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Your wife commits insurance fraud. You repay. Can you deduct?

January 06, 2010

Peter Dentist hires his wife, Karen, to handle insurance company billing for the dental office. Mrs. Dentist went a bit overboard and billed insurance companies for work that was never done. This displeased the insurance companies, and the dentist ended up paying it back. He had picked up the fraudulent payments in his Schedule C income, so he reasonably deducted the repayments there. This generated a net operating loss, so he carried them back to claim refunds from earlier years.

The IRS was OK with a deduction, but they wanted to call it a non-business deduction. Non-business deductions only generate NOLs to the extent of non-business income, so the deduction would be worth a lot less to the dentist. The Tax Court sorted things out yesterday.

The tax law says that you can't be in the business of fraud and embezzlement, so Karen Dentist wouldn't be entitled to a Schedule C deduction. But it's different for Peter:

This strikes a nerve with the Commissioner, who bristles at seeming to give Karen a tax benefit. And we agree with him that Karen could probably not get carryback-generating deductions if she were filing by herself. But the Supreme Court has said, "The deductions to which either spouse would be entitled would be taken, in the case of a joint return, from the aggregate gross income." Helvering v. Janney, 311 U.S. 189, 191 (1940). We have interpreted this to mean that one spouse may take a deduction on the joint return even if the other spouse would be prohibited from taking the same deduction. DeBoer v. Commissioner, 16 T.C. 662 (1951) (loss on sale to wife's grandson deductible by husband, despite prohibition on recognition of losses to family members, because husband not himself related to grandson),6 affd. 194 F.2d 289 (2d Cir. 1952). So even though Karen could not deduct the payments as business expenses on the Cavarettas' joint return, we hold that Peter is not similarly barred.

The Moral? If your husband-wife business defrauds insuarance companies, make sure only one spouse knows about it.

UPDATE: More at Federal Tax Crimes blog.

Cite: Cavaretta, T.C. Memo. 2010-4