Using Section 105 as a Health Care Tax Strategy

Rising health care costs are one of the biggest concerns for employers and employees alike.  It’s become increasingly common for businesses to shop annually for a more cost effective health insurance solution.  Many small businesses are turning to professional employer organizations (PEOs) to provide savings available to larger groups.  Employees are experiencing increasing out of pocket health care costs for which there is virtually no tax benefit available due to the 10% of AGI itemized deduction limitation for taxpayers under 65 years old.  If you’re a sole proprietor experiencing these difficulties, the following strategy is worth considering.

It’s first important to understand that this strategy is most effective for sole proprietors with only one employee – their spouse.  If your spouse isn’t already an employee, hire them.  Of course, as an employee, your spouse will have to do bona fide work for the business and be paid a fair wage. 

Once employed, your spouse will take full advantage of the company’s very generous 100% paid family insurance coverage.  Suddenly, your above the line self employed health insurance deduction is transformed into an employee benefit expense deduction that offsets self employment income.

The last step is for the proprietor to adopt, under Section 105 of the Internal Revenue Code, an employee medical reimbursement plan.  This plan is simple to establish and calls for all employee out of pocket health care costs (co-pays and deductibles) to be reimbursed.  The reimbursements are fully tax deductible by the proprietor and also offset self employment income.  Without the 105 plan in place, these costs can only be deducted to the extent they exceed 10% of the proprietor’s AGI and they would not reduce self employment income.

Please contact your Ander’s advisor to determine if this strategy can work for you.