursed after December 31, 1979. In determining plan discrimination and the taxability of excess reimbursements made for a plan year beginning in 1979 and ending in 1980, a plan's eligibility and benefit requirements as well as actual reimbursements made in the plan year during 1979, will not be taken into account. In addition, this section does not apply to expenses which are incurred in 1979 and paid in 1980. (k) Special rules (1) Relation to cafeteria plans. If a self-insured medical reimbursement plan is included in a cafeteria plan as described in section 125, the rules of this section will determine the status of a benefit as a taxable or nontaxable benefit, and the rules of section 125 will determine whether an employee is taxed as though he elected all available taxable benefits (including taxable benefits under a discriminatory medical reimbursement plan). This rule is illustrated by the following example: Example. Corporation M maintains a cafeteria plan described in section 125. Under the plan an officer of the corporation may elect to receive medical benefits provided by a self-insured medical reimbursement plan which is subject to the rules of this section. However, the self-insured medical reimbursement plan fails the nondiscrimination rules under paragraph (c) of this section. Accordingly, the amount of excess reimbursement is taxable to the officer participating in the medical reimbursement plan pursuant to section 105(h) and this section. Therefore, the self-insured medical reimbursement plan will be considered a taxable benefit under section 125 and the regulations thereunder. (2) Benefit subject to reimbursement. For purposes of this section, a benefit subject to reimbursement is a benefit described in the plan under which a claim for reimbursement or for a payment directly to the health service provider may be filed by a plan participant. It does not refer to actual claims or benefit reimbursements paid under a plan.

Rev. Rul. 71-588 Code Secs. 105, 162 26 CFR 1.105-2: Amounts expended for medical care. (Also Section 162; 1.162-10.) Amounts reimbursed under an accident and health plan covering all bona fide employees, including the owner's wife, and their families are not includible in the employee's gross income and are deductible by the owner as business expenses. The taxpayer operated a business as a sole proprietorship with several bona fide full-time employees including his wife. The taxpayer had an accident and health plan covering all employees and their families. During 1970 two employees, including the wife, incurred expenses for medical care for themselves, their spouses, and their children, and were reimbursed pursuant to the plan. The reimbursed amounts qualified both as amounts received under an accident or health plan for employees within the meaning of section 105(e) of the Internal Revenue Code of 1954 and as amounts described in section 105(b) of the Code. Held, the reimbursed amounts received by the employees are not includible in their gross income pursuant to section 105(b) of the Code and these amounts are deductible by the taxpayer as a business expense under section 162(a) of the Code. <<END RULING>>

Private Letter Ruling 9409006 ISSUES:

(0) Whether A, a sole proprietor, is entitled to deduct under

section 162(a) of the Internal Revenue Code, amounts paid to B, A’s spouse and employee, as reimbursement of medical expenses under an employer-provided accident or health plan.

(0) Whether amounts B receives as reimbursement of

expenses that B incurs on behalf of B, A, and their dependents are excluded from B’s gross income under section 105(b).

FACTS:

A operates a consulting business as a sole proprietor and employs B, A’s spouse, to perform certain services in connection with the business. B receives compensation for the services B performs and includes the compensation in gross income on the couple’s jointly-filed federal income tax return. A adopted a written employer-provided accident and health plan that, by its terms, covers all employees of A’s business. During the year in question, A reimbursed B, pursuant to the plan, for the expenses of medical care that incurred on behalf of B, A, and their dependents. You agreed that there is a bona fide employer-employee relationship between A and B.

LAW: Section 162(a) of the Code allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business, including reasonable salaries and other compensation for services rendered.

Section 213(a) of the Code allows a deduction for the expenses paid during the taxable year, not compensated by insurance or otherwise, for medical care of the taxpayer, the taxpayer’s spouse, or a dependent, to the extent that such expenses exceed 7.5% of the taxpayer’s AGI. The term “medical care” is defined in section 213(d).

Section 105(b) of the Code generally allows an employee to exclude from gross income employer-paid reimbursements for the expenses of medical care (as defined in section 213(d)) of the employee and the employee’s spouse and dependents.

Rev. Rul. 71-588, 1971-2 C.B. 91, holds that amounts paid by a sole proprietor to his spouse, a bona fide employee of the business, under an accident and health plan covering all employees are (1) excludable from the employee-spouse’s gross income under section 105(b) of the Code and (2) deductible by the employer-spouse as a business expense under section 162(a).

CONCLUSION:

Applying the law to the facts of the present case, the amounts paid to B under the plan as reimbursement for medical expenses are deductible by A as a business expense under section 162(a) of the Code. Further, B may exclude these amounts from gross income under section 105(b).

Industry Specialization Papers Health Insurance Deductibility for Self-Employed Individuals UIL 162.35-02 ALL INDUSTRIES: Health Insurance Deductibility for Self-Employed Individuals UIL 162.35-02 Effective Date: March 29, 1999

COORDINATED ISSUE PAPERS

ISSUES:

0. Where an employer, who is self-employed, provides

accident and health coverage to his spouse as an employee, is the cost of that coverage deductible by the employer-spouse under section 162 of the Internal Revenue Code.

2. Where an employer, who is self-employed, provides

accident and health coverage to his spouse as an employee, is the cost of that coverage and medical reimbursements excludable by the employee under sections 106 and 105(b) of the Code.

CONCLUSIONS:

0. The cost of the accident and health coverage is deductible

by the employer spouse if he provides such coverage to his spouse as an employee.

2. Both the cost of the coverage and the medical

reimbursements are excludable from the gross income of the employee-spouse.

STATEMENT OF FACTS:

An arrangement is marketed through accounting firms and a national tax return preparer that encourages self-employed persons to deduct 100% of accident and health plan expenses. This arrangement has been utilized by the self-employed in partnerships, limited liability corporations, subchapter S corporations and sole proprietorships. Through this promotion, a self-employed individual hires his or her spouse as an employee. The employer-spouse provides family accident and health coverage for the employee-spouse through a self-insured medical expense reimbursement plan or by purchasing an accident and health insurance policy. The employer-spouse is then covered by the plan as a member of the employee's family.

By utilizing this arrangement, the employer-spouse deducts 100% of the cost of providing health coverage to himself and his family, including reimbursement of medical expenses. Expenses claimed for reimbursement include insurance premiums and other expenses not reimbursed by insurance. The employee-spouse excludes from gross income the cost of the health coverage and medical expense reimbursements.

Often, compensation for the employee-spouse is determined upon the amount of the accident and health cost for the taxable year. In this situation, Form W-2 is not issued or is issued for a small dollar amount because the cost of the coverage and medical expense reimbursements are excluded from the employee-spouse's income.

LAW AND ANALYSIS:

ISSUE 1:

Section 162(a)(1) of the Code provides that a taxpayer may deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered. Section 1.162-7(a) of the Income Tax Regulations provides that there shall be included among the ordinary and necessary expenses paid or incurred in carrying on any trade or business a reasonable allowance for salaries or other compensation for services actually rendered. The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services.

Section 1.162-10(a) of the regulations provides, in part, that amounts paid or incurred within the taxable year for dismissal wages, unemployment benefits, guaranteed annual wages, vacations, or a sickness, accident, hospitalization, medical expense, recreational, welfare or similar benefit plan (other than deferred compensation plans referred to in section 404 of the Code) are deductible under section 162(a) if they are ordinary and necessary expenses of the trade or business.

Section 262(a) provides that except as otherwise provided, no deduction shall be allowed for personal, living, or family expenses.

In Rev. Rul. 71-588, 1971-2 C.B. 91, the taxpayer operated a business as a sole proprietorship with several bona fide full-time employees, including his wife. The taxpayer had a self-insured accident and health plan that covered all employees and their families. During 1970, two of the employees, including the wife, incurred expenses for medical care for themselves, their spouses and their children, and were reimbursed pursuant to the plan. Under these facts, the Service held that the amounts paid in reimbursement were deductible by the taxpayer as business expenses under section 162 of the Code and excludable by the employees (including the wife) under section 105(b) of the Code.

Accordingly, the Service's position is that the cost of accident and health coverage, including medical expense reimburse- ments, are deductible by the employer-spouse if the employee-spouse is determined to be a bona fide employee of the business under the common law rules or otherwise provides services to the business for which the accident and health coverage is reasonable compensation. However, if the "employee-spouse" does not meet this standard, the accident and health coverage is a personal expense under section 262(a) of the Code, which is not deductible under section 162(a). Other Code provisions apply in this situation.

Section 213(a) allows a deduction for expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the taxpayer, his spouse, or a dependent to the extent that such expenses exceed 7.5 percent of adjusted gross income.

Section 162(l) provides, in the case of a self-employed individual, there shall be allowed an amount equal to the applicable percentage under this section of the amount paid during the taxable year for insurance which constitutes medical care for the taxpayer, his spouse, and dependents. If the "employee-spouse" is not an employee of the "employer-spouse's" business, or does not otherwise provide services to

the business, the cost of accident and health insurance purchased by the "employer-spouse" is deductible by the employer-spouse only up to the applicable percentage under section 162(l) of the Code. The cost of insurance in excess of the applicable percentage is deductible to the extent permitted under section 213(a) of the Code. In addition, if the "employee-spouse" is not an employee of the "employer-spouse's" business or does not otherwise provide services to the business, amounts paid by the "employer-spouse" for the reimbursement of medical expenses under the self-insured plan for himself, his spouse, and his dependents are only deductible to the extent provided under section 213(a) of the Code. Note that if an accident and health insurance policy is purchased in the name of the employer-spouse the limitations of section 162(l) of the Code apply, notwithstanding that the policy provides coverage for the employer-spouse, the employee-spouse and their dependents.

ISSUE 2:

Section 104(a)(3) of the Code provides that, except in the case of amounts attributable to and not in excess of deductions allowed under section 213, gross income does not include amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness other than amounts received by an employee, to the extent such amounts (A) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (B) are paid by the employer.

Section 106(a) of the Code provides that gross income of an employee does not include employer-provided coverage under an accident and health plan.

Section 105(a) of the Code provides that, generally, amounts received by an employee through accident and health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.

Section 105(b) of the Code provides an exception to the general rule of inclusion under section 105(a). Section 105(b) states that gross income does not include amounts referred to in subsection (a) (employer-provided accident and health insurance) if such amounts are paid, directly or indirectly, to the employee to reimburse the employee for expenses incurred by him, his spouse or dependents for medical care.

Section 105(e) provides that amounts received under an accident or health plan for employees shall be treated as amounts received through accident or health insurance for purpose of sections 105(a) and (b).

Accordingly, because self-insured medical expense reimbursement plans are treated as accident and health insurance under section 105(e), medical expense reimbursements paid under such plans are excludable from the employee's gross income under section 105(b) (to the extent benefits do not discriminate in favor of highly compensated individuals under section 105(h)).

The Service's position is that the cost of accident and health coverage or medical expense reimbursement is excludable from gross income by the employee-spouse only if the employee-spouse is a bona fide employee under the common

law rules. If the "employee spouse" is not a bona fide employee, then the cost of accident and health coverage provided by the "employer-spouse" is not excluded from the gross income of the "employee-spouse" under section 106(a) of the Code, because the section 106 exclusion only applies to the "gross income of an employee". Similarly, medical expense reimbursements received by the "employee-spouse" are not excluded from gross income under section 105(b) of the Code. However, if the cost of accident and health coverage provided by the "employer-spouse" is included in the "employee-spouse's" gross income, all amounts received by the "employee-spouse" and family for personal injury and sickness under the coverage are excludable under section 104(a)(3). An additional factor to consider in this situation is the eligibility provisions of a self insured accident or health plan. The adoption agreement and plan document must provide that the employee-spouse is eligible to participate. For example, very often a specific service requirement applies to current employees as well as new employees. This waiting period may not have been applied to the employee-spouse, but may have been used to exclude other employees. Thus, if it is not documented that the employee-spouse has met the service requirement, the employee-spouse may not participate and medical expense reimbursements would not be excludable under section 105(b) because they would not be received under an accident and health plan.

In addition, if the service requirement has not been consistently applied to all employees, the self-insured plan could be discriminatory under section 105(h). Whether the "employee-spouse" is an employee, must be determined on a case-by case basis. See Attachment for additional guidance.

The extent and nature of the spouse's involvement in the business operations are critical. Although, part-time work does not negate employee status, the performance of nominal or insignificant services that have no economic substance or independent significance may be challenged. Merely calling a spouse an "employee" is not sufficient to qualify a non-working spouse as an employee.

In addition, a spouse may be a self-employed individual engaged in the trade or business as a joint owner, co-owner, or partner. For example, a significant investment of the spouse's separate funds in (or significant co-ownership or joint ownership of) the business assets may support a finding that the spouse is self-employed in the business rather than an employee.

Marital property or community property laws that give a spouse an ownership interest in a business operated by a self-employed individual may be relevant, but not necessarily conclusive, for determining whether the spouse is also self-employed in that business. Note that state laws that impose on one family member a legal obligation to support another family member are generally irrelevant in determining the tax treatment of fringe benefits. See, Rev. Rul. 73-393, 1973-2 C.B. 33.

Under sections 318 and 1372 of the Code, a spouse of more than a 2-percent shareholder of a subchapter S corporation is treated as more than a 2-percent shareholder for certain employee fringe benefit purposes, including accident and health benefits. Thus, both the spouse and the more than 2-percent shareholder are treated as partners in a partnership for

benefit purposes. See, Rev. Rul. 91-26, 1991-1 C.B. 184. For the tax treatment of limited liability corporations, see Rev. Rul. 88-76, 1988-2 C.B. 360.

INDUSTRY'S ARGUMENTS:

Promoters of this arrangement do not dispute the assertion that the critical issue is whether the “employee- spouse" is a bona fide employee of the "employer-spouse's" business. If the employee-spouse is a bona fide employee, then Rev. Rul. 71-588 is applicable for purposes of deductibility and income tax exclusion.

ATTACHMENT

The following is a brief outline of the law regarding employment status. It is important to note that either worker classification -- independent contractor or employee -- can be valid. For an in-depth discussion, see the training material "Independent Contractor or Employee?" Training 3320-102 (Rev. 10-96) TPDS 842381, for determining employment status. The training materials are also available on the IRS home page on the Internet at http://www.irs.ustreas.gov.

In determining a worker's status, the primary inquiry is whether the worker is an independent contractor or an employee under the common law standard. Under the common law, the treatment of a worker as an independent contractor or an employee originates from the legal definitions developed in the law of agency -- whether one party, the principal, is legally responsible for the acts or omissions of another party, the agent -- and depends on the principal's right to direct and control the agent.

Guidelines for determining a worker's employment status are found in three substantially similar sections of the Employment Tax Regulations: sections 31.3121(d)-1, 31.3306(i)-1, and 34.3401(c)-1, relating to the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), and federal income tax withholding. The regulations provide that an employer-employee relationship exists when the business for which the services are performed has the right to direct and control the worker who performs the services. This control refers not only to the result to be accomplished by the work, but also to the means and details by which that result is accomplished. In other words, a worker is subject to the will and control of the business not only as to what work shall be done but also how it shall be done. It is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if the employer has the right to do so. To determine whether the control test is satisfied in a particular case, the facts and circumstances must be examined.

The Service now looks at facts in the following categories when determining worker classification: behavioral control, financial control and relationship of the parties.

Behavioral Control Facts that substantiate the right to direct or control the details and means by which the worker performs the required services are considered under behavioral control. This includes factors such as training and instructions provided by the business. Virtually every business will impose on workers, whether independent contractors or employees, some form of instruction (for example, requiring that the job be performed within specified time frames). This fact alone is not sufficient evidence to determine the worker's status. The weight of "instructions" in any case depends on the degree to which instructions apply to how the job gets done rather than to the end result. The degree of instruction depends on the scope of instructions, the extent to which the business retains the right to control the worker's compliance with the instructions, and the effect on the worker in the event of noncompliance. The more detailed the instructions that the worker is required to follow, the more control the business exercises over the worker, and the more likely the business retains the right to control the methods by which the worker performs the work. The absence of detail in instructions reflects less control. Financial Control

Whether the business has the right to direct or control the economic aspects of the worker's activities should be analyzed to determine worker status. Economic aspects of a relationship between the parties illustrate who has financial control of the activities undertaken. The items that usually need to be explored are whether the worker has a significant investment, unreimbursed expenses, whether the worker's services are available to the relevant market, the method of payment and opportunity for profit or loss. The first four items are not only important in their own right but also affect whether there is an opportunity for the realization of profit or loss. All of these can be thought of as bearing on the issue of whether the recipient has the right to direct and control the means and details of the business aspects of how the worker performs services.

The ability to realize a profit or incur a loss is probably the strongest evidence that a worker controls the business aspects of services rendered. Significant investment, unreimbursed expenses, making services available, and method of payment are all relevant in this regard. If the worker is making decisions which affect his or her bottom line, the worker likely has the ability to realize profit or loss.

Relationship of the Parties

The relationship of the parties is important because it reflects the parties' intent concerning control. Courts often look to the intent of the parties; this is most often embodied in contractual relationships. A written agreement describing the worker as an independent contractor is viewed as evidence of the party's intent that a worker is an independent contractor -- especially in close cases. However, a contractual designation, in and of itself, is not sufficient evidence for determining worker status. The facts and circumstances under which a worker performs services are determinative of a worker's status. This means that the substance of the relationship governs the worker's status, not the label.

PURSUANT TO INTERNAL REVENUE CODE SECTION 7463(b),

THIS OPINION MAY NOT BE TREATED AS PRECEDENT FOR ANY OTHER CASE.

T.C. Summary Opinion 2006-25

UNITED STATES TAX COURT

PETER F. & MAUREEN L. SPELTZ, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 5851-04S. Filed February 14, 2006.

Thomas B. Copeland, for petitioners. Melissa J. Hedtke, for respondent.

KROUPA, Judge: This case was heard pursuant to the provisions of section 74631 of the Internal Revenue Code in effect at the time the petition was filed. The decision to be entered is not reviewable by any other court, and this opinion should not be cited as authority.

Respondent determined deficiencies in petitioners Federal income taxes of $9212 for 2000 and $1,082 for 2001. The issues for decision are:

1. Whether petitioners, husband and wife, had an

employer-employee relationship. We find that they did.

2. Whether petitioners may exclude from gross income medical benefits of $3,279 in 2000 and $4,539 in 2001 paid by an employer-spouse to an employee-spouse. We find that they may.

3. Whether petitioners may deduct from gross income medical benefits of $3,279 in 2000 and $4,539 in 2001 paid by an employer-spouse to an employee-spouse. We find that they may.

Background

Some of the facts have been stipulated and are so found. The stipulation of facts and the accompanying exhibits are incorporated by this reference. Petitioners resided in Rollingstone, Minnesota, at the time they filed the petition. Maureen Speltz

Petitioner Maureen Speltz (Mrs. Speltz) has operated a sole proprietorship daycare business in petitioner’s home since 1982. Mrs. Speltz has an elementary education degree, and she has been licensed

1 All section references are to the Internal revenue Code in effect for the years at issue, unless otherwise indicated, and Rule references are to the Tax Court Rules of Practice and Procedure. 2 All monetary amounts have been rounded to the nearest dollar.

by the State of Minnesota to run the daycare business since 1987. Mrs. Speltz cared for up to 16 children daily during the years at issue. Mrs. Speltz has managed the daycare since 1987 through the years at issue. Mrs. Speltz established the daycare’s rules, policies, and hours of operation. She established a daycare business checking account and credit card account in her name and purchased a professional pre-school curriculum that she has used to instruct the children.3 In addition, Mrs. Speltz drafted all parental contracts, addressed parental complaints, negotiated daycare rates, collected payment, administered bookkeeping, handled State of Minnesota regulatory personnel, utilized the services of Mr. Speltz, and taught the curriculum.

In comparison, Mr. Speltz, while integral to the daycare, had a limited and narrowly defined role during 2000 and 2001. Mr. Speltz assisted Mrs. Speltz by monitoring the children from approximately 2:30 p.m. until 6:00 p.m. and by performing other maintenance-type tasks. Mr. Speltz’s part-time role was designed specifically to fit a medical reimbursement plan that Mrs. Speltz established with the help of a tax adviser. Medical Reimbursement Insurance Plan

Mrs. Speltz established an employer-provided accident and health plan for employees with the help of a tax adviser in 2000. Mrs. Speltz executed three documents in 2000, an employment contract, a salary redirection document, and a client data sheet.

The employment contract described Mr. Speltz’s job duties. Mrs. Speltz and Mr. Speltz signed the contract. Mr. Speltz’s duties were described as childcare, lawn care, chopping firewood, and repairing toys and sundry items. Mr. Speltz was also required to work an “average” of 12.5 hours weekly in return for a medical reimbursement benefit limited to $6,500 per year. Medical benefits, according to the contract, included deductibles, insurance premiums, and medical costs not covered by insurance.

The Employee Salary Redirection document provided that $542 per month would be directed to a flexible spending account on Mr. Speltz’s behalf to pay for Mr. Speltz’s insured and uninsured healthcare costs. Mr. Speltz signed the employee salary redirection document as an “employee” and Mrs. Speltz as his “employer.”

In addition, Mrs. Speltz signed a client data sheet requiring Mr. Speltz to work a minimum” of 12.5 hours a week and “minimum” of 7 months a year. The client data sheet also stated that Mr. Speltz’s medical reimbursement was limited to$6,500 per year.

Mrs. Speltz relied upon an Internal Revenue Service Coordinated Issue Paper, entitled “Health Insurance Deductibility for Self-Employed Individuals,” dated March 29, 1999, and Rev. Rul. 71-588, 1971-2

3 The curriculum was a pre-kindergarten program designed to teach children colors, letters, and numbers.

C.B. 91, in setting up the plan.4 Each document permits, under certain circumstances, a sole-proprietor employer-spouse to deduct medical benefits provided to an employee-spouse, and the employee-spouse to exclude those same benefits from his or her gross income. Mr. Speltz Mr. Speltz has provided childcare services (and other general services) for the daycare since 2000 and has been reimbursed under the daycare’s accident and health plan for a limited amount of medical care expenses and insurance premiums as compensation for his services. Mr. Speltz also worked full time during the years at issue as a machinist for Fastenal Company, Inc. (Fastenal). Mr. Speltz’s hours at Fastenal were from approximately 6 a.m. until approximately 2:15 p.m. Mr. Speltz had medical and dental insurance through Fastenal. Mr. Speltz’s spouse and dependents were eligible to receive benefits. Mr. Speltz also had a snow removal and lawncare service during 2000 and 2001. Mr. Speltz began working for the daycare when he returned home from his full-time job on weekdays, around 2:30 p.m., and he worked until at least 6 p.m., when the daycare closed. Mr. Speltz cared for all the children if Mrs. Speltz was absent, usually when Mrs. Speltz had doctor or dentist appointments. For a short period of time, Mr. Speltz cared for a small boy whose mother had to work very early from 5 a.m. until 6 a.m. Generally, however, Mrs. Speltz directed Mr. Speltz to monitor and care for about five or six older children when he arrived home. 5 Mr. Speltz monitored the children indoors and whenever possible outdoors, where the children could be active playing kickball, soccer, and basketball, and sledding on the vast stretch of property that petitioners maintained according to State of Minnesota daycare standards. Sometimes Mr. Speltz took the children on nature walks along the creek running through petitioner’s property. Mr. Speltz also took the children for rides in a trailer connected to his tractor, and he often took them across the many acres of petitioner’s farm to collect firewood that Mr. Speltz chopped to heat petitioner’s home.6 In addition, Mr. Speltz spent time repairing the children’s toys, cleaning, and organizing the daycare areas. Mr. Speltz also performed tasks benefiting petitioners personally, including picking up mail,

4 Internal Revenue Service Coordinated Issue Papers and Revenue Rulings are generally not entitled to deference in this Court. See Lunsford v. Commissioner, 117 T.C. 159, 182 (2001); see also N. Ind. Pub. Serv. Co. v. Commissioner, 105 T.C. 341,350 (1995), affd. 115 F.3d 506 (7th Cir. 1997). 5 When the children were split into two groups, Mrs. Speltz watched the younger children, whose care involved diapering, toilet training, and playing with toys. 6 Firewood was the only source of heat in their home.

groceries, chopping firewood, and transporting the wood by tractor from their distant farmhouse to their home. If Mr. Speltz took the older children in the trailer when he picked up the firewood, he might spend up to 2 hours returning because he drove the children around the property. During the snowy Minnesotan winter months, Mr. Speltz plowed petitioner’s driveway and shoveled snow from the walkway to petitioner’s house. Mr. Speltz did this several times daily on blustery days as Mrs. Speltz’s clients were usually mothers carrying small children who dropped them off and picked them up at several times during the day (Mr. Speltz sometimes left his full-time job to do this). Mrs. Speltz directed that Mr. Speltz perform only childcare and maintenance tasks, and she made contemporaneous notes detailing his activities. Mr. Speltz’s assistance was integral to Mrs. Speltz’s daycare business. Moreover, as the nature of Mr. Speltz’s daycare-related work varied little, he required minimal instruction. Though petitioners derived a personal benefit from some of Mr. Speltz’s activities, Mr. Speltz would not have spent the amount of time or devoted the degree of care to those activities were there no daycare business. Training Mrs. Speltz directed Mr. Speltz to take classes in nutrition and general childcare because the State of Minnesota and County in which petitioners resided required daycare personnel to have this training. Mr. Speltz’s training consisted of about 2 hours of child-nutrition training and about 4 hours of child-behavioral guidance. Mrs. Speltz substantiated that Mr. Speltz 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. License Mrs. Speltz had a State of Minnesota issued daycare license. From 1987 through February 1999, Mrs. Speltz’s license listed her name only. In February 1999, the State issued the license in Mrs. Speltz’s and Mr. Speltz’s names. Mr. Speltz did not apply for the license and took no part in interviews or inspections required to obtain the license. The State of Minnesota listed Mrs. Speltz’s and Mr. Speltz’s names most likely because they were listed as co-owners of the home where Mrs. Speltz maintained the daycare. The license issued in August 2001 omitted Mr. Speltz’s name and listed only Mrs. Speltz’s name. Tax Returns Petitioners reported daycare income and expenses on Schedules C, Profit or Loss From Business, of their joint Federal income tax returns for 2000 and 2001,

listing their principal business as “child care.” Petitioners deducted $3,279 as an employee benefit program expense in 2000, including $705.82 for health insurance premiums. Petitioners deducted $4,539 as an employee benefit program expense in 2001, including $968.06 for health insurance premiums. Respondent disallowed petitioners’ claimed employee benefit program expense deductions because respondent found Petitioners failed to establish that the amounts were ordinary and necessary business expenses or that Mr. Speltz was a bona fide employee of the daycare. Respondent mailed petitioners a deficiency notice on February 23, 2004, and petitioners timely filed a petition. Discussion We are presented with two issues, the excludability of medical premiums and reimbursements from petitioners’ gross income and the deductibility of those same amounts from the daycare business income. Regarding the excludability issue, we must determine whether petitioners entered into a valid arrangement for the payment of health benefits under section 105(b) and whether Mr. Speltz was a bona fide employee of the daycare. Regarding the deductibility issue, we must determine whether the deduction amount was an ordinary and necessary business expense of the daycare. Respondent makes a number of alternative arguments to disallow the deductions and exclusions. Respondent argues that petitioners’ section 105(b) plan was improper and/or failed on its own terms, that Mr. Speltz was not a bona fide employee of the daycare, and that the expenses were not ordinary and necessary business expenses. Petitioners counter that the medical premiums and reimbursements should be excluded from Mr. Speltz’s gross income because petitioners set up a proper section 105(b) plan for daycare employees and that Mr. Speltz was a bona fide employee. Petitioners also contend that the medical premiums and reimbursements are deductible from the daycare business income because they were ordinary and necessary business expenses of the daycare. We first address the burden of proof. I. Burden of Proof The Commissioner’s determinations are presumptively correct, and the taxpayers bear the burden of proving that the Commissioner’s determinations are erroneous. Rule 142(a); see Welch v. Helvering, 290 U.S. 111, 115 (1933). Taxpayers also bear the burden of proving that they are entitled to the claimed deductions. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). A taxpayer’s burden, however, may shift to the Commissioner if the taxpayer introduces “credible evidence” complete with the necessary substantiation and documentation. See sec. 7491(a); Higbee v.

Commissioner, 116 T.C. 438, 440-443 (2001). To shift the burden, the taxpayer must also have complied with requirements to cooperate with the Commissioner’s reasonable requests for witnesses, information, documents, meetings, and interviews. Sec. 7491(a)(2). The taxpayer has the burden to prove the requirements have been met. Snyder v. Commissioner, T.C. Memo. 2001-255 (citing H. Conf. Rept. 105-599, at 240-241(1998), 1998-3 C.B. 747, 994-995). Petitioners reasonably complied with respondent’s requests for information, documents, and meetings. Petitioners also produced credible evidence to establish that Mr. Speltz worked a sufficient number of hours and the nature of the activities he performed.7 Accordingly, we find that section 7491 shifts the burden of proof to respondent. Respondent therefore bears the burden of proving that petitioners are not entitled to exclude or deduct Mr. Speltz’s reimbursements for insurance premiums and medical expenses. II. Excludability of Medical Premiums and Reimbursements Gross income generally includes all income from whatever source derived. Sec. 61(a). This section has been interpreted broadly to encompass all gains except those specifically excluded by Congress. See Commissioner v. Glenshaw Glass Co., 348 U.S.426, 430 (1955). Consistent with this rule, payments by an employer to an employee through accident and health insurance for personal injuries or sickness are generally included in gross income. Sec. 105(a). An exception exists, however. Employees may exclude from gross income employer-paid “reimbursements” for medical care expenses. See secs. 105(b), 106(a), 213(d); Schmidt v. Commissioner, T.C. Memo. 2003-325; see also Rev. Rul. 71-588,1971-2 C.B. 91 (sanctioning payments from an employer-spouse to an employee-spouse).8 We must therefore determine whether the exception applies and whether petitioners may exclude benefits from income.

7 Petitioners conceded that some of the hours Mrs. Speltz noted were personal and could not be counted. Mrs. Speltz subtracted those hours from the tabulation of the hours Mr. Speltz spent performing daycare-related tasks. 8 We are aware that revenue rulings are not binding on this Court or other Federal courts. Rauenhorst v. Commissioner, 119T.C. 157, 171 (2002); Frazier v. Commissioner, 111 T.C. 243, 248(1998). The public has a right, however, to rely on positions taken by the Commissioner in published guidance. Alumax, Inc. v.Commissioner, 109 T.C. 133, 163 n.12 (1997), affd. 165 F.3d 822(11th Cir. 1999); Am. Campaign Acad. v. Commissioner, 92 T.C.1053, 1070 (1989); Nissho Iwai Am. Corp. v. Commissioner, 89 T.C.765, 778 (1987); see also Rev. Proc. 89-14, sec. 7.01(5), 1989-1C.B. 814, 815 (taxpayers may rely on published revenue rulings in determining the tax treatment of their own transactions).

To qualify for excludability, benefits must be received under a proper plan, notice or knowledge of the plan must be reasonably available to those covered, and there must be a bona fide employee. See secs. 105(b),(e), and 106(a); Larkin v. Commissioner, 48 T.C. 629, 635 (1967), affd. 394 F.2d 494 (1stCir. 1968); Tschetter v. Commissioner, T.C. Memo. 2003-326 (there need not be a written plan or enforceable employee rights under the plan so long as the participant has notice or knowledge of the plan); sec. 1.105-5(a), Income Tax Regs. Respondent argues that Mr. Speltz’s medical premiums and reimbursements should not be excluded from petitioner’s income because there was no proper plan under section 105(b). Alternatively, if there was a proper plan, respondent argues that notice or knowledge of the plan was not reasonably available to Mr. Speltz. Respondent also argues that Mr. Speltz did not meet his contractual obligations under the “client data sheet” to work 12.5 hours each week. Finally, respondent argues that Mr. Speltz was not an employee of the daycare. We address each argument in turn. Whether There Was a Proper Plan Section 105(b) and the underlying regulations provide guidelines as to what constitutes an accident and health plan. See sec. 105(e); sec. 1.105-5(a), Income Tax Regs. A plan may be nonfunded or funded, insured or uninsured, it may cover one or more employees, and different plans may exist for different classes of employees. See sec. 105(e); Wigutow v. Commissioner, T.C. Memo. 1983-620 (the regulation contemplates a plan for the benefit of a single employee); sec. 1.105-5(a), Income Tax Regs. So long as the participant has notice or knowledge of the plan, there is no requirement that it be in writing or that an employee’s rights under the plan be enforceable. See Wigutow v.Commissioner, supra. The daycare accident and health plan is detailed in Mrs. Speltz’s “client data sheet,” which states 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 that employees had to work a minimum of 12.5 hours a week to be eligible to receive benefits. On these facts, we find that the daycare established a proper accident and health plan. Whether Mr. Speltz Had Notice or Knowledge of the Plan Respondent also argues that notice or knowledge of the plan was not reasonably available to Mr. Speltz. We disagree. Mr. Speltz signed a document indicating that his salary would be in the form of reimbursements for insurance premiums and medical expenses up to $6,500 a year, he credibly testified that he had knowledge of the accident and health plan, and most importantly, Mr. Speltz used the plan. See id. (a taxpayer’s signing declaring the plan is evidence that the taxpayer had

knowledge of the plan); see also Charles Schneider & Co. v. Commissioner, 500 F.2d 148, 155 (8th Cir. 1974) (the Court is the exclusive judge of the credibility of the witnesses in making its factual findings), affg. T.C. Memo. 1973-130. We therefore find that Mr. Speltz had notice and knowledge of the plan. Whether Mr. Speltz Met the Hourly Requirement Respondent also argues that Mr. Speltz worked less than the minimal hour requirement and, consequently, failed to fulfill his contractual obligations under the accident and health plan. More specifically, respondent cites Mrs. Speltz’s “client data sheet,” which states that employees are to work a “minimum” of 12.5 hours a week and a minimum of 7 months a year. Respondent interprets the term “minimum” as requiring Mr. Speltz to work 12.5 hours “every” week, rather than an average of 12.5 hours a week. Interpreting the client data sheet, as respondent contends, to require Mr. Speltz to work 12.5 hours every week would render the 7 month a year minimum requirement superfluous--Mr. Speltz would by definition have to work 12 months a year. Moreover, petitioners’ employment contract requires employees to work an “average” of 12.5 hours a week, not a “minimum” of 12.5 hours. We find that Mrs. Speltz intended employees to work an average of 12.5 hours a week. Interpreting the client data sheet in this manner produces consistency among the client data sheet, the employment contract, petitioners’ stated intent that Mr. Speltz work an average of 12.5 hours a week, and that petitioners documented that Mr. Speltz worked an average of 12.5 hours a week. Accordingly, Mr. Speltz fulfilled his contractual obligations under the accident and health plan. We next determine whether Mr. Speltz was a bona fide employee of the daycare. Whether Mr. Speltz Was an Employee Whether an employer-employee relationship exists is a factual question. See Profl. & Executive Leasing, Inc. v. Commissioner, 862 F.2d 751, 753 (9th Cir. 1988), affg. 89 T.C.225 (1987); Air Terminal Cab, Inc. v. United States, 478 F.2d575, 578 (8th Cir. 1973); Packard v. Commissioner, 63 T.C. 621,629-630 (1975); see also Haeder v. Commissioner, T.C. Memo.2001-7. Courts typically apply a common law agency test to determine whether an employer-employee relationship exists. See, e.g., Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 323-324(1992); Community for Creative Non-Violence v. Reid, 490 U.S.730, 751-752 (1989); Matthews v. Commissioner, 92 T.C. 351, 360(1989), affd. 907 F.2d 1173 (D.C. Cir. 1990). Moreover, where a family relationship is involved, close scrutiny is required to determine whether a bona fide employer-employee relationship existed and whether payments were made on account of the employer-employee relationship or on account of the family relationship.

See Denman v. Commissioner, 48 T.C. 439 (1967); Haeder v. Commissioner, supra; Shelley v. Commissioner, T.C.Memo. 1994-432; Martens v. Commissioner, T.C. Memo. 1990-42, affd. without published opinion 934 F.2d 319 (4th Cir. 1991); Jenkins v. Commissioner, T.C. Memo. 1988-292, affd. without published opinion 880 F.2d 414 (6th Cir. 1989); Furmanski v.Commissioner, T.C. Memo. 1974-47. Because we shifted the burden under section 7491, respondent has the burden to prove that Mr. Speltz was not a bona fide employee of the daycare during the years at issue. In determining whether a hired person is an employee under the general common law of agency, we consider several non-exclusive factors.9 See Nationwide Mut. Ins. Co. v. Darden, supra; NLRB v. United Ins. Co., 390 U.S. 254, 258 (1968); Profl.& Executive Leasing, Inc. v. Commissioner, 89 T.C. 225, 232(1987), affd. 862 F.2d 751, 753 (9th Cir. 1988). Inevitably cases turn on the particular facts of each case, and no one factor is controlling. See Profl. & Executive Leasing, Inc. v.Commissioner, supra. The “fundamental” test of whether an employer-employee relationship exists is whether the hiring party has the “right to control” the activities of the individual whose status is in issue. See Profl. & Executive Leasing, Inc. v. Commissioner, supra; McGuire v. United States, 349 F.2d 644, 646 (9th Cir.1965); Packard v. Commissioner, supra at 629; Weber v.Commissioner, 103 T.C. 378, 387 (1994), affd. 60 F.3d 1104 (4thCir. 1995); see also Alsco Storm Windows, Inc. v. United States, 311 F.2d 341, 343 (9th Cir. 1962); secs. 31.3401(c)-1(b),31.3121(d)-1(c)(2), Employment Tax Regs. We consider this factor first. Mr. Speltz was contractually obligated to work for the daycare, and he credibly testified that he understood Mrs. Speltz had the right to control his activities. See Charles Schneider & Co. v. Commissioner, 500 F.2d at 155. When Mr. Speltz arrived home, Mrs. Speltz generally split the children into two groups, directing which children Mr. Speltz cared for and where he cared for them. Mrs. Speltz also controlled the amount of compensation Mr. Speltz received, and she had the contractual right to discharge Mr. Speltz.

9 Courts have looked to factors including the hiring party’s right to control the employee, the skill required, the source of the instrumentalities and tools, the location of the work, the duration of the relationship between the parties, whether the hiring party has the right to assign additional projects to the hired party, the extent of the hired party’s discretion over when and how long to work, the method of payment, the hired party’s role in hiring and paying assistants, whether the work is part of the regular business of the hiring party, whether the hiring party is in business, provides employee benefits, and the tax treatment of the hired party. See Community for Creative Non-Violence v. Reid, 490 U.S. 730, 751-752 (1989).

Further, Mr. Speltz did not require repetitious instruction. His tasks were limited and consistent. See Ewens & Miller v.Commissioner, 117 T.C. 263, 270 (2001) (the employer need not supervise every detail of the work environment or set the employee’s hours to control the employee) (citing Gen. Inv. Corp.v. United States, 823 F.2d 337, 342 (9th Cir. 1987)); Weber v. Commissioner, supra at 387 (the degree of control necessary to find employee status varies with the nature of the services provided). Mrs. Speltz provided a sufficient level of direction and control for Mr. Speltz to perform his required duties under the circumstances. We find on the record that Mrs. Speltz had the right to control Mr. Speltz. In addition to the control factor, other factors support petitioner’s employer-employee characterization. For instance, Mrs. Speltz’s calendar notations during the years at issue confirm that Mr. Speltz consistently worked for the daycare, she paid Mr. Speltz in employee benefits, Mr. Speltz’s work was integral to the daycare’s operation, Mr. Speltz was trained to work in childcare, and petitioner’s employment contract evidences petitioner’s intent to create an employer-employment arrangement. See generally Community for Creative Non-Violence v. Reid, 490U.S. 730, 751-752 (1989). Moreover, this case is distinguishable from cases finding that no employer-employee relationship existed among family members, usually where the taxpayers failed to substantiate the services provided. See, e.g., Shelley v. Commissioner, supra (taxpayer did not document any services the taxpayer’s spouse performed); Martens v. Commissioner, supra (little to no records substantiated the services provided). Petitioners substantiated the tasks Mr. Speltz performed in detail. We also find Haeder v. Commissioner, supra, which respondent cited, distinguishable. In Haeder, the Court found no employer-employee relationship existed between two spouses, where one spouse had a legal practice at home and the other spouse assisted with secretarial, clerical, bookkeeping, and cleaning services. Haeder v. Commissioner, T.C. Memo. 2001-7. In Haeder, the taxpayer-attorney admitted that the law practice had few clients during the years at issue and required little assistance. Moreover, only the taxpayer-attorney testified, and the Court found that testimony vague, generalized, and conclusory. Nor did the taxpayers document the spouse’s purported work activities or the time spent working. Id. Our case is therefore distinguishable from Haeder. While the record in Haeder was “devoid” of credible evidence that an employer-employee relationship existed, petitioners submitted credible evidence and testimony concerning the nature of Mr. Speltz’s activities and Mrs. Speltz’s direction of those activities. Finally, we have applied close scrutiny to the facts and find that the daycare payments were made on account of the employer-employee relationship and not on account of the family relationship. See Denman v.

Commissioner, 48 T.C. 439 (1967); Haeder v. Commissioner, supra; Shelley v. Commissioner, T.C.Memo. 1994-432; Martens v. Commissioner, T.C. Memo. 1990-42. Mr. Speltz’s activities were essential to the daycare business operations. Accordingly, we find that payments made under the daycare’s medical benefits plan in the form of reimbursements are excludable from gross income under section 105(b). III. Deductibility of Medical Premiums and Reimbursements We next determine whether Mrs. Speltz may deduct the medical cost of insurance premiums and medical reimbursements paid on Mr. Speltz’s behalf from daycare business income. Petitioners may deduct medical costs attributable to Mr. Speltz if they substantiated the amount deducted and established that the amounts were ordinary and necessary and reasonable in amount.10 Whether Payments to Mr. Speltz Were Ordinary and Necessary Business Expenses Respondent argues that petitioners’ employee benefit program expense should be disallowed because petitioners deducted, in part, personal expenses, which are not ordinary and necessary business expenses and are therefore not deductible. Petitioners aver that the amounts deducted were ordinary and necessary business expenses and that the personal characteristics of the activities Mr. Speltz performed should not supplant the predominant business purpose of those activities. Taxpayers may deduct all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered. Sec.162(a)(1). An expense is considered “ordinary” if commonly or frequently incurred in the trade or business of the taxpayer. Deputy v. du Pont, 308 U.S. 488, 495-496 (1940). An expense is “necessary” if it is appropriate or helpful in carrying on a taxpayer’s trade or business. Commissioner v. Heininger, 320U.S. 467, 475 (1943); Welch v. Helvering, 290 U.S. at 113. Ordinary and necessary business expenses include payments to employees for sickness, hospitalization, medical expense, or a similar benefit plan. Secs. 162(a), 213(a); sec. 1.162-10(a). Income Tax Regs. The test for deductibility in the case of compensation payments is whether they are reasonable in amount and are in fact payments purely for services. See Cardwell v.Commissioner, T.C. Memo. 1982-453 (citing United States v. Haskel Engg. & Supply Co., 380 F.2d 786, 788 (9th Cir. 1967)); sec.1.162-7(a), Income Tax Regs. Expenses must also be directly or proximately related to

10 We previously determined that an employer-employee relationship existed.

the taxpayer’s trade or business. Deputy v. du Pont, supra at 494-495; sec. 1.162-1, Income Tax Regs. While taxpayers may generally deduct ordinary and necessary expenses paid or incurred in carrying on a trade or business, taxpayers may not deduct personal, living, or family expenses. See secs. 162(a), 262; see also Feldman v. Commissioner, 86 T.C.458, 464 (1986); Sharon v. Commissioner, 66 T.C. 515, 522-525(1976), affd. 591 F.2d 1273, 1275 (9th Cir. 1978). Moreover, where there is a mixture of business and personal aspects, some discretion is permitted to determine which considerations predominate and whether any part of the expenditure may qualify for a deduction. See Feldman v. Commissioner, supra at 464; Heineman v. Commissioner, 82 T.C. 538, 542 (1984) (the distinction between business expenses and personal expenses is based on a weighing and balancing of the facts and circumstances in each case); Sharon v. Commissioner, supra at 524 (a weighing and balancing of the facts is required to give the business and personal characteristics their proper order of importance). We agree with respondent that the hours Mr. Speltz spent picking up mail and groceries and those spent transporting firewood without children are not sufficiently business oriented to warrant an expense deduction. Nonetheless, Mr. Speltz completed a substantial number of hours of business-oriented services for the daycare that Mrs. Speltz credibly substantiated. We therefore find that the medical expense deductions attributable to Mr. Speltz’s business-oriented activities were ordinary and necessary business expenses of the daycare. Whether the Payments Were Reasonable in Amount We must also determine whether the amounts paid to Mr. Speltz as compensation were reasonable in amount. Mr. Speltz was paid $3,279 in 2000 and $4,539 in 2001. Whether amounts paid as wages are reasonable compensation for services rendered is a question of fact to be decided on the basis of the facts and circumstances of each case. See Estate of Wallace v.Commissioner, 95 T.C. 525, 553 (1990), affd. 965 F.2d 1038 (11thCir. 1992). Further, there are no fixed rules or exact standards for determining what constitutes reasonable compensation. See Golden Constr. Co. v. Commissioner, 228 F.2d 637, 638 (10th Cir.1955), affg. T.C. Memo. 1954-221. With these rules in mind, we determine whether the compensation Mr. Speltz received for business-related services was reasonable in amount. Mrs. Speltz recorded that Mr. Speltz worked 517.25 hours in2000 and 655 hours in 2001. During those years, Mr. Speltz received medical benefits of $3,279 and $4,255.58, respectively. Mr. Speltz therefore received approximately $6.34 an hour in 2000 ($3,279/517.25) and $6.50 an hour in 2001 ($4,255.58/655). Mr. Speltz’s hourly rate is comparatively low considering the $13 an hour that Mrs. Speltz testified she would have had to pay a

daycare substitute. Eliminating even half of Mr. Speltz’s hours would produce a not unreasonable amount of compensation at $12.69 an hour in 2000 ($3,279/258.5) and $13.06 an hour in 2001 ($4,255.58/325.75). Even assuming arguendo, therefore, that half the hours Mrs. Speltz logged for Mr. Speltz were personal and disallowable, we would nonetheless still find the compensation provided Mr. Speltz in the years at issue reasonable in amount. IV. Whether Petitioners May Deduct Insurance Premiums In the alternative, respondent argues that the “insurance premium” component of Mr. Speltz’s reimbursements is not deductible under section 162(l). On the contrary, petitioner contends that section 162(l) applies only to self-employed individuals and that because the deductions are attributable to Mr. Speltz, an employee, section 162(l) does not apply.11 We agree. Under section 162(l), a self-employed taxpayer may deduct the cost of medical insurance premiums under certain conditions. A self-employed taxpayer may not deduct the cost of medical insurance premiums, however, if the self-employed taxpayer is eligible to participate in a subsidized health plan of another employer of the taxpayer or of a spouse’s employer. Sec.162(l)(2)(B). Mrs. Speltz is self-employed. She deducted on the daycare Schedules C the cost of medical insurance premiums paid for Mr. Speltz under the daycare’s accident and health plan for employees, and she was eligible to receive medical benefits through Mr. Speltz’s subsidized health plan with Fastenal, his full-time employer. While section 162(l) applies to Mrs. Speltz because she is self-employed, section 162(l) does not apply to Mr. Speltz. See secs. 162(l)(1)(A), 401(c)(3). Because the premiums were paid for medical insurance for Mr. Speltz, the limits of section and section 162(l)(2)(B) do not apply. Accordingly, petitioners are entitled to deduct their expenses for medical insurance premiums for Mr. Speltz. In reaching our holding, we have considered all arguments made, and, to the extent not mentioned, we conclude that they are moot, irrelevant, or without merit. To reflect the foregoing and the concessions of the parties, Decision will be entered for petitioners.

11 The deduction amounts of $705.82 in 2000 and $968.06 in 2001 constituted medical, dental, and cancer insurance premiums. The full amounts deducted were $3,279 in 2000 and $4,539 in 2001.

UNITED STATES TAX COURT RONALD AND JUDITH FRANCIS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE,

Respondent

Docket No. 6742-05. Filed February 8, 2007. MEMORANDUM FINDINGS OF FACT AND OPINION KROUPA, Judge: Respondent determined a $2,167 deficiency in petitioners’ Federal income tax for 2001. There are two issues for decision. The first issue is whether petitioners are entitled to deduct $9,502 of medical expenses under section 162(a).1 We hold that they are not entitled to deduct the medical expenses under section 162(a) because the compen-sation to which the claimed deduction was attributable was not reasonable in amount. The second issue is whether $5,571 of the medical expenses is 60 percent deductible under section 162(l). We hold that it is. FINDINGS OF FACT Some of the facts have been stipulated and are so found. The stipulation of facts and accompanying exhibits are incorporated by this reference. Petitioners resided in Pipestone, Minnesota, at the time they filed the petition. Petitioner Ronald Francis (Mr. Francis) has operated a farm (the farm) as a sole proprietorship for 40 years. Petitioner Judith Francis (Mrs. Francis) assisted Mr. Francis by performing farm chores, such as milking cows, since Mr. Francis began operating the farm. The farm established an employer-provided accident and health plan for employees (the plan) through an organization called AgriPlan/BizPlan in 1991. Eligible employees under the plan would be fully reimbursed by the farm for health insurance costs for themselves and their families and reimbursed up to $8,000 for out-of-pocket medical expenses. To be reimbursed, an eligible employee was required to submit a transmittal form to AgriPlan/BizPlan noting the amount the eligible employee paid or incurred for heath insurance and out-of-pocket medical expenses during the year. AgriPlan/BizPlan would then audit the transmittal form and issue a statement to the farm stating the amount it should reimburse the eligible employee. 1 All section references are to the Internal Revenue Code effective for 2001, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated. Amounts are rounded to the nearest dollar.

Mr. Francis, as owner and operator of the farm, and Mrs. Francis executed a written employment agreement in 1997. Mrs. Francis agreed to keep the farm’s books, run business errands, and answer telephone calls. The employment agreement also specified that Mrs. Francis would annually receive $2,004 of wages and would be an eligible employee under the plan. The employment agreement did not, however, specify the number of hours Mrs. Francis was required to work, nor establish the days or times she was required to be available to work. In 2001, Mrs. Francis performed some services for the farm. Neither Mr. Francis nor Mrs. Francis recorded how many hours, if any, Mrs. Francis worked, or otherwise documented the nature and extent of the services Mrs. Francis may have performed. Mrs. Francis received $1,9982 of wages from the farm in 2001. Mrs. Francis also ran errands for a farming business operated by petitioners’ son in 2001. Petitioners’ son did not treat Mrs. Francis as an employee of his farming operation. Petitioners’ son performed services on the farm without being treated as an employee of the farm. Mrs. Francis submitted an employee benefit expense transmittal form to the plan, claiming that she had paid $9,502 of eligible medical expenses in 2001. Of this amount, $5,571 was attributable to premiums paid on a joint Blue Cross/Blue Shield health insurance policy and a Medicare supplemental policy solely for Mr. Francis. The farm reimbursed Mrs. Francis for the $9,502 of eligible expenses. Adding the $9,502 medical expenses reimbursement to the $1,998 wages she received, Mrs. Francis received $11,500 of total compensation for 2001. Petitioners filed a joint Federal income tax return for 2001. Petitioners reported income and expenses from the farm on Schedule F, Profit or Loss From Farming. Petitioners deducted $9,502 as an employee benefit plan expense. The $9,502 deduction was attributable to the medical expenses Mrs. Francis paid and for which the farm reimbursed her. Respondent sent petitioners a deficiency notice. Respondent determined that petitioners were not allowed to deduct 100 percent of their medical expenses on Schedule F as ordinary and necessary expenses under section 162(a).3 Respondent 2 The record is unclear why Mrs. Francis received $6 less than the $2,004 she was specified to receive in 2001 under the employment agreement. 3 Respondent made no determination in the deficiency notice regarding the deductibility of the $3,931 out-of-pocket medical expenses under sec. 213.

determined that 60 percent of the $5,571 health insurance premium payments for Mr. Francis was deductible under section 162(l) as the health insurance costs of a self-employed individual. Petitioners timely filed a petition. OPINION We are asked to decide whether petitioners are entitled to deduct medical expenses under section 162(a) and, if not, whether they are entitled to deduct the health insurance premiums component of their medical expenses under section 162(l). The parties agree that petitioners are entitled to deduct the $1,998 wage component of Mrs. Francis’s compensation for 2001; they disagree as to whether her total compensation, including the reimbursement under the plan, was reasonable in amount. We look to the general rule that deductions are a matter of legislative grace, and the taxpayer must show that he or she is entitled to any deduction claimed. Rule 142(a); Deputy v. du Pont, 308 U.S. 488, 493 (1940). This includes the burden of substantiation. Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975), affd. per curiam 540 F.2d 821 (5th Cir. 1976). In addition, taxpayers may fully deduct all ordinary and necessary expenses paid or incurred during the taxable year carrying on a trade or business. Sec. 162(a). Ordinary and necessary business expenses include the reimbursement of employee benefit plan expenses for expenses the employee pays or incurs. Sec. 162(a)(1); sec. 1.162-10, Income Tax Regs. Employee benefit plan expense reimbursements are deductible if they are paid to a bona fide employee, they are an ordinary and necessary expense, the amount deducted is substantiated,4 the amount deducted was reasonable in amount, and the payment was in fact purely for services. Sec. 162; secs. 1.162-7(a), 1.162-10(a), Income Tax Regs. Respondent argues that petitioners are not entitled to a business expense deduction for the employee benefit plan expense reimbursement because they failed to prove that the total compensation paid to Mrs. Francis in 2001 was reasonable in amount. We agree. The deductibility of employee benefit plan expenses generally requires proof, in the first instance, of an employer-employee relationship. Respondent concedes that Mr. Francis had the right to control5 4 Respondent concedes that the amount deducted was substantiated. 5 Although no single factor is controlling, the “right to control” the activities of the individual whose status is in issue is the “fundamental test” of whether an employer-employee relationship exists. Profl. &

Mrs. Francis in her performance of services for the farm, but he also points to several factual incon-sistencies that discredit petitioners’ characterization of Mrs. Francis as an employee of the farm. Specifically, Mrs. Francis performed services for the farm for many years before 1997 (the year her employment agreement was executed), Mrs. Francis performed services for their son’s farming operation without being treated as an employee of the son’s operation, and petitioners’ son performed services on the farm without being treated as an employee. While these facts are troubling,6 we need not determine whether Mrs. Francis was a bona fide employee of the farm to decide this case. Even assuming arguendo that Mrs. Francis was a bona fide employee,7 we find that petitioners failed to prove that any compensation paid to Mrs. Francis in excess of $1,998 was reasonable in amount given that petitioners failed to document any hours or times Mrs. Francis may have performed services for the farm. Whether amounts paid to an employee are reasonable compensation for services rendered is a question of fact to be decided on the basis of the facts and circumstances of each case. See Estate of Wallace v. Commissioner, 95 T.C. 525, 553 (1990), affd. 965 F.2d 1038 (11th Cir. 1992). Further, there are no fixed rules or exact standards for determining what constitutes reasonable compensation, although a number of factors have been identified as relevant. See Golden Constr. Co. v. Commissioner, 228 F.2d 637, 638 (10th Cir. 1955), affg. T.C. Memo. 1954-221. With these rules in mind, we determine whether the compensation Mrs. Francis received for business-related services was reasonable in amount. The employment agreement for Mrs. Francis did not set the number of hours she was required to work to earn her pay and benefits, nor did Mrs. Francis keep a time log recording the number of hours she worked for the farm in 2001. Petitioners did not establish what Mrs. Francis earned on an hourly basis because they did not prove how many hours she worked, and they did not establish what employees doing comparable Executive Leasing, Inc. v. Commissioner, 89 T.C. 225, 232 (1987), affd. 862 F.2d 751, 753 (9th Cir. 1988) 6 Equally as troubling is respondent’s argument that no bona fide employer-employee relationship existed, yet respondent conceded that petitioners were entitled to deduct $1,998 of “wages” paid to Mrs. Francis. 7 If we were to find Mrs. Francis was a bona fide employee, respondent would concede that the claimed employee benefit plan expense would be an ordinary and necessary expense.

work on other similarly sized farms in the vicinity were paid hourly. We apply close scrutiny to the facts in a family situation and find petitioners did not prove that any of the compensation paid to Mrs. Francis for services she provided the farm was reasonable in amount to the extent it exceeded the $1,998 that respondent has conceded to be deductible. See Denman v. Commissioner, 48 T.C. 439 (1967); Haeder v. Commissioner, T.C. Memo. 2001-7; Shelley v. Commissioner, T.C. Memo. 1994-432; Martens v. Commissioner, T.C. Memo. 1990-42, affd. 934 F.2d 319 (9th Cir. 1991). Accordingly, we hold that petitioners are not entitled to deduct the $9,502 claimed employee benefit plan expense under section 162(a). Finally, we address whether $5,571 of the claimed employee benefit plan expenses attributable to health insurance premium costs for Mr. Francis is deductible under the special rules of section 162(l). For 2001, self-employed individuals are allowed to deduct only an amount equal to 60 percent of the amount paid during the year for health insurance. Sec. 162(l)(1)(A) and (B). Respondent determined that petitioners’ health insurance costs are 60 percent deductible under section 162(l). We agree. Petitioners paid $5,571 in premiums on two health insurance policies for Mr. Francis in 2001, and Mr. Francis was self-employed. Accordingly, we hold that petitioners are entitled to deduct $3,343 (60 percent) of the $5,571 health insurance premiums they paid under section 162(l). To reflect the foregoing, Decision will be entered for respondent.

T.C. Memo. 2007-34

UNITED STATES TAX COURT

IVAN G. AND ROSEMARY J. SNOREK, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 12863-05. Filed February 8, 2007.

MEMORANDUM OPINION KROUPA, Judge: Respondent determined a $607 deficiency in petitioners’ Federal income tax for 2001. After concessions,1 the sole issue for decision is whether health insurance premiums for petitioner Rosemary Snorek (Mrs. Snorek) are fully deductible under section 162(a)2 or only 60 percent deductible under section 162(l). We hold that they are 60 percent deductible. Background This case was submitted fully stipulated pursuant to Rule 122, and the facts are so found. The stipulation of facts and accompanying exhibits are incorporated by this reference. Petitioners resided in Owatonna, Minnesota, at the time they filed the petition. Mrs. Snorek operated a sole proprietorship upholstery business, Snorek Upholstery, during 2001. that year, Snorek Upholstery executed an adoption agreement to provide a medical reimbursement plan for eligible employees through an organization called AgriPlan/BizPlan (the plan). Eligible employees under the plan would be fully reimbursed by Snorek Upholstery for health insurance costs for themselves and their immediate family and reimbursed up to $3,000 for other out-of-pocket medical expenses. To be reimbursed, an eligible employee was required to submit a transmittal form to AgriPlan/BizPlan noting the amount the eligible employee paid or incurred for health insurance and out-of-pocket medical expenses during the year. AgriPlan/ BizPlan would then audit the transmittal form and issue a statement to Snorek 1 Both petitoners and respondent have conceded adjustments to the amount of the business expense deductions petitioners claimed on the return for 2001. 2 All section references are to the Internal Revenue Code in effect for 2001, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated. Amounts are rounded to the nearest dollar.

Upholstery stating the amount it should reimburse the eligible employee. Mrs. Snorek, as owner and operator of Snorek Upholstery, and petitioner Ivan Snorek (Mr. Snorek) executed a written employment agreement near the end of 2000, in which Mr. Snorek agreed to perform repair and recovery services for Snorek Upholstery beginning in 2001. The employment agreement specified that Mr. Snorek would annually receive $480 in wages and would be an eligible employee under the plan. Mr. Snorek performed services for Snorek Upholstery in 2001 and was paid $480. Near the end of 2001, Mr. Snorek submitted an employee benefit expense transmittal form (transmittal form) to the plan, claiming that he had paid $10,355 of eligible medical expenses during the year. Of this amount, $3,906 was attributable to premiums paid on a Blue Cross/ Blue Shield individual health insurance policy for Mrs. Snorek. The record does not contain any evidence showing that Mr. Snorek paid the health insurance premiums for Mrs. Snorek, or that he was reimbursed by Snorek Upholstery. Petitioners filed a joint Federal income tax return for 2001. Petitioners reported income and Expenses from Snorek Upholstery on Schedule C, Profit or Loss From Business. Petitioners deducted $10,355 as an employee benefit plan expense. The $10,355 deduction was attributable to the claimed eligible medical expenses submitted to the plan. Respondent sent petitioners a deficiency notice. Respondent determined that petitioners were not allowed to deduct the $3,906 claimed employee benefit plan expenses attributable to the health insurance premiums for Mrs. Snorek. Respondent determined that 60 percent of $3,906 was deductible under section 162(l). Petitioners timely filed a petition. Discussion We are asked to decide whether petitioners can deduct the health insurance premiums for Mrs. Snorek and, if so, to what extent. This is an unusual substantiation case because the parties agree that the health insurance premiums for Mrs. Snorek were paid; they disagree as to who paid the premiums. We look to the general rule that deductions are a matter of legislative grace, and the taxpayer must show that he or she is entitled to any deduction claimed. Rule 142(a); Deputy v. du Pont, 308 U.S. 488, 493 (1940). This includes the burden of substantiation. Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975), affd. per curiam 540 F.2d 821 (5th Cir. 1976). Petitioners do not assert that the burden shifts to respondent under section 7491(a). Therefore the burden of proof remains with petitioner.

In addition, taxpayers may fully deduct all ordinary and necessary expenses paid or incurred during the taxable year carrying on a trade or business. Sec. 162(a). Ordinary and necessary business expenses include the reimbursement of employee benefit plan expenses to an employee for expenses the employee pays or incurs. Sec. 162(a)(1); sec. 1.162-10, Income Tax Regs. The deductibility of health insurance costs paid or incurred by self-employed individuals, however, is subject to the special rules of section 162(l). For 2001, self-employed individuals are allowed to deduct only an amount equal to 60 percent of the amount paid or incurred during the year for health insurance. Sec. 162(l)(1)(A) and (B). Respondent argues that Mrs. Snorek, a self-employed individual, paid her own health insurance premiums, and therefore the premium payments are only 60 percent deductible under section 162(l). Petitioners counter that Mr. Snorek, an eligible employee under the plan, paid the health insurance premiums for Mrs. Snorek, and further argue that Snorek Upholstery reimbursed him. They argue, therefore, that the health insurance premiums for Mrs. Snorek are fully deductible as an ordinary and necessary business expense. We disagree. Petitioners failed to provide evidence that Mr. Snorek, the eligible employee, paid the health insurance premiums for Mrs. Snorek or that he was

reimbursed by Snorek Upholstery for that amount. Petitioners introduced the transmittal form that Mr. Snorek submitted to the plan, on which he claimed he paid the health insurance premiums for Mrs. Snorek. Petitioners introduced no documentary evidence, however, showing that Mr. Snorek actually paid the health insurance premiums for Mrs. Snorek. Petitioners did not, for example, introduce receipts or canceled checks showing that Mr. Snorek paid the health insurance premiums for Mrs. Snorek. Petitioners also did not introduce the premium statement or policy itself, which may have identified the party responsible for making the premium payments for the insured. Petitioners’ failure to produce this documentation caused respondent to determine that Mrs. Snorek paid the health insurance premiums for herself. Nothing in the record rebuts this determination nor convinces us that petitioners have carried their burden of proving that Mr. Snorek paid the health insurance premiums for Mrs. Snorek to entitle him to deduct 100 percent of the premium payments. Accordingly, we hold that petitioners may deduct only $2,344 (60 percent) of the $3,906 health insurance premiums for Mrs. Snorek under section 162(l). To reflect the foregoing and the concessions of the parties, Decision will be entered under Rule 155

.