In general Group Health insurance including dental & qualified long-term care insurance is deductible as a business expense, but there are very specific issues with respect to small business owners. A sole proprietor, partner or 2% or more shareholder of an S-corporation cannot deduct more than they earned from self-employment and cannot deduct medical insurance under self-employment for any time they are covered under any other employer’s plan including their spouse’s employer.
- Payments made by a partnership on behalf of a partner are deductible as Guaranteed Payments to the partners, not as medical insurance expense/employee benefits. The partnership must reimburse the partner if the partner pays for the insurance in their own name.
- For 2% shareholders such payments must be included in their wages subject to the usual withholding taxes. 2% shareholders must be reimbursed by their S-corporations in order for the insurance to be considered established under the business to qualify for the adjustment.
- Self-employed persons, AKA Sole Proprietors, can take the Medical Insurance Adjustment to 1040 Income, whether they purchase the insurance in their own name or the name of the business.
However there is a way to obtain medical insurance for business owner that is deductible as a business expense. Based on Section 105 of the Internal Revenue Code, a small business owner who can demonstrate employable interest in the business can become eligible for an employee benefit program. All business filing types are eligible including sole proprietors, partnerships, C- and S- corporations. Section 105 HRA plans are designed specifically for small business owners that can legitimately hire their spouse. Because the spouse/employee can be reimbursed for family expenses the employer indirectly benefits as well. This type of plan is made possible by Section 105 of the Internal Revenue Code, Revenue Ruling 71-588 and IRS Letter Ruling 9409006. For C-corporation and S-corporation owners it will not be necessary to use the spouse/employee method. The corporation becomes the employer and the owner is an employee as long as they are an employee receiving a regular paycheck.
So you are saying, “So what. If I can take the deduction on my personal tax forms why would I care?” Whereas it is true that up to 100% of the payments made for health insurance maybe deductible on your 1040, which saves on the associated income tax, all those premiums will be subject to Self-employment taxes as well. Under a section 105 Plan, the amounts paid for the plan premiums will not be, a tax savings of 15.3% of those premium costs. Furthermore out-of-pocket medical expenses are only deductible if you itemize, subject to the 7.5% limitation of income; under a section 105 it may be possible to write off 100% of out-of-pocket medical expenses too.
Setting up a Section 105 Plan is not a trivial exercise. Care must be taken when establishing a Section 105 HRA to ensure that a legitimate employer/employee relationship exists with the family member. In 1999 the IRS Industry Specialization Program issued a paper that said: “The extent and nature of a spouse’s involvement in the business operations is 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”.
If you are going the employee/spouse route, the spouse must provide meaningful services to the company, those services must be necessary (have economic substance), and the spouse’s compensation, which includes the Section 105 plan, must be reasonable. Furthermore it is essential that business and personal funds not be co-mingled. e.g. If you hire your spouse to do filing for 4 hours a week and then pay them $10/per hour and provide them with family medical plan costing $800 per month, you can bet the IRS is going to look askance at compensation which is 82% benefits and 18% hourly wages. It probably won’t fly.
How do I establish a section 105 plan? If you are a business owner, you are going to have to hire your spouse. Really, we are talking the whole employment enchilada here. Your business will need an EIN for payroll purposes. You will need an employment application, w-4, I-9, New Hire paperwork and other items from your spouse, just as you would for any other employee. You will need to keep a record tracking hours your spouse worked and a description of your spouse’s duties. You will need to pay reasonable compensation for those duties on a regular payroll schedule. The household account and the business account must be separate so that paychecks and reimbursed medical expenses won’t be deposited back into the account they came out of. Your spouse/employee will need to be the policy holder. Finally you will need the Section 105 plan documents.
In order for a Section 105 plan to work there are a lot of rules that must be followed, which is why Art and Business Consulting LLC recommends you get help if you think your business might qualify for a one. Section 105 plans are really outside Art and Business Consulting LLC’s bailiwick, although we could certainly advise you on the related tax issues. So we have found someone who does do Section 105 plans.
Art and Business Consulting LLC is not affiliated with the following entity, Total Administrative Service Corporation (TASC), but we did meet with Todd Kuehn, Regional Sales Director-Scottsdale Region Office TASC at an Arizona Society of Enrolled Agents event. TASC’s bailiwick does include Section 105 Plans; they are a third-party benefits administrator based out of Madison, Wisconsin, can simplify compliance and the administrative procedures associated with Section 105. According to their website, TASC has been doing just that for over 30 years with BizPlan. They even offer a savings guarantee and a full Audit Guarantee!
For more information see http://www.tasconline.com/buytasc/affiliate/bizplan/460163769708. Please note if you click on this link you will be navigating away from our website; you will be subject to their policies and we have no idea what those policies are. Art and Business Consulting LLC has not received any gifts or other compensation for mentioning these folks, and we are not specifically endorsing them.
As always Art and Business Consulting is here to help. If you need help with a small business and or tax issue, please give us a call.
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