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Find tax relief from a medical-reimbursement plan

by on
in Employee Benefits Program,Human Resources,Small Business Tax,Small Business Tax Deduction Strategies

As a small business owner, you generally can deduct 100 percent of your family’s medical insurance costs even if you’re self-employed. But you can do better tax wise by taking an unusual approach.

Strategy: Set up a self-insured medical reimbursement plan—also called a Section 105 plan—for your business. This kind of plan reimburses specified medical expenses to your employees—and to you—from the business’s coffers.

Assuming that the plan is in writing and meets other technical requirements, it’s a win/win situation. As the employer, you can deduct the reimbursements, including those to cover employees’ out-of-pocket medical costs. And eligible employees generally aren’t taxed on this perfectly legal fringe benefit.

Sound too good to be true? The IRS approved this medical reimbursement setup years ago. (IRS Revenue Ruling 1971-588) But you must toe the line to avoid any tax trouble.

Here’s the whole story: Typically, a Section105 plan reimburses employees for uninsured health or accident expenses they or their dependents incur. (The plan document should define eligible costs to include medical and dental insurance premiums, insurance deductibles, co-payments, prescriptions and other eligible expenses such as vision care.)

So long as you stay within the tax law boundaries,you can customize the plan to meet your needs. For instance, you generally should establish annual reimbursement maximums for each employee. You may also want to limit eligibility to full-timers.

What have you accomplished from a tax perspective? Plenty. Here’s a quick look:

You can generally deduct all the medical expense reimbursements paid to employees as business expenses.

If you’re self-employed, you grab an extra tax break because the write-off also reduces yourself-employment tax.

Employees receive the payments 100 percent tax-free as a fringe benefit.

This arrangement works especially well for a sole proprietor or the owner of a single-member LLC who employs a spouse (see example).

But the plan can’t discriminate in favor of highly compensated employees, including yourself (e.g., a more-than-10-percent shareholder) or other key employees. If it does, the medical reimbursements are taxable to the highly compensated employee.

Tip: In any event, fringe benefits paid to you or another 2 percent-or-more shareholder of an S corp are taxable. But other tax perks for a Section105 plan may be worth it to S corp owners.

Additional tips

Are you covering your spouse under a Section 105 plan? Here's what to do in this situation:
  • Consider paying your spouse some cash wages, as shown in the example. It looks better to the IRS if some of the payment is taxable compensation. That said, paying your spouse cash compensation is not strictly required under tax rules.
  • Check with a tax pro before drafting the plan document. It doesn't have to be complicated, but it must be in writing.
  • Don't wait until year-end to submit all medical expenses for reimbursement. Have the plan pay out expenses at least semiannually. Quarterly or monthly is even better.

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