The Tax Adviser (May 1993)

Maximizing Deductions for Self-Employed Persons' Medical Expenses

As medical expenses, including medical insurance premiums, continue to climb, tax deductions would make this cost easier to bear. Generally, sole proprietors, partners and more-than-2% S shareholders may deduct up to 25% of their medical insurance premiums (through June 30, 1992) in computing their adjusted gross income (AGI). (President Clinton has proposed the retroactive extension of this deduction from July 1, 1992 through Dec. 31, 1993.) The remaining premiums and other medical expenses may be claimed as itemized deductions to the extent exceed 7.5% of the taxpayer's AGI However, these expenses usually do not exceed this threshold; therefore, they are frequently not deductible.

Possible resolution

In Rev. Rul. 71-588, a sole proprietor employed several employees, including his wife. The proprietor has an accident and health plan covering all employees and their families. During 1970, the proprietor's wife and another employee incurred medical expense for themselves, their spouses and their children. Of course, one of the spouses was the sole proprietor. These expenses were reimbursed pursuant to the plan. The IRS held that the reimbursements were not taxable to the employee and were fully deductible by the proprietor as a business expense.

Planning opportunity

Sole proprietors and partners are prime candidates for this favorable treatment if their spouses are legitimately employed in their businesses. A more-than-2% S shareholder may not obtain this treatment, however; under the Sec. 1372(b) attribution rules, the shareholder's spouse also is deemed to be a more-than-2% shareholder.

The benefits provided under a self-insured medical reimbursement plan must not discriminate in favor of highly compensated employees (Sec. 105(h)). Therefore, the taxpayers that would gain the greatest advantage are those that have a spouse working in a business with only a few (or no) employees other than family members. In contrast, these nondiscrimination rules do not apply to an insured medical reimbursement plan.

Compensation paid to the spouse will be subject to social security and Medicare taxes. Consequently, the taxpayer must consider these additional payroll taxes before adding a spouse to the payroll. However, spousal wages are exempt from the Federal unemployment tax and most state unemployment taxes.

The spouse's employment should be covered in an employment contract that specifies duties and establishes a detailed package of compensation and fringe benefits.

Example: Deductible Medical Expenses For Self-employeds Husband, H owns an unincorporated printing business. He performs the graphics and printing.His wife W, maintains the company's books and solicits sales from customers. These are no other employees. The company has consistently generated profits of approximately $150,000 over the past few years and H expects these annual profits to continue. H and W have no other Taxable income. H and W incurred $4,000 for medical insurance through June 30, 1992 and $6,000 for other 1992 medical expenses. If H's business paid the $10,000 medical expenses under an accident and health plan for W and her family (which would include H) the entire cost would be deductible as a business expense. On the other hand, if H personally paid there expenses for himself, W and their children, only 25% of the medical insurance premiums, or $1,000, would be deductible in computing H's AGI. The $9,000 remaining medical expenses would not be deductible because they are less than the $10,775 "AGI limit," computed as follows:

Business income	$150,000
Less: Special 25% deduction	$1,000
One-half of Self-employment tax	$5,329	$6,326
AGI	$143,671
7½% of AGI	$ 10,775

Source:
John P. Pridnia, CPA, Grand Rapids, Mich, and Charles J. DeLanoy, CPA, Washington, D.C.

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