Sole proprietorships face strict rules when setting up a Section 105 plan. If the sole proprietorship has no employees, then it cannot set up a Section 105 plan at all, since the first requirement must be to have at least one employee who is not the owner of the business.
In this situation, the best recourse is to hire the spouse or a family member of the sole proprietor. This person must be legitimately employed to do real work in the business, but they do not have to be employed full-time.
A simple example would be a married sole proprietor who employs his wife as a receptionist for the business. She could answer phone calls, schedule appointments, set up travel arrangements and handle light bookkeeping for a set hourly part-time wage. This would enable the proprietor of the business to offer a section 105 self-insured plan to her and their family.
The employee (the owner’s wife) and their family would be covered tax-free since she is a valid employee of the business. The wife would receive the benefits of the section 105 plan as a tax-free fringe benefit, and the owner could deduct the payment of the insurance premiums from the taxable income of the company. This actually results in a double savings on taxes, since medical premiums and expenses are paid for with tax-free dollars, and the reduced taxable income results in lower earnings that are subject to taxation.
Such arrangements are subject to IRS scrutiny, so it is imperative that the Section 105 plan is created with care and abides to the tax law and labor regulations. The spouse must perform legitimate work for the company and receive a regular paycheck (even if it is only for part-time hours).
It is also important that the earnings by the spouse be small in comparison to the Section 105 plan benefits – otherwise, the IRS may challenge the legitimacy of the business structure and claim that it is a partnership, and not a sole proprietorship, which would eliminate the validity of the Section 105 benefit.
In summary, for a Section 105 plan to work for a sole proprietorship, the following must be done:
1 – The sole proprietor must hire their spouse or family member to work for them in a legitimate capacity on at least a part-time basis.
2 – A set of plan documents must be created that comply with IRS and Department of Labor regulations.
3 – The plan should include a reasonable cap on medical expenses that are available to the spouse each year for medical expenses. Typical caps are $12,000 – $18,000 per year.
4 – The spouse of the sole proprietor should be paid a reasonable wage to establish eligibility but should not earn enough to raise the scrutiny of the IRS, who could challenge the legitimacy of the sole proprietorship status and question if it was truly a partnership.
5 – The spouse must ensure that they keep proper receipts and documentation of insurance premiums paid and submit them to the business for accurate recordkeeping.
Section 105 Plan Savings Under a Sole Proprietorship: An Example
A business owner of a sole proprietorship cannot elect to set up a Section 105 plan and reap the full benefits of tax-free medical reimbursement unless the owner’s spouse is a legitimate employee performing a necessary function within the company on at least a part-time basis.
In this example, let’s consider Jim, the owner of SP Business, whose wife, Allison, works part-time as a bookkeeper for the business. She earns a wage of $15 per hour and works 30 hours per week. There are no other employees in the business. Jim chooses to elect a Section 105 plan so the he, his wife and their family can pay for their medical plans using tax-free monies.
They choose to elect a stand-alone one-person HRA. They investigate the cost of family medical coverage through the marketplace and find a plan they feel would offer the coverage they seek at a cost of $12,000 per year. Based on prior years’ experiences, they feel they will average an additional $3,000 in qualified out-of-pocket medical expenses and co-pays. Jim decides to set up the Section 105 plan to allow a $15,000 employer contribution each year, payable to his wife, the employee. They work with a plan administrator to set up the compliant plan documents, and the policy goes into effect January 1, 2018.
Allison purchases the policy on January 1, 2018 through the marketplace. She makes the first monthly payment of $1,000, and submits a copy of the receipt for the premium payment to the plan administrator. The plan administrator processes the receipt and pronounces it eligible for reimbursement. On Allison’s next paycheck, Jim includes the cost of the premium in her paycheck. It is listed as a non-taxable fringe benefit on her pay stub.
Throughout the year, Allison continues to work for Jim as his bookkeeper. She keeps track of the medical receipts and submits them for reimbursement in a timely manner. At the end of the year, they have spent exactly $15,000 in qualified medical expenses. She has earned $23,400 in W-2 wages through her job at SP Business. SP Business has earned income before deductions for salary and medical expenses of $150,000.
How does this impact the taxes for Jim, Allison and SP Business? Jim is able to deduct the cost of the cost of the medical expenses and Allison’s salary directly from the income of the business. Therefore, his taxable income is:
- $150,000 Income before deductions
- (23,400) Allison’s salary
- (15,000) Section 105 plan
- $111,600 taxable income
The taxable self-employment tax that Jim must include in his tax expense is $7,884.
Jim and Allison file their taxes as married, filing jointly. Together, their total taxable income is $135,000 (we add back the cost of Allison’s salary, since she receives it as a regular W-2 employee of SP Business). Their tax expense for 2018 is $29,700, plus Jim’s self-employment tax of $7,884, since they fall into the 22% income tax bracket.
Had Jim and Allison not elected to set up the Section 105 plan, their tax bill would be $33,000, since the cost of their medical plan would not be tax-deductible, and their total taxable earnings would be the entire $150,000. Jim’s self-employment tax would be $8,994. Electing a Section 105 plan has saved Jim and Allison $4,410 in tax expense, as calculated below:
With Section 105 plan:
- $29,700 tax on income
- $7,885 SE tax
- $37,585 total tax owed
Without Section 105 plan:
- $33,000 tax on income
- $8,995 SE tax
- $41,995 total tax owed
Savings from adoption of Section 105 Plan:
$41,995 – $37,585 = $4,410