Part 6: The 10 Most Expensive Tax Mistakes, Are You Satisfied with The Taxes You Pay?
Now let’s talk about health-care costs. Surveys used to show that taxes used to be small business owners’ biggest concern. Now it’s rising health care costs.
If you pay for your own health insurance, you can deduct it as an adjustment to income on Page 1 of Form 1040. If you itemize deductions, you can deduct unreimbursed medical and dental expenses on Schedule A, if they total more than 10% of your adjusted gross income. But most of us just don’t spend that much on our healthcare. So we wind up losing thousands in otherwise legitimate deductions.
What if there was a way to write off medical bills as business expenses? There is, and it’s called a Medical Expense Reimbursement Plan, or Section 105 Plan.
The first thing you need to know about a MERP is that it’s an employee benefit plan. That means (spoiler alert) it requires an employee:
- If your business is taxed as a sole proprietorship, you’re considered self-employed. You can’t establish the plan for yourself. However, if you’re married, you can hire your spouse.
- If your business is taxed as a partnership, you’re also considered self-employed. Again, you can’t establish the plan for yourself. However, you can still hire your spouse so long as he or she owns less than 5% of the business.
- If your business is taxed as an S corporation, both you and your spouse are considered self-employed. This means you’ll need another source of income, not taxed as an S corporation, to establish the plan. (Alternatively, you can establish a health savings account, which we’ll discuss in a few pages, to give yourself most of the same benefit as the 105 plan.)
- If your business is taxed as a “C” corporation, you qualify as your own employee, so you can simply hire yourself.
If you’re married, and you choose to hire your spouse, you don’t even have to pay him or her a salary. You can compensate them in the form of benefits only, which avoids the hassle of filing payroll returns. The main requirement here is that the benefits you pay have to be “reasonable compensation” for the service they perform. If your spouse works an hour a month filing invoices for you, you’ll probably have a hard time convincing an auditor that that’s “reasonable” for $4,000 worth of LASIK surgery!
Once the plan is in place, you can reimburse your employee for any medical expense they incur for themselves, their spouse, and their dependents.
- This includes any kind of health insurance, including major medical, long-term care (up to specific IRS limits), Medicare premiums, and even Medigap coverage.
- It includes all your copays, deductibles, “co-insurance,’ and other amounts insurance doesn’t pay.
- It includes all your prescription drugs.
- It includes expenses for things like dental care, vision care, and chiropractic care that traditional insurance might not cover.
- It includes some really “big-ticket” items like braces for your kids’ teeth, fertility treatments, and special schools for learning-disabled children. Let’s say your physician diagnoses your 8-year-old son with ADHD, and prescribes tai kwon do lessons. Guess what – those lessons are now tax-deductible!
- It even includes over-the-counter medications and supplies, so long as they’re actually prescribed by a physician.
One big advantage of the MERP is that it works with any insurance policy. You don’t have to buy special coverage. You can use a MERP with insurance you buy on your own or insurance you buy through an exchange. If your spouse gets coverage from their employer, you can even set up a MERP in your business to cover whatever out-of-pocket expenses your spouse’s insurance doesn’t cover.
Let’s assume you’re a sole proprietor with two kids and you’ve hired your husband to work for your business. The plan lets you reimburse your husband/employee for all medical and dental expenses he incurs for himself – his spouse (which brings you into the plan) – and his dependents, the kids.
This includes all the expenses listed above.
The best part is, this is money you’d spend anyway, whether you got a deduction or not. You’ll spend your money on glasses or your kids’ braces whether it’s deductible or not. The MERP just lets you move it from someplace on your return where you certainly can’t deduct all of it (and probably can’t deduct any of it), to a place where you can.
Okay, how do you make it work? Well, for starters, you’ll need a written plan document. (We can help with that.)
If you’ve hired your spouse, you’ll need to be able to verify that they qualify as a bona fide “employee.” That means you need to direct the work they perform for the business, the same as you would direct the work that any other employee performs.
Here’s one important requirement that the IRS will pay attention to in the unlikely event you get audited. You do have to run the payments through the actual business. You can’t just pay medical bills out of the family personal account, total them up at the end of the year, and throw them on the business return.
This means you have two choices. You can pay health-care providers directly out of the business account. Or you can reimburse your employees for expenses they pay out of
their personal funds. Let’s say your husband needs to pick up a prescription. He can use his own money, and you can reimburse him. Or he can use a business credit card and charge it to the business directly.
There’s generally no need for an outside third-party administrator, or “TPA,” if you’ve simply hired your spouse to write off your own family’s medical expenses. However, you will need a TPA if you’re reimbursing nonfamily employees in order to avoid violating medical privacy rules.
There’s no pre-funding required. You don’t have to open a special bank or investment account, like with Health Savings Accounts or flex-spending plans. You don’t have to decide up front how much you want to contribute to the plan, like you do with flexible spending accounts, and there’s no “use it or lose it” rule. The MERP is really just an accounting device that lets you re-characterize your family medical bills as a business expense.
The MERP doesn’t just help you save income tax. It also helps you save self-employment tax. Remember, when you work for yourself, you pay a special self-employment tax, which replaces the Social Security and Medicare taxes that you and your employer would share on your salary. That self-employment tax is based on your “net self-employment earnings” – but when you set up a MERP, the deduction reduces that self-employment income.
Now, here’s the bad news. If you have non-family employees, you have to include them too. Now, you can exclude employees under age 25, who work less than 35 hours per week, less than nine months per year, or who have worked for you less than three years. You can also exclude employees covered by a collective bargaining agreement that includes health benefits. But still, having non-family employees may make it too expensive to reimburse everyone as generously as you’d cover your own family.
Obamacare also imposes a pesky new excise tax requirement on MERPs called the “Patient Centered Outcomes Research Trust Fund Fee,” or PCORI fee. For plans operating in 2016, that amount is projected to be $2.25 per person, reported on IRS Form 720, and due by July 31, 2017.
Yes, you heard that right. $2.25. You can’t even buy a decent cup of coffee for that much. But the statutory penalty for failing to file that report can be as high as $10,000. And while it’s not likely the IRS will ever actually impose that fine, you probably want to make sure you dot your “i’s” and cross your “t’s.”
Health Savings Accounts
If a Medical Expense Reimbursement Plan isn’t appropriate – either because you don’t have a spouse to hire, or you have non-family employees you would have to cover – consider establishing a Health Savings Account. These arrangements combine a high-deductible health plan with a tax-free savings account to cover unreimbursed costs.
To qualify, you’ll need to be covered by a “high deductible health plan.” This means the deductible is at least $1,300 for single coverage or $2,600 for family coverage. Neither you nor your spouse can be covered by a “non-high deductible health plan” or by Medicare. The plan can’t cover any expense, other than certain preventive care benefits, until you satisfy the annual deductible. You’re not eligible if you’re covered by a separate plan or rider offering prescription drug benefits before the minimum annual deductible is satisfied.
Once you’ve established your eligibility, you can open a deductible “health savings account” to cover out-of-pocket expenses not covered by your insurance. For 2017, you can contribute up to $3,400 if you have individual coverage or $6,750 if you have family coverage. (If you’re 55 or older, you can save an extra $1,000 per year.)
HSAs are easy to open. Most banks, brokerage firms, and insurance companies offer them. Many times you can even get a debit card to charge expenses directly to the account.
Once you’re up and running, you can use your account for most kinds of health insurance, including COBRA continuation and long-term care (but not “Medigap” coverage). You can also use it for the same sort of expenses as a MERP – copays, deductibles, prescriptions, and other out-of-pocket costs.
Withdrawals are tax-free so long as you use them for “qualified medical costs.” Withdrawals not used for qualified medical costs are subject to regular income tax plus a 20% penalty.
After your death, your account passes to your specified beneficiary. If your beneficiary is your spouse, they can treat it as their own HSA. If not, your beneficiary will pay ordinary tax on the account proceeds (but not the 20% penalty).
The Health Savings Account isn’t quite as powerful or flexible as the MERP. You’ve got specific dollar limits on what you can contribute to the account, which might not match your out-of-pocket costs. And there’s no self-employment tax advantage as there is with a MERP. But Health Savings Accounts can still help cut your overall health-care costs by giving you bigger tax deductions.
Flexible Spending Accounts
Flexible spending accounts (“FSAs”) let you set aside pre-tax dollars for a variety of nontaxable fringe benefits, including health and disability insurance and medical expense reimbursement. Plan contributions avoid federal income and FICA tax.
The new Obamacare rules let you contribute up to $2,550 per year to your account. Before Obamacare, there were no contribution limits at all. Many observers have called the new $2,550 limit a tax in disguise, especially for older workers with expensive prescriptions who tend to contribute more to their accounts.
Once the money is in the account, you can use it for most medical expenses. However, nonprescription drugs and supplies, long-term care coverage, and associated expenses are not eligible FSA expenses.
Your employer deducts plan contributions from your paycheck and deposits them into your account until you claim your reimbursements.
When you enroll, you have to choose how much to contribute each pay period. You generally can’t change your contribution amount in the middle of the plan year unless there’s a change in your “family status.” Eligible changes include marriage or divorce; birth, adoption, or death of a child; spousal employment; change in a dependent’s student status; and the like.
You can claim your full year’s reimbursement as soon as you incur qualifying expenses, whether you’ve fully funded your account for that amount or not.
Historically, FSA rules have required you to use your account balance by the end of the year or forfeit it. However, many employers’ plans have taken advantage of a subsequent ruling that lets them amend their plans to provide a 2½ month grace period immediately following the end of the year.
ABOUT PROVIDENT CPA & BUSINESS ADVISORS
Winning the game of chess and being successful in business share something in common: Both require strategic thinking and diligent execution. Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact in their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life and win the chess game of business. If you want more information, follow us on social media.
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