By Aaron Lerma, CPA
February 10, 2016
Tax Benefits of a Section 105 Plan
A Section 105 plan provides medical benefits to an employee by allowing the business to pay for the employee’s medical costs. The payments are tax free to the employee. They are also tax deductible by the business. The business can either pay the medical costs directly or reimburses the employee.
A Section 105 plan can help the whole family when the business’s one employee is also the business owner’s spouse. Here, because the 105 benefits extend to the employee’s spouse and dependents, the business owner, spouse, and children (i.e. the whole family) are covered under the plan.
One-Two Tax Savings Punch!
- The business can deduct 100% of the family’s medical expenses as business expenses instead of reporting the medical expenses as itemized deductions and possibly finding that they are all limited and not deductible. Income tax, Social Security and Medicare tax all go down.
- The spouse does not have to report any income for the money paid for medical expenses. Income tax goes down again.
Consider a husband and wife who own a sole proprietorship and incur $10,000 in out-of-pocket medical expenses for the year. Generally, medical deductions are limited to amounts that exceed 10% of Adjusted Gross Income (AGI). If the taxpayer has AGI of $100,000 or more, there is no deduction at all. But, if the owner of the sole proprietorship employs his spouse, and a Section 105 plan is in place, the $10,000 is 100% deductible as a business expense. Since it affects both income and SE tax, a taxpayer in the 25% bracket would have an effective rate of nearly 40% with respect to the deduction. The $10,000 deduction saves the taxpayer $4,000.
Who can have this plan?
Any business with employees can have a 105 Plan. A 105 plan works best for a sole-proprietor who has only one employee: the business owner’s spouse. Similar tax benefits can be achieved in the case of a C-corporation with only one employee. 105 Plans typically do not work for owners of partnerships or S-Corporations.
Why only one employee? Because new rules under ObamaCare (the Affordable Care Act) limit the way a business can provide health benefits to its employees, thereby limiting the effectiveness of 105 Plans. The new ACA rules do not apply to businesses that have only one employee.
Record Keeping is a Must!
Although the IRS and the courts recognize the validity of the employee-spouse arrangement, the taxpayer should be diligent in establishing the formality of the plan.
- A formal written plan
- The spouse must provide real and not just nominal service to the business.
- The spouse should be paid reasonable compensation.
- Payroll forms should be filed. These may include Forms W2/W3, Form 941, and Form 940.
For tax year 2016, Forms W2/W3 are due Jan 31, 2017. Form 940 is generally due Jan 31. Forms 941 are due quarterly. In Texas, you do not have to file state unemployment insurance for an employee who is the spouse of a sole proprietor.
- For an employee-spouse arrangement, medical expenses should be paid or reimbursed out of the sole proprietor’s (or business) bank account. This provides a paper-trail showing the expenses were actually paid by the business.
What is a “Medical Expense”?
Deductible medical expenses are defined in Section 213 of the Internal Revenue Code, and described in IRS Publication 502. They include “the cost of diagnosis, cure, mitigation, treatment, or prevention of disease, and the costs for treatments affecting any part or function of the body.” You don’t have to be sick to have a deductible medical expense. For example, medical insurance premiums are deductible. Also, you can deduct an annual physical exam and diagnostic tests performed by a doctor.
Per IRS Pub 502, medical expenses do not include “expenses that are merely beneficial to general health, such as vitamins or a vacation.”