Commentary on the Speltz Case by Tom Copeland

For years I have spoken at training workshops about the possibility of family child care providers hiring their spouses and setting up medical reimbursement plans to help reduce their taxes. One provider who did this in Minnesota was audited by the IRS and told she could not claim medical expenses under such a plan. She called me for help and eventually we ended up in Tax Court.

This Tax Court case was a frustrating one to handle for me because the IRS kept raising new objections at every stage to the deductibility of the provider's medical expenses as part of a medical reimbursement plan and none of their objections, in my opinion, ever made any sense. Below is a summary of what happened at each stage in the case and some suggestions on how you might use this case in your practice.

Meeting with the Auditor and Appeals Officer

The Speltz's auditor and the appeals officer said she couldn't deduct these expenses and gave her four reasons:

You can't hire your husband in your business under any circumstances.

You can't establish a medical reimbursement plan, particularly if you are establishing it in order to reduce your taxes.

You must pay your husband a salary, not just reimburse medical expenses.

You cannot count the hours your husband works for your unless he is caring for children.

At this stage I was advising Mrs. Speltz by telephone through the audit and appeals process. I told her that these reasons didn't make sense and asked her to push the IRS to give her some explanation for their position. She sent them IRS documents (IRS Coordinated Issue All Industries Health Insurance Deductibility for Self-Employed Individuals, UIL 162.35-02, March 29, 1999) that clearly showed that a medical reimbursement plan was valid and accepted practice. I had done some research on the issue of nonpayment of salary, but found that this was not a strict requirement under the law. Because nothing the IRS was saying made any sense, and they were unwilling to follow this Coordinated Issue Paper, I decided we had no alternative but to go to Tax Court.

Meeting with the IRS Lawyer Before Trial

I met with the lawyer for the IRS before trial. At that time the lawyer acknowledged that the first three reasons cited above were not valid arguments against Mrs. Speltz's deduction. I gave the lawyer my client's calendar that showed a daily record of the hours he worked and the activities he performed. I argued that even if we did not count hours he spent on activities when children were not present (shopping, lawn mowing, errands, etc.) the calendar still showed enough hours to support the deduction she claimed. Despite the daily records we produced, the lawyer was not convinced even though she admitted that "your client has better records than most."

The lawyer then raised several new objections to the deduction:

Mrs. Speltz didn't establish a flexible benefit account as described in her plan documents. We argued that the establishment of a separate checking account by Mrs. Speltz met this requirement. The lawyer raised this issue at the trial, but did not bring it up in the legal briefs they filed.

Mrs. Speltz was required to file Form 5500 for her plan to be accepted. After we did research on this point the lawyer agreed that that there was no legal requirement to file this form.

Mrs. Speltz was required to give Form W-2 to her husband/employee and did not. Although Form W-2 is not required to be filed with the IRS, it should have been given to her husband, even if no payroll taxes were owed. The IRS raised this issue at trial and in their legal brief. We argued that the maximum penalty for this oversight should be $50, not a denial of the plan. The judge concluded that the IRS position was without merit.

Despite my attempt to argue that these issues were not valid reasons to deny the deduction, the lawyer insisted that we would resolve the issues at trial. At this point I still didn't see anything compelling about the IRS's position. Over the telephone I repeatedly asked the lawyer what was the real issue for the IRS in this case. I asked what my client should have done differently. I tried to find out what other clients in this position should be doing to be able to deduct such medical expenses. Finally the lawyer said, "I'm not going to answer your question because do so will help you at the trial." This was an interesting answer that surprised me. In every other appeals case I have handled the IRS lawyer or hearing officer attempted to settle the case or was willing to identify their specific objection to my client's position. Clearly the IRS had no intention of settling.

At the Trial

The trial for this case lasted three hours. Moments before the trial began the IRS lawyer handed me a legal memo that identified a number of new reasons why the deduction should be denied. Of course I was not happy that none of these issues were raised with me in my earlier conversations with the lawyer. They also raised these issues during the trial.

Mrs. Speltz cannot deduct medical insurance premiums under Section 162(l) because she is eligible to receive medical insurance through her husband's company plan. Although the IRS raised this at the trial at some length, surprisingly, they did not raise it in their legal brief filed later! I assumed this meant that upon further reflection they decided they couldn't support this position. Or it could mean that they thought they didn't need to raise this in their brief because they did so in their legal memo. But after I responded to their argument at length in my brief, the IRS still did not address this in their reply brief. I was a little surprised the judge addressed this in her opinion since they didn't bring it up in their briefs. I assume the court did so because they wanted to put the issue to rest.

Basically, the IRS position is not valid because tax law allows an employer to set up a medical plan for its employees and that the employee is entitled to the medical benefit.

Mrs. Speltz didn't pay her husband a salary. The IRS said that the plan fails because he didn't get paid in cash, even though the plan documents specifically refer to payment in the form of reimbursed medical expenses. The IRS did not pursue this issue in their legal brief. It surprised me to see this since the lawyer had told me before the trial that this was not a problem.

Mr. Speltz did not work 12.5 hours each week. The plan documents said that he was to work "12.5 minimum hours worked weekly." We argued that this meant an average of 12.5 hours per week, not each week. The court agreed with our position.

Mr. Speltz was not an employee because not all of the payments received by Mrs. Speltz from parents were deposited in her business checking account; thus she did not have financial control of her business. One month Mrs. Speltz didn't deposit a check from a day care parent until the next month. No evidence was introduced that Mr. Speltz ever had control of this money. The court concluded that this IRS objection had no merit.

Mrs. and Mr. Speltz were co-owners of the business, not employer/employee. The IRS argued that because his name was on the policies of the business and the child care license he could not be treated as an employee. We introduced evidence showing that he had nothing to do with the oversight of the business and that the Food Program and the licensor dealt directly with her, not him. The court ruled that the IRS position had no merit.

Mrs. and Mrs. Speltz co-owned their home and therefore Mr. Speltz could not be an employee since he had a financial investment in the business. We argued that there was no "substantial" investment as required by law and that if the IRS position prevailed, no person running a home-based business could ever hire her spouse. The court ruled that this IRS position had no merit.

Filing Legal Briefs

As I was about to give the closing argument at the trial, the judge interrupted to say that she wanted both parties to write legal briefs to explain our positions. The IRS lawyer objected but the judge insisted. I was happy because it gave me a better opportunity to respond to the issues first raised at the trial.When I received the IRS brief I was not surprised that they had again raised new issues.

Mrs. Speltz didn't set up a qualified medical reimbursement plan because her husband wasn't aware of it. We produced the plan documents showing that he signed two documents on the same day that Mrs. Speltz signed another document with the tax advisor who set up the plan. He also testified that he was aware of the plan. The court agreed with us.

Mr. Speltz wasn't an employee because Mrs. Speltz didn't direct and control his work. Mr. Speltz testified that he understood that his wife controlled the business and that he followed her instructions as to what to do each day. The court said he did not require repetitious instructions.

Mr. Speltz wasn't an employee because Mrs. Speltz did not evaluate him. Both testified that the children and parents loved his work. In our brief we said that there is no requirement that an employer evaluate an employee. The court ruled that this IRS position had no merit.

Mr. Speltz was not an employee because he was not reimbursed for day care expenses. He testified at trial that on some occasions he bought food out of his own pocket and the IRS tried to use this to say he had financial control over the business and was thus an independent contractor, not an employee. The court ruled that this IRS position had no merit.

Mr. Speltz was not an employee because Mrs. Speltz did not have the right to fire him. We introduced the employment contract that showed that Mrs. Speltz hired him and therefore she had a right to fire him. The court ruled that this IRS position had no merit.

My legal brief was about 35 pages long. After receiving it the IRS attorney contacted me to ask if I would agree with her motion to the court to extend the time to file our reply briefs by 30 days. She complained that my brief was long and she was busy with other cases. I replied that the reason my brief was long was because I had to respond to so many issues that she raised for the first time at trial and in her brief! I said I would not agree. She submitted her motion to the court and the court asked me to respond. I objected to the extension of the time and made a point of highlighting all the new issues the IRS kept raising throughout the process. Ultimately the court granted the IRS an extra two weeks.

So, both the IRS and I then wrote another brief replying to the first brief we received from each other. Four months after these reply briefs were submitted the court announced its decision.

Lessons

Record keeping is important. In many cases where spouses hire each other the taxpayer loses because she did not keep proper records showing what work was done for the business and how many hours were worked. In our case Mrs. Speltz kept a daily log of the work done. This was the backbone of our case.

Medical reimbursement plan documents should be carefully prepared. We had to cope with several IRS attacks on the medical deduction because the plan documents were poorly written. One document said Mr. Speltz would work "an average of 12.5 hours a week" and another document said, "12.5 minimum hours worked weekly." This created confusion since he didn't work 12.5 hours each week. The job description read, "My duties will include lawn care, preparing firewood, fix and repair toys and sundry items, and general childcare when needed." The IRS looked at this and believed that his primary work had nothing to do with caring for children and they used this to try to argue that his work was personal, not related to the business.

Job descriptions should be more carefully written to show how the work is business related.

Another document said that Mr. Speltz elected to have "all or a portion of my salary $542 per month, redirected to a Flexible Spending Account to pay for uninsured and/or other health care costs." This last document unnecessarily confused things by implying that there had to be a separate account to hold the funds and that a flat amount was paid each month. In fact, the plan called for the payment of uninsured health care costs with a maximum yearly limit, not a monthly pay out.

Family child care providers should not count certain hours as business activities. Mrs. Speltz claimed hours that her husband spent on activities that should probably not have been counted. These include hours he spent food shopping, doing errands, chopping firewood and mowing the lawn. The court ruled that these hours do not count if the day care children are not present. There were times that he did shopping, went to the post office, and did household chores where day care children were with him. The court's opinion suggests that it was proper to claim these hours. In our brief we argued that as long as he was with children his hours should count because he is teaching children about real life activities.

Although this case cannot be cited as legal precedent, it can be used by any tax professional to argue in support of their client who has hired their spouse and set up a medical reimbursement plan. Because the court's opinion is so comprehensive and clear, I hope that this reduces the number of times this issue gets challenged in the future.

Finally

I still do not understand why the IRS went to Tax Court on this case when it involved only $2,000 in taxes. The cost for the IRS to get a copy of the trial transcript was over $500 alone. In my opinion the original auditor and hearing officer simply did not understand medical reimbursement plans. But why the IRS continued to pursue this case and kept raising new objections is a mystery to me.