Effective Date: March 29, 1999
COORDINATED ISSUE
ALL INDUSTRIES
HEALTH INSURANCE DEDUCTIBILITY FOR
SELF-EMPLOYED INDIVIDUALS
UIL 162.35-02
ISSUES:
1. 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:
1. The cost of the accident and health coverage is deductible by the employerspouse
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.
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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)(l) 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 reimbursements, 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-
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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.
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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 “employeespouse’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 selfinsured
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.
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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-bycase
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 84238I, 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.