For the self-employed...

Medical-reimbursement plans offer tax savings

Spouse as employee can be reimbursed for health costs, and 100% deduction taken

By D. Kent Lawson
Special to the Journal of Business

If you're self-employed, how would you like to deduct as a business expense 100 percent of the health-insurance premiums you pay for your family? How about health-care expenses not covered by insurance? Want to take 100 percent of those as a tax deduction?

That may sound impossible, but it isn't. Thousands of small businesses already are enjoying such deductions, and saving $1,800 or more a year in taxes, by implementing what's called a tax qualified medical-reimbursement plan.

First, some background.

People who are self-employed, whether as sole proprietors, partners in a partnership, or owners of a limited-liability company, are limited in the tax benefits they can claim for health insurance, compared with employees of larger companies.

That's because employees can pay for insurance and out-of-pocket expenses entirely with pretax dollars through certain types of plans, while the self-employed can deduct only up to 60 percent of their premiums in computing their adjusted gross income (AGI). Their remaining premiums and other medical expenses they incur can be claimed as itemized deductions to the extent that they exceed 7.5 percent of AGI, but usually those costs don't reach that threshold, so they aren't deductible.

Actually, it's worse than that. Because the premiums that self-employed workers can take as deductions are applied directly to their AGI, rather than on their business tax forms-such as a Schedule C-those deductions don't reduce the income used to calculate the self-employment tax, which equals about 15 percent. Also, limitations may prevent the self-employed from benefiting from the 60 percent deduction at all. Especially as health-care costs continue to soar, tax deductions would make those costs easier for small businesses to bear.

When properly structured, an employee-benefits package can be a fully deductible business expense. The Internal Revenue Service has blessed an arrangement that under certain circumstances allows sole proprietors, partners in partnerships, and limited-liability company owners to take a 100 percent deduction of health-insurance premiums and unreimbursed out-of-pocket expenses-and to take the deduction on business tax form, thus reducing both their self-employment tax and, indirectly, their AGI.

Here's how it works. The self-employed person would need to hire his or her spouse as a legitimate employee, and provide him or her with W-2 wages and a medical-reimbursement plan qualified under Section 105 of the Internal Revenue Code. That rule allows employers to provide medical-expense reimbursements to an employee (including a spouse and dependents) and not include the benefits in the gross income of the employee. Under the plan, all family health-insurance premiums and any additional uninsured medical expenses then are reimbursed to the spouse by the company, but aren't included as income by the spouse. The self-employed person then deducts the cost of this reimbursement as an expense on the business tax form.

For example, you and your spouse pay premiums of $4,500 a year for family medical insurance. In addition, your medical, dental, and vision expenses that aren't covered by insurance total $2,000 for the year. As a small-business owner with your spouse as a legitimate employee and a properly designed and written medical-reimbursement plan, you could deduct the entire $6,500 as a business expense.

Assuming a 15 percent (minimum) federal tax rate, you would save about $975 in income tax and another $975 in self-employment tax, for a total of $1,950. Compare that to the about $400 you might have been able to save using the standard health-care deduction allowed for self-employed.

To use the plan, there must be a legitimate employer-employee relationship between the self-employed person and his or her spouse, and the compensation must be reasonable. There also must be an employment agreement that specifies the services the spouse/employee will perform and the compensation and benefits to be paid. Other limitations also might apply.

A plan document should list what medical expenses are included in the plan. The package could be arranged to cover only health-insurance premiums. In addition to health insurance, you may want to include medical costs that aren't covered by insurance and also other insurance premiums, such as for term-life and long-term disability insurance for your spouse/employee, and cancer and long-term care insurance premiums.

If your spouse is your business's only employee, it makes sense to include as many benefits as possible. If you have employees other than your spouse, you must follow nondiscriminatory regulations administered by the U.S. Department of Labor. Under those regulations, the benefits provided under a medical-reimbursement plan must not discriminate in favor of any highly compensated employees.

Labor department rules require that you cover-under the compensation plan-part-time employees who work at least 35 hours per week, seasonal employees who work at least nine months a year, employees who are at least 25 years old, and employees with more than 36 months of service.

In summary, if you operate your business as a sole proprietorship, partnership, or limited-liability company, you are married and your spouse provides a legitimate and meaningful service to your company, you may be eligible for some incredible tax savings.

-D. Kent Lawson is a Registered Health Underwriter and owner of Flex Benefits & Administration, of Spokane.

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