Section 105 Plans: A Tax-Smart Spousal Strategy
Are you married and run your family business as a sole proprietorship (or a single-member LLC treated as a sole proprietorship for federal tax purposes)? If so, it can be a tax-smart move to hire your spouse as an employee and then provide most or all of his or her compensation as payments from a medical expense reimbursement plan set up for your company. These plans are often referred to as "Section 105 plans."
By using a Sec. 105 plan compensation strategy, you can claim business write-offs — on Schedule C of your Form 1040 — for the reimbursements paid under the plan to your employee-spouse. Those payments can cover the family's health and dental insurance premiums, as well as out-of-pocket medical, dental and vision care expenses. This can be valuable because:
Schedule C deductions lower your federal income tax bill and your self-employment tax bill.
Sec. 105 plan reimbursements aren't subject to Social Security and Medicare taxes.
The reimbursements are federal-income-tax-free to your employee-spouse because they're considered a tax-free fringe benefit.
How Much Compensation Can Be Paid Through a Sec. 105 Plan?
The IRS has stated that you may be able to provide your employee-spouse's total compensation in the form of Sec. 105 plan reimbursements, which could be the best of all worlds from a tax perspective. When that's the case, there's no need to provide your employee-spouse with an annual Form W-2 wage statement or withhold or pay any federal payroll taxes.
In contrast, paying your spouse "regular" cash wages triggers the W-2 filing requirement, as well as Social Security and Medicare taxes. The wages also have to be reported as W-2 income earned by your employee-spouse, though that income would be neutralized on your joint return by the offsetting Schedule C wage deduction.
Naturally, the amount of compensation paid to your employee-spouse under this strategy must be reasonable in relation to the work that he or she performs for your family business. Therefore, your written Sec. 105 plan should include a maximum annual reimbursement cap to prevent exceeding the reasonable compensation standard. At the same time, your employee-spouse's compensation shouldn't be ridiculously low either. Your tax adviser can help you decide whether you need to pay some cash wages because the Sec. 105 plan reimbursements aren't enough.
Another point: If you decide to adopt this strategy, it's advisable to pay your employee-spouse's Sec. 105 plan reimbursements with checks drawn on your separate business account. That way, there's no blurring of the lines between business and personal expenses.
An Example of a Sec. 105 Plan in Action
In one case decided by U.S. Tax Court, an individual operated a sole proprietorship daycare business and employed her husband on a part-time basis. His entire compensation was in the form of Sec. 105 Plan reimbursements. The compensation arrangement was supported by written documents signed by the proprietor and her husband. The plan specified that reimbursements would be limited to no more than $6,500 annually. For the two tax years in question, the wife's Schedule C reported deductible reimbursements of $3,279 and $4,539, respectively.
In spite of the good documentation, the IRS disallowed the write-offs. Here's what the IRS claimed:
The Sec. 105 plan wasn't set up properly.
The husband wasn't a legitimate employee of his wife's daycare business.
The Sec. 105 plan reimbursements weren't an "ordinary and necessary" business expense of the daycare business.
The reimbursements weren't reasonable compensation for the husband's duties.
The verdict? The IRS lost on all counts. The defendants planned wisely and, in the end, won their case. (Source: Speltz v. Commissioner, Tax Court Summary Opinion 2006‑25.)
Five Smart Steps for a Successful Sec. 105 Plan
Warning: The tax law considers a Sec. 105 plan to be a self-insured medical reimbursement plan. There are negative tax consequences if a plan discriminates in favor of highly compensated employees or employees who are owners of the business (including employees who are spouses of owners). These nondiscrimination rules must be respected if your sole proprietorship has employees other than your spouse. However, you don't need to worry about them if there are no other employees.
Moreover, a Sec. 105 plan that reimburses for individual health insurance premiums and out-of-pocket medical expenses is generally viable if there is only one employee at a time that participates during the plan year.
Rather than going into all the details behind the Tax Court's decision in favor of the taxpayers, let's look at what the husband and wife team did right in the case above. They're the same things that you should do to successfully implement a tax-smart Sec. 105 plan compensation strategy:
1. There was a written employment agreement between the proprietor and the employee-spouse. The court found the employee-spouse was clearly qualified to perform the work assigned.
2. The Sec.105 plan was established in writing, and reimbursements from the plan were designated as a form of compensation for the employee-spouse. (They were the only form of compensation in this particular case.)
3. It was established in writing that the employee-spouse would work a certain number of hours per week on average. Those hours were properly documented with written records. (Tip: It's a good idea to require the employee-spouse to turn in weekly time sheets.)
4. There was an annual cap on reimbursements from the Sec. 105 plan, and the actual reimbursements paid to the employee-spouse weren't excessive compensation for the work performed.
5. The employee-spouse turned in adequate evidence for the medical expenses that were reimbursed to him under the Sec.105 plan.
Conclusion: Having done all of these things, there was essentially no chance the taxpayers would lose, and they didn't. If interested, talk with your tax advisor or accountant about implementing a Sec. 105 plan for your own sole proprietorship family business.