v. Commissioner [I.R.C. §§61,74,162,166,274,408,6651 and 6662]
to show that his wife provided services as an employee)
Facts.Taxpayer, a sole-proprietor attorney, deducted wages that he claimed
were paid to his wife for services performed for his legal practice and amounts
for a medical reimbursement plan on his Schedule C (Form 1040). The amounts deducted
as wages were transferred into wife’s IRA account and deducted as IRA contributions
on taxpayers’ jointly filed tax returns. The IRS disallowed the wage deductions,
IRA contributions, medical plan expenses, legal and professional fees, travel,
entertainment, bad debt deduction, and repairs to an Oriental rug. The IRS also
determined that the taxpayers failed to report prize income and additional business
income, but the taxpayers overstated their dividend income. The IRS imposed penalties
for failure to file and understatement of taxes.
Issue 1. Whether taxpayer wife was an employee of taxpayer husband’s attorney
practice, which would allow deductions for wages, medical plan expenses, and IRA
Issue 2. Whether taxpayers were allowed deductions for legal and professional
fees, travel and entertainment expenses, bad debt, and repairs to Oriental rug.
Issue 3.Whether taxpayers were subject to the failure to timely file penalty
under I.R.C. §6651 and the accuracy- related penalties for negligence and substantial
understatement of taxes under I.R.C. §6662.
Analysis and Holding
Issue 1. According to Treas. Reg. 1.162-7(a), salaries are deductible only
if reasonable in amount and paid or incurred for services actually rendered. The
court pointed out that, where a family relationship is involved, close scrutiny
is applied to determine whether a bona fide employer-employee relationship exists
and whether the payments received were made on account of the employer-employee
relationship or the family relationship [Denman v. Commissioner, 48 T.C. 439 (1967)].
The court concluded that taxpayers failed to show that wife provided services
as an employee since they provided no documentary evidence of the work performed,
Forms W-2 were not issued in four of the five years at issue, and the payments
were transferred directly to the IRA account. The court found that the taxpayers
determined the purported salary on the basis of the maximum IRA deduction and
claimed the employee relationship to enable them to deduct personal medical and
dental expenses as business expenses and make deductible IRA contributions. Therefore,
the Tax Court held that taxpayer wife was not an employee of taxpayer husband’s
attorney practice, which would not allow deductions for wages, medical plan expenses,
and IRA contributions.
Issue 2. The court concluded that the taxpayers failed to substantiate the
legal and professional fees for the law practice as required under I.R.C. §162
and failed to satisfy the substantiation requirements of I.R.C.§274(d) for travel,
meal, and entertainment expenses The court disallowed the bad debt deduction
since the taxpayers failed to show that the debt arose from a true debtor-creditor
relationship. The court found that the taxpayers failed to substantiate the rug
repair cost or to show it was an ordinary and necessary business expense under
I.R.C. §162. Therefore, the Tax Court held that taxpayers were not allowed deductions
for legal and professional fees, travel and entertainment expenses, bad debt,
and repairs to Oriental rug.
Issue 3. The Tax Court held that taxpayers were subject to the failure to timely
file penalty under I.R.C. §6651 and the accuracy-related penalties for negligence
and substantial understatement of taxes under I.R.C. §6662.
[Haeder v. Commissioner, 81 T.C.M. (CCH) 987 (2001)]
See also James A. Poyda, et ux. v. Commissioner (T.C. Summary Opinion
2001-91) for a similar result. In this case, medical insurance premiums were disallowed
for a Schedule F farm activity because the compensation (including medical insurance)
paid to the spouse was not commensurate with duties actually performed.
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