Section 105 plans are a great option to offer for small businesses. They allow the company to provide a group insurance plan, even when the company is very small. This is tremendous for employees who might otherwise seek employment with larger companies who are able to offer a group health insurance plan.
They also provide some pre-tax advantages to both the employer and the employee. However, there are a few disadvantages to enacting a Section 105 plan, including limited tax benefits under some company structures and the cost and time it can take to administer such plans.
Advantages of Section 105 Plans
Section 105 plans can be highly beneficial to both employers and employees. They can allow a qualified employer to reimburse employees or pay directly for medical insurance premiums free of federal, state or FICA taxes. Let’s explore some of their best benefits below.
Enacting a Section 105 plan can reduce the amount paid for medical expenses for
both the employer and employee. These benefits depend upon the legal structure
of the business, but are generally applied as follows:
- Sole proprietorships – If the owner of a sole proprietorship legitimately employs a spouse or dependent, they can enact a Section 105 plan and deduct the cost of medical, dental, vision and long-term care premiums directly as a business expense. The cost of these expenses will not be subject to federal or state taxation. They also reduce the taxable income of the sole proprietorship. However, if the owner of the sole proprietorship is not married and cannot employ another family member, they can still use a plan but costs of premiums will be subject to federal and state taxes.
- Partnership – Similar to the sole proprietorship, the partner must legitimately employ a spouse or dependent to realize the tax-free benefits of the Section 105 plan. If the partner is not able to employee a spouse or family member, they may still participate in a Section 105 plan but premiums or expenses paid will be subject to full federal and state taxation.
- S-Corporation – Owners of an S-Corporation with a business ownership percentage greater than 2% may participate in a Section 105 plan but should ensure that the plan is set up directly by the business and premiums are paid by the business to realize a reduction of federal and state taxes. However, they will still incur FICA taxes (15.3% in 2019, to a maximum of $16,479.60 in 2019). These cannot be avoided.
- C-Corporation – Owners of a C-Corporation may participate in the Section 105 plan and receive benefits of it entirely tax free. There are no restrictions on the use of a Section 105 plan with this type of company structure.
The enaction of a Section 105 plan also allows employees and business owners to have access to medical coverage – which is a huge savings in itself, since out of pocket costs to visit a hospital can be financially devastating.
- Flexibility. A Section 105 plan can be designed to fit the business’ needs and budget. A qualified plan administrator will work with the business owner to ensure that the business chooses the best option to fit the needs and goals of the business. A qualified CPA can help the business owner to choose the type of plan that provides the greatest tax benefits according to the company’s legal structure.
- Retention of employees. Offering qualifying medical, dental and vision benefits to employees is very important, and can improve employee retention rate. Employees who receive these benefits will be less likely to leave the company to seek other opportunities where such coverage is offered.
Disadvantages of Section 105 Plans
Section 105 plans that are enacted under a sole proprietorship or partnership company structure are generally unable to realize entirely tax-free Section 105 plan benefits, unless they can legitimately employ a spouse at least part-time. If they cannot employee a spouse, they can still deduct the cost of their medical premiums and expenses on Form 1040, but these amounts will still be subject to the self-employment tax of 15.3%.
Shareholders of S-Corporations that own greater than 2% of the business cannot avoid the self-employment tax on medical premiums, regardless of whether they employ a spouse part-time. Under current law, all immediate family members, including spouse and children, are considered to be owners of the S-Corporation by definition even if they have no part in the business whatsoever.
By default, any Section 105 plan benefits that they receive will be subject to the 15.3% self-employment tax. It is also crucial to ensure that any Section 105 plan that is enacted by an S-Corporation has plan benefits set up in the name of the corporation – not the business owner – otherwise, the benefits will be taxable on a federal and state level as well.
Plan Administration Costs
The cost to administer a plan can be high, particularly upon start up. The business owner must consult with both a qualified plan administrator and their certified public accountant (CPA) to ensure that they choose a Section 105 plan that will meet the qualification requirements set forth by the Department of Labor and IRS. They also should seek to maximize their tax benefit, while providing adequate coverage to eligible employees. The initial expense for consultation and plan start-up can be several thousand dollars, depending on the complexity and size of the plan required.
However, it is imperative that the consultation and proper set-up occur to avoid potential pitfalls in the future. A plan that is not set up properly can result in thousands of dollars in legal fees and penalties, so a few dollars spend at the beginning can do much to put the business owners’ mind at ease.
Ongoing Plan Administration Requirements
Ongoing plan administration requirements can be a time and money drain, but they are required by law. A Form M-1 and either a Form 5500, Form 5500-SF or Form 5500-EZ must be filed each year. The Form 5500’s can be incorporated into the yearly tax filing for the business, but the Form M-1 must be submitted to the Department of Labor.
There are some software packages available to small businesses that enable the business owner to handle the filings on their own. Otherwise, qualified plan administrators and CPA’s should be outsourced to submit the filings and ensure they are handled accurately.