Similar to sole proprietorships, partnerships also face strict rules when setting up a Section 105 plan. To be eligible for the full tax-free benefits of the plan, each partner must employ a spouse in a legitimate work arrangement on at least a part-time basis. The partners may then offer Section 105 benefit plan options to their spouses (who are seen in the eyes of the IRS and Department of Labor as employees).
The spouses can accept the Section 105 plan benefits, and in turn cover the partners on their respective plans. The plan benefits will appear on the spouse’s W-2s as tax-free fringe benefits, and the partners can deduct the cost of the plan benefits directly from the business’s income on Form 1065. In order for a spouse to be considered a legitimate employee, he or she must perform work for the company that serves a specific purpose.
For example, he or she could handle advertising and sales, perform reception duties, or handle light bookkeeping. However, the spouse must not earn a high enough income that would cause the IRS to consider whether the spouse was actually a partner in the business. If the spouse was found to be a partner and not an employee, this would invalidate the Section 105 tax-free benefits.
Obviously, some business owners who engage in partnership business structures will not be married or will not have spouses who are able or willing to work regularly in the business. In this case, the partner can purchase insurance through the market or through another plan provider. They can deduct the cost of their premiums from their Form 1040 under line 29.
However, they are still subject to the self-employment tax rate of 15.3% on these expenses. If a spouse of a business owner cannot work for the partnership because they work for another company (or for themselves), it may be most cost-effective to cover the partner through a policy available through their own employer.
For partnerships where there is a combination of members who have spouses who can work legitimately for the company and others who do not, they can adopt Section 105 plans for those who are eligible. The cost for the plans can be directly deducted from the business’ income, and eligible spouse beneficiaries can cover their spouse partner, thus realizing the tax-free benefits.
Partnerships who adopt Section 105 plans are still subject to Department of Labor and IRS administrative filing requirements. They must file Form M-1 with the Department of Labor and the relevant Form 5500 (either Form 5500, Form 5500-SF or Form 5500-EZ, depending upon how many employees are covered through the plan). They must also track their expenses and all reimbursements that are made to employees throughout the year to ensure accurate recordkeeping. It is also suggested that they consult with a third-party plan administrator and certified public accountant (CPA), especially during the initial set-up of the plan, to ensure that the plan is set up according to current regulations and maximizes the benefits available to the business owners.
Section 105 Plan Savings Under a Partnership: An Example
Similar to sole proprietorships, owning partners of a partnership are ineligible for Section 105 plan tax-free benefits unless their spouse is employed through the company in a legitimate wage-earning capacity. Let’s look at an example of a partnership, Professional Company, where both partner’s spouses are employed as regular employees, one as a receptionist and one as a sales associate. Both spouses earn $20 per hour and work 40 hours per week in the business.
The partners discuss ways to save tax dollars with their CPA, who suggests that they elect a Section 105 plan – specifically, a Qualified Small Employer Health Reimbursement Arrangement (QSEHRA). Using this plan, the partnership can offer tax-free reimbursement of up to $5,150 per individual and $10,450 per family to use towards health insurance premiums or medical reimbursements. The partners agree, set up the plan with a qualified plan administrator, and their spouses accept the coverage under the family plan. The partnership begins coverage for the plan on January 1, 2019, and elect to contribute the full $10,450 to both spouses.
Each spouse chooses a plan on the health insurance marketplace that fits their family’s needs. The cost of both plans is $9,000 each. During the year, both spouses submit receipts for the cost of the premiums and other eligible expenses, such as physician co-pays and laboratory testing. At the end of the year, both spouses have spent the entire $10,450 contribution on qualified expenses.
At the end of the year, the partnership has $300,000 in taxable income. The income paid to their spouses is a deductible expense, as is the cost of the QSEHRA contributions:
- $300,000 partnership income
- ($20,900) QSEHRA contributions
- ($83,200) Spouse W-2 salaries
- $195,900 taxable income to the partners
Both partners have a 50% basis in the partnership and split the earnings of the partnership equally. Thus, they both show $97,950 as their income for the year on their K-1. They both file their taxes as married filing jointly. The self-employment taxes that each partner owes is $6,920.
Both partners fall into the 22% income tax bracket with a $139,550 total in taxable income. Thus, they owe $30,701 in income taxes, plus the $6,920 in self-employment tax expense, for a grand total of $37,621.
Had the partners not elected to adopt the QSEHRA plan, they would have had to pay any medical expenses or premiums with after-tax dollars. The impact to their year-end taxes is calculated below:
- $300,000 partnership income
- ($83,200) Spouse W-2 salaries
- $216,800 taxable income to the partners
Since they are equal partners, they will each claim $108,400 as their income for the year on their K-1. They both file their taxes as married filing jointly. The self-employment taxes that each partner owes is $7,658.
Both partners fall into the 22% income tax bracket with a $150,000 total in taxable income. Thus, they owe $33,000 in income taxes, plus the $7,658 in self-employment tax expense, for a grand total of $40,658.
By electing the Section 105 QSEHRA plan, both partners will be able to save $3,037 in income taxes for the year.