Hiring spouses and other relatives on the farm or ranch can be a good business decision and good tax planning. The IRS and the courts scrutinize employ ment of relatives, however, much more closely than that of other employees. This is illustrated in a recent court case.

Milo Shellito, a Kansas farmer, was ad vised by his CPA to pay his wife a salary and, thereby, set up an employee medical reimbursement plan. Shellito began in 2001 to pay his wife $100 per month as well as reimburse her for medical expenses and insurance premiums that she continued to pay out of their joint checking account. His wife had helped Shellito on the farm since 1982 but had not been paid a salary.

In addition to her salary, the Shellitos deducted on their Schedule F for the years 2001 and 2002 the amounts of $15,593 and $20,897 for "employee benefit programs." Upon audit, the IRS disallowed all the expenses except for a portion of the medical insurance premi ums. (In 2001 and 2002 only 60% and 70%, respectively, of self-employment insurance premiums were deductible for adjusted gross income.)

The tax court sided with the IRS, noting that Mrs. Shellito had received no pay for her services before 2001 and had instead rendered her service as part of the "shared enterprise" of marriage. The court did not believe that anything changed in 2001 that materially changed the nature of their economic relation ship. The court noted that the medical expenses and health insurance premiums continued to be paid from their joint checking "just as they always had been." So there was "no bona fide employment relationship." The court said that trans actions between family members should invite "a heightened level of skepticism and scrutiny."

A raft of similar cases were decided in 2007, some with different results. In one case that seems similar to the Shellitos, the tax court ruled in favor of the taxpay ers. One difference in that case was that the medical expenses were not paid from a joint checking account.

In another case, the health plan was unwritten, and the tax court said there was no proof that the health insurance premiums were paid for the wife as an employee rather than in an individual capacity as the primary insured.

In a third case, the taxpayer failed to prove that the compensation was reason able. And in yet another case, the court decided that the wife was not a bona fide employee because she performed no services "other than those reasonably expected of a family member."

As previously noted, in 2001 and 2002 only a portion of health insurance premiums for self-employed taxpayers was deductible for adjusted gross income (since 2003 the deduction is 100%). Thus, there is a reduced incentive to employ spouses so that health insurance premiums can be deducted as an employee expense. But medical reimbursement plans that reim burse for expenses not covered by health insurance would still provide some benefit.