We all know that health insurance premiums for self employed individuals (individuals filing Schedule(s) C, E, or F on their personal income tax return) are deductible on the front page of a personal income tax return. The issue becomes much muddier when you have a self employed individual that has a wife and children, whom are not covered under their own plan. One tax smart move, may be to start a section 105 medical plan.
This plan also known as a self-insured medical reimbursement plan offers many benefits (and a few pitfalls, if it is not implemented properly).
Usually, the first step in this exercise is to hire the spouse of the self employed individual as an employee. A helpful hint in this exercise is to draft an employment contract with the spouse employee, highlighting job duties, pay, hours of work required, etc. This employee will receive compensation for his/her work, but much of that compensation may end up being paid through tax-free reimbursements of medical expenses.
The second step is to create the plan. The employer must have a plan document and provide both the plan document and an agreement with all employees.This document offers them coverage under the plan. Keep signed copies of both the plan document and employee offers in a safe place. The plan document should highlight specific definitions, as well as how medical expenses will be reimbursed. In addition, most plans of this type have a maximum dollar amount that the business will reimburse for employees (this as well as other things can be amended in the future).
1. For the spouse- They receive medical reimbursements tax free.
2. For the family- They would have previously filed these expenses on Schedule A and had to apply a 7.5% (of AGI) floor against these medical expenses before a deduction would have been available. With this change they do not have to worry about this ‘penalty’.
3. For the business- These items are deductible against self-employment income avoiding the additional tax (SE) on their personal income tax return.
Warning- Follow these steps very carefully and do your homework. There is nothing illegal or improper about these plans, but the IRS is on the lookout for self employed individuals who are not following the rules and attempting to avoid paying their fare share of taxes. For more information consult IRC section 105, your accountant, or tax attorney.