Defined Benefit Plans

Leased Employee Rules: The Complete Guide

Employee leasing is a popular concept.  The leasing company, or Professional Employer Organization (PEO), provides the paperwork, payroll, human resources, and/or benefits to the employees who work for one of their clients’ businesses. 

The issue as to who is considered the actual “employer” comes into question when the company for whom the employee reports to work each day is not the one involved in producing his or her paycheck.  For retirement plan purposes, what must be determined is:  which entity is considered the “common-law employer” of the employees?

DETERMINING THE COMMON-LAW EMPLOYER

A leased employee is a person who receives a paycheck from one employer, a “staffing firm”, but is performing services for another company, a “recipient company”.  Which of the two companies is actually considered the employer for purposes of the retirement plan?  A leased employee will be considered common-law employee of the recipient company if each of the following occurs:

  • The worker is assigned on a long-term basis to the recipient company
  • The recipient company makes the hiring and firing decisions about the worker
  • The recipient company determines the worker’s rate of pay
  • The worker’s services are provided under an agreement between the recipient company and the staffing firm
  • The worker has performed services for the recipient company on a substantially full-time basis for at least one year, defined as:
    • 1500 hours of service in a year, or
    • A number of hours of service at least equal to 75% of the average number of hours that are customarily performed by an employee of the recipient company in a particular position.
  • The worker’s job is supervised and performed under the primary direction of the recipient company

RETIREMENT PLAN COVERAGE RULES FOR COMMON-LAW EMPLOYEES

If the worker is considered the common-law employee of the recipient company, then the worker is covered under the recipient company’s retirement plan for testing purposes as outlined below.:

  • Participation and coverage requirements (§401(a)(3), §401(a)(26), and §410)
  • Workers are counted in the coverage tests of the recipient company’s plan once the worker is considered a Leased Employee.
  • Leased employees, as a class, may be excluded from participation, but not to the extent that the coverage testing fails (no more than 30% of the workforce)
  • Leased employees may be excluded under a Safe Harbor IF leased employees represent fewer than 20% of the recipient company’s non-highly compensated workforce OR the staffing firm provides a money purchase plan with a 10% employer contribution that is 100% vested immediately.
  • Nondiscrimination rules (§401(a)(4))
    • The Actual Deferral Percentage test and Actual Contribution Percentage tests required for 401(k) plans fall under this compliance provision.
  • Vesting requirements (§401(a)(7), and §411)
  • Contribution and benefit limits (§401(a)(16) and §415)
    • A worker can be covered under the staffing firm’s retirement plan, only if the recipient company co-sponsored the staffing firm’s plan.
    • Any contributions made to a plan maintained by the staffing firm count as contributions to the recipient company’s plan, but not vice versa.
  • Compensation limits (§401(a)(17))
    • All compensation earned by the worker while working for the recipient company
  • SEP and SIMPLE rules (§408(k))
  • Top heavy rules (§416)
  • Exclusive benefit rule (§401(a))
  • Deduction limits (§404)

An employer cannot contract away its ultimate obligation and responsibility for wages and taxes to another organization, and thereby escape all liability for its workers.  As an extension, just because an employee is paid through a leasing company, it doesn’t mean that the employee isn’t counted when it comes to participation in a company’s retirement plan.

INDEPENDENT CONTRACTORS

Independent contractors may also fall under the leased employee rules too.  Most outside consultants who have their own business (e.g., attorneys, accountants, actuaries, doctors, computer programmers, systems analysts and engineers) would generally not be considered leased employees because they are not subject to the “primary direction and control” of the employer.

RULES AND REGULATIONS

Official rules about leased employees are outlined in Internal Revenue Code §414(n) and Notice 84-11.  Revenue Procedure 2002-21 addresses Professional Employer Organizations (PEOs).

SUMMARY

These rules were put in place to prevent manipulation of eligibility for retirement benefits.  There are dozens of nuances to the rules, and it requires careful consideration to be sure that in the event your company has leased employees to determine if those employees might be considered your common-law employees. 

Don’t try to wade through these regulations on your own.  One of our pension consultants would be happy to review your situation and give you guidance.  You may also wish to have your situation reviewed by an ERISA attorney.

Beneficiary Forms for Retirement Plans: The Complete Guide

Beneficiary forms should not be taken lightly. When setting up a cash balance plan or defined benefit plan, one of the initial tasks you will have is completing beneficiary forms for the plan.

Many business owners simply fill out the form and then forget about the form and the election. Some might not even fill it out to begin with. Why is it such a big deal?

At Emparion, we understand the importance of these forms and recommend that our clients review and discuss them with a qualified attorney if they have any questions. This article is meant to give you some basic information and be the starting point for these discussions.

What is a beneficiary form?

At first glance, the beneficiary form might not seem too challenging. But designating a beneficiary for a retirement plan is one of an employee’s most important financial decisions.

Simply stated, the beneficiary form designates who will receive the retirement funds should the employee/participant pass away. A beneficiary can be essentially any person or entity the owner chooses to receive the benefits of the retirement account or an IRA.

Typically, the forms will request the following:

1) name of the beneficiary(s);
2) amount that each beneficiary would receive; and
3) relationship between the plan participant and the beneficiary.

Beneficiary forms will ask for the beneficiary’s Social Security number or taxpayer-identification number. In some situations, they must be notarized.

Aside from a primary residence, retirement plan accounts are often the largest asset in a person’s estate. So make sure the form is completed.

Why is it so important?

Failure of a retirement plan employee to complete the beneficiary form can potentially raise significant problems for the employee’s family members. You want to ensure that your retirement assets are distributed to the person(s) of your choosing.

If an employee fails to make a beneficiary election, the plan document will specify a default beneficiary. Usually, the surviving spouse is the default beneficiary, making it easy if the participant is married at death.

But when there is no surviving spouse, the plan document lists who is next in line to be the designated beneficiary. It’s not uncommon for plans to have the deceased participant’s estate as the beneficiary of last resort when there is no election on file and no surviving spouse.

Sharpened colored pencils

A clearly established beneficiary designation will also ensure that funds can be paid promptly after death. Each plan document will have specific rules regarding the timing of benefit payments to beneficiaries.

The rules for a qualified retirement plan will usually require the company (or plan sponsor) to offer the beneficiary distribution of a deceased participant no later than the plan year following the plan year in which the employee died.

Wills, pre-nuptial agreements and other estate planning documents are subject to state laws. At the same time, retirement plan documents are subject to federal laws and, often, may not consider any of the estate documents.

Business owners with auto-enrolled employees should request their employees to complete the beneficiary form as part of the auto-enrollment process.

Timely updating

Life events can often cause beneficiary problems upon passing of the employee. Ensuring the beneficiary forms are updated timely is extremely critical upon changes in marital status or upon the birth of additional children.

For example, often, an employee gets a divorce and then re-marries but forgets to update the beneficiary election form. Depending upon the plan document and terms, the funds could go to their ex-spouse if not updated.

What if you want to name someone other than your spouse as the beneficiary? For example, let’s assume you get divorced and then re-marry. If there are kids from the prior marriage, you might want to designate the children as the beneficiaries. As such, the new spouse must consent to that election.

Remember that each retirement plan will have separate beneficiary forms. The beneficiary form for a 401(k) is only for the 401(k) plan, and the beneficiary form for a cash balance plan only applies to that plan. So when one is updated, make sure you update ones for other accounts.

It would be best to consider an annual review of your forms to ensure they are updated and complete. This is often done at the onset of a plan year or at the time participant statements and notices are distributed.

It is quite normal for people to get confused on the principles of solo 401k beneficiary distributions. Here are a few questions and their answers to help you know more:

Solo 401k Beneficiary Question: My wife and kids are the official beneficiaries of my Solo 401k account. In case something happens to me, can they immediately take funds out of the account? Are there any age requirements set regarding my situation?

ANSWER: According to the Federal rulebook, your spouse is automatically the primary recipient of your Solo 401k funds. In your case, your wife can choose to ignore this right, and there are four options that she can further choose from:-

  • She can take a complete distribution.
  • If she is self-employed, she can transfer the funds directly to her Solo 410k account.
  • She can also transfer the assets to her own IRA as well.
  • A transfer is also possible in case of a hereditary or beneficiary IRA.

In case you are unmarried, and your kids are beneficiaries, then each recipient has two options to choose from:-

  • Take complete distributions
  • First transfer the assets to the beneficiary’s IRA. Then start taking distributions on a yearly basis by 31st December following the account owner’s death.

Beneficiary rules:

Here are a few things you should keep in mind concerning beneficiary distributions:

  • In case you are unmarried, you will need to conduct direct rollovers. This means that the funds are required to shift directly into the recipient’s IRA.  You should also avoid touching the assets in the period of transition.
  • Unmarried beneficiaries should also avoid doing rollovers of their Solo 410k funds into their IRAs/qualified plans/Solo 410kplans.
Solo 401k Beneficiary rules

QUESTION: Is there any extendable withdrawal option in case of inheriting an IRA account? I’m currently writing up some directions for my daughter on how to inherit my Solo 401k. For this, I’ve started some estate-planning in case I pass away.

I’m looking forward to telling her to transfer the Solo 401k assets to the inherited IRA account. This will defer any need of the form 5500ez making things easier for her. Is this assumption correct? If not, please tell me what to do.

ANSWER: It is important to know that the withdrawal stretch option is available for IRA accounts but not for Solo 401k accounts. It means the Solo 401k funds will directly transfer to your daughter’s IRA account. This will also include her getting the distributions based on her life expectancy.  Another important thing is that you should not forget listing your daughter as your main beneficiary in the beneficiary form.

QUESTION: Is it possible to make my main beneficiary as my alterable trust to keep the money a part of my whole estate?

ANSWER: It is possible to establish your main recipient as your revocable trust.  After your death, the Solo 410k assets will automatically flow under your named trust’s account.

Final thoughts

As you can see, it is essential to complete a beneficiary form. Not completing beneficiary forms (and not correctly updating them) can cause confusion and hardship for the deceased employee’s family. Keeping beneficiary elections up to date will ensure a smooth process and minimize headaches down the road.

At Emparion, we understand that these forms can have a major significance. That’s why it is so important for you to review and discuss the issue with your family and also an estate attorney.

Section 105 Plan for Partnership: The ‘Legal’ Structure [Example + Pitfalls]

Partnerships also face strict rules when setting up a Section 105 plan like sole proprietorships. 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 DOL as employees). The spouses can accept the Section 105 plan benefits and, in turn, cover the partners on their plans.

Basic Structure

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. For a spouse to be considered a legitimate employee, they must perform work for the company that serves a specific purpose.

For example, they could handle advertising and sales, perform reception duties, or handle light bookkeeping. However, the spouse must not earn a high enough income to cause the IRS to consider whether the spouse was a partner in the business. If the spouse were a partner and not an employee, this would invalidate the Section 105 tax-free benefits.

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 this case, the partner can purchase insurance through the market or another plan provider.

They can deduct premium costs on Form 1040 underline 29. However, they are still subject to the self-employment tax rate of 15.3% on these expenses. Suppose a business owner’s spouse 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 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 eligible members. 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 that adopt Section 105 plans are still subject to the Department of Labor and IRS administrative filing requirements. They must file Form M-1 with the Department of Labor and the relevant Form 5500 (Form 5500, Form 5500-SF, or Form 5500-EZ, depending on how many employees are covered through the plan).

They must also track their expenses and all reimbursements 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 setup 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

Like 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 a partnership, a Professional Company, where both partners’ 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.

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 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 elects to contribute $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. 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 at the end of the calendar year. 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 partnership’s earnings 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 tax 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 $37,621.

Had the partners not adopted the QSEHRA plan, they would have had to pay any medical expenses or premiums with after-tax dollars. The impact on 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 tax 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 $40,658.

By electing the Section 105 QSEHRA plan, both partners will save $3,037 in income taxes.

Final Thoughts

Similar to the sole proprietorship, the partner must legitimately employ a spouse or dependent on realizing the tax-free benefits of the Section 105 plan.

If the partner cannot hire a spouse or family member, they may still participate in a Section 105 plan, but paid premiums or expenses will be subject to federal and state taxation.

Section 105 Plan Guide: How to ‘Legally’ Set Up [+ IRS Pitfalls]

By now you are probably aware of how great Section 105 plans can be. In the right situation, they can be a home run.

But how much do you know about the plans? In this guide, we will discuss some of the plan details and show you how to structure a plan for maximum tax benefit. We will also point out a few pitfalls along the way.

What is a QSEHRA Plan, and How Does it Work?

A Qualified Small Employer Health Reimbursement Arrangement (QSEHRA) is a company-funded health reimbursement plan small businesses offer to their employees. It is advantageous to small businesses that want to provide a formal benefit to their employees and realize the advantages of a tax-free Section 105 plan but want to reduce the cost of a traditional group insurance plan. 

QSEHRA enables small businesses to contribute up to $5,150 for single employees per year or $10,450 per family towards qualified health care expenses. There are no minimum contribution requirements.

The employee can, in turn, choose to purchase a health insurance plan that fits their needs through the health insurance marketplace. The contribution can also be used for other qualified medical expenses, such as physician co-payments or prescription medications. QSEHRA contributions are not taxable to the employee.

QSEHRA’s are flexible, and they can be used by any company with less than fifty full-time employees that do not offer any other option for a group insurance, dental or vision plan. The plan can also be provided to part-time employees at the company’s discretion, stipulating that the same benefit offered to full-time employees must be available to part-timers.

To set up a QSEHRA, a company should meet with a qualified plan administrator and a certified public accountant (CPA). The CPA can assist with any tax-related questions that the small business owner may have and ensure that the QSEHRA is the best option for the type of business that the owner has.

The plan administrator can advise the business owner of plan options, rules, and filing requirements. The administrator can also set up the formal plan documents to ensure that the company complies with Department of Labor and IRS regulations. 

Once the plan has been set up, the company can notify its employees of the new benefit. The owner can invite the plan administrator to explain the unique benefits and answer any questions the employees may have about choosing a health plan, qualified medical expenses, and how reimbursement of medical costs occurs.

Employees must understand that proper receipts must be submitted to the plan administrator to receive reimbursement. Otherwise, fees may be denied, and employees may not realize the full benefit. 

To the business owner, QSEHRA expenses for W-2 employees are fully deductible as a business expense up to the annual contribution limit. However, only owners of C-Corporation entities can fully deduct the plan’s cost as a tax-free benefit to themselves.

Sole proprietorships and partnerships can realize the tax-free advantages of the plan, but only if they employ a spouse as a regular employee and offer the benefit to them. S-Corporations cannot realize a tax-free benefit of a QSEHRA plans themselves at all. 

QSEHRA’s are an excellent way to improve employee retention and morale. They allow employees to choose their insurance plan that fits their needs without paying for the plan with after-tax dollars. 

What Types of Expenses Can Be Covered By A Section 105 Plan?

Qualified medical expenses under a Section 105 plan include amounts paid for the diagnosis, cure, treatment, or prevention of disease or affecting any structure or function of the body. Qualified expenses also include any relevant transportation to receive medical care.

Lodging expenses up to fifty dollars per day to receive specialized care in a specific location are reimbursable, so long as there is no vacation element to receiving the medical care in that location. 

A Section 105 plan can also include qualified long-term care services. Specific yearly premium amounts that are fully deductible using Section 105 plans include the below:

40 years old or less: $200 per year

Between 40 and 50 years old: $375 per year

Between 50 and 60 years old: $750 per year

Between 60 and 70 years old: $2,000 per year

More than 70 years old: $2,500 per year

Let’s look at an example of Jane, who spent $10,000 on medical-related fees, indicated below:

AmountExpense Type
$5,000Medical Premiums
$500Prescriptions
$250Co-pays for physician visits
$250Nutritional supplements
$1,000X-ray to diagnose a back injury
$1,500Dental crown
$500Teeth whitening
$750Hair removal
$250Gym fees

Jane may be reimbursed for $8,500 of these expenses. Teeth whitening, hair removal, and gym fees are non-qualified medical expenses under Section 105 plans and cannot be reimbursed tax-free. 

Annual Compliance Requirements for Section 105 Plans

Department of Labor Filing Requirements:

Companies that offer Section 105 plans must submit Form M-1 by March 1 of the calendar year following the calendar year for which the report is required. Form M-1 provides specific information on the plan, including the following:

– What type of coverage is provided

– Insurance coverage information

– Number of participants covered in the plan

– Information about any enforcement actions

– Information regarding compliance with Part 7 of ERISA, including any litigation alleging non-compliance

The form must be filed electronically to the U.S. Department of Labor, Employee Benefits Security Administration. 

At least thirty days before offering a Section 105 plan, the business must file Schedule M-1 to comply with regulations. Only companies that plan to provide medical coverage benefits (not just disability or life insurance benefits) must file Form M-1. If significant changes occur during a calendar year that affects the plan’s status, a Form M-1 must be filed.

Significant changes can include coverage for employees located in another state or an increase in the number of employees covered by the plan by more than 50% from the preceding calendar year. If the plan experiences a material change as defined in the plan documents, Form M-1 must also be filed.

Companies must ensure that they file Form M-1 completely and accurately. EINs and contacts for any other individuals or companies who have control or authority over the Section 105 plan or its assets should be given.

Information regarding every state in which the Section 105 plan operates must be listed. A confirmation number will be presented at the end of the filing process, which should be retained until the following year since it will be required for the new filing. 

IRS Annual Filing Requirements

Companies must file either Form 5500, Form 5500-SF, or Form 5500-EZ with the IRS depending upon the number of participants in the plan. This form provides general information on the plan, including the plan’s name, plan administrator information, number of people covered under the plan, total assets available in the plan, contributions made towards the plan during the year, and specific compliance and funding questions.

Companies that offer the plan to more than 100 participants must file Form 5500, which is quite complicated and requires outside actuarial valuation done by an outside qualified party. 

Smaller businesses can complete form 5500-SF with less than 100 participants. It must be filed electronically. Form 5500-EZ is available for one-person (or one-person plus spouse) plans. It must be filed on paper and submitted to the IRS. However, if the company would instead file electronically, the owner may submit Form 5500-SF instead.

Typical schedules in the Form 5500 filing include Schedule A, which details premium and agent commissions. This schedule does not apply to self-funded plans. Schedule C is sometimes required and lists the fees associated with the plan. Form 5500, Form 5500-SF, and Form 5500-EZ must be filed by the last day of the seventh month following the plan year’s end.

Where Are Section 105 Expenses Included on My Tax Return?

Section 105 expenses are classified on the tax return according to the type of legal structure the company falls under. Business owners should work with their CPAs to ensure correct classification.

Sole Proprietorships

Sole proprietorships who qualify for Section 105 plans by employing a spouse or family member may include the expense in line 14 of Schedule C (Profit or Loss from Business). Under labor and tax regulations, the reimbursement expense must be paid directly to the employee.

The employee must, in turn, cover the sole proprietor on the insurance policy for this to be deductible from the business’s taxable income. The reimbursement expense will appear on the employee’s W-2 as non-taxable fringe benefits, generally in box 12 FF. These amounts are excluded from the employees’ taxable income.

chart with finance, tax and debt

 Owners of sole proprietorships with no employees do not qualify for the Section 105 tax-free treatment of medical expense deduction. Instead, they can include the cost of their medical plans in line 29 of Form 1040. However, they are still subject to the 15.3% self-employment tax on these expenses.

Partnership

Partnerships who qualify for Section 105 plans by employing a spouse or family member may include the expense in line 19 of form 1065. This expense is directly deducted from the business’s taxable income divided into each partner’s K-1 tax form.

However, partners who do not qualify for Section 105 treatment must include any payments for health insurance premiums made by the business in the “Guaranteed Payments” section of form 1065. This amount is then included in taxable income to the partner but can be deducted in line 29 of Form 1040. It is still subject to the 15.3% self-employment tax like a sole proprietorship. 

S-Corporation

S-Corporations are eligible to set up Section 105 plans. Still, they cannot claim tax-free exemptions that sole proprietorships or partnerships can if they have family members who work for the company.

Instead, the payments for shareholder health insurance premiums and reimbursements made through the company appear on 1120-S under item 1b) Returns and allowances. These payments are taxable income to the business owner. However, payments made for group health employee benefits to employees who are not classified as shareholders can be deducted directly from taxable income in line 18. 

Like sole proprietorships and partnerships, the premiums and medical reimbursements can be deducted on Form 1040, line 29. It is still subject to the 15.3% self-employment tax.

C-Corporation

C-Corporations file Form 1120 and may deduct the total cost of health insurance premiums for both owners and employees on line 24, Employment benefit programs. C-corporations enjoy the tax-free benefits of Section 105 plans and are not subject to some of the limitations on individual reimbursements that sole proprietorships, partnerships, and S-Corps are.

Premiums and reimbursement payments flow through to the owner’s and employee’s W-2 forms as fringe benefits and are not subject to further taxation. 

Section 105 Plan for S-Corporation: The IRS Strategy [Example + Illustration]

Many small businesses choose to structure their companies as S-Corporations. S-Corporations have many legal and financial benefits and can be an excellent option for business shareholders and owners.

Their benefits include limited liability for business owners and shareholders and pass-through taxation. This means that all profits are distributed to owners and taxed on an individual basis according to the individual’s income tax bracket.

However, one of the distinct disadvantages of the S-Corporation structure is that it does not allow shareholders or owners of the business with an ownership percentage of 2% or more to receive the tax-free benefits of Section 105 plans.

Under current tax law, spouses and children of a shareholder with an ownership percentage of more than 2% are also treated as shareholders, even if they do not participate in the business. 

Owners and their families are still eligible to set up a Section 105 plan even if the business is an S-Corporation. The cost of their premiums will be passed through as taxable wages on Form 1120S. They can then claim a deduction for the cost of the premiums on page one of their Form 1040.

This will allow them to reclaim any federal and state tax dollars paid on monies used for health insurance premiums. However, they are still subject to FICA taxes of 15.3% – to a maximum of $16,479.60 – in 2019. It should also be noted that the deduction for the health insurance premiums and out-of-pocket expenses on Form 1040 cannot exceed the amount of earned income derived by the taxpayer from the business.

To avoid federal and state taxation on health insurance premiums, the business must pay the premiums for the plan directly unless there is only one sole shareholder with greater than 2% ownership in the company. Suppose multiple shareholders pay for their premiums directly and do not receive any reimbursement from the business.

In that case, the shareholders can only claim the premiums as a medical expense deduction if they exceed 10% of the shareholder’s adjusted gross income. In addition, considerations on reimbursement of health care premiums should be made considering the Affordable Care Act (ACA) of 2014. The ACA introduced a ban on employers from reimbursing employees for individual health insurance premiums.

However, there is some confusion on the reimbursement of multiple shareholders with a greater than 2% ownership in S-corporations and how the ban impacts the reimbursement of policies for owners’ spouses. Current guidance suggests taking a conservative view – ensure that the health insurance plan is purchased through the company, under the company’s name, and premiums are paid directly by the company.

The ban also introduced penalties of $100 per day for employees reimbursed for health insurance plans that are not directly paid for by the company. In short, it is best to ensure that health insurance premiums are paid directly by the company to avoid any confusion or non-compliance issues. 

Section 105 Plan Savings Under an S-Corporation: An Example

S-Corporations have the least favorable conditions for electing a Section 105 plan of all company structures. If the shareholders of the S-corporations own more than 2% of the company, they are unable to participate in the tax-free benefits of the Section 105 plan.

Spouses and children of majority shareholders in an S-corporation are business owners in the eyes of the law, regardless of whether they participate in the affairs of the business at all. However, electing a Section 105 plan can benefit S-Corporations with employees who are not relatives. Such a plan can reduce taxable income and increase employee morale and retention rates.

Consider an example business called Smart S-Corp with forty-nine regular full-time employees. Smart S-Corp’s owner chooses to enact a QSEHRA for the employees, all of which have families and choose to accept the contribution. Smart S-Corp is generous and grants a full $10,450 contribution to each employee, which they can use to purchase their own qualified medical insurance plans and pay for physician co-pays and prescription medications.

The plan is enacted to begin on January 1, 2019. Each employee chooses a plan that fits their needs and faithfully submits their receipts for reimbursement to the plan administrator. At the end of the tax year, each employee has used their full contribution allowance.

In Smart S-Corp, each employee works forty hours per week and earns a salary of $15 per hour. Total earnings before deductions for the company is $3,000,000. Using this information, we can calculate the savings the Section 105 plan generates below:

$3,000,000 earnings

($1,528,800) employee salaries

($512,050) QSEHRA contributions

$959,150 total taxable income

This income is carried over to Smart S-Corp’s only shareholder and appears on their 1040. The total self-employment tax that the owner must pay under married filing jointly status is $26,656. They fall into the 37% income tax bracket, so their tax expense is $354,886, plus the $26,656 self-employment tax for $381,542.

Now, if Smart S-Corp had decided to be stingy and not elect the QSEHRA plan, their total taxable income would be $1,471,200, as calculated below:

$3,000,000 earnings

($1,528,800) employee salaries

$1,471,200 total taxable income

This income is carried over to Smart S-Corp’s only shareholder and appears on their 1040. The total self-employment tax that the owner must pay under married filing jointly is $37,660. They fall into the 37% income tax bracket, so their tax expense is $544,344, plus the $37,660 self-employment tax for $582,004.

By electing to participate in the Section 105 plan, they save $200,462 in tax expense – 40% of the cost of the plan contributions. Their income after taxes does drop by $311,588 if they choose to participate in the Section 105 plan, but they can examine other ways to save on taxes or increase revenues with their CPA. They will also improve employee morale and retention rates throughout the company.

Section 105 Plan for C-Corporation: The #1 Structure [+ IRS Hazards]

Owners of a C-Corporation are in a great position to realize the tax-free benefits of a Section 105 plan. They may entirely deduct the cost of such a plan from the business’s taxable income.

The benefit is included within the W-2 statements of their employees as non-taxable income. Since C-Corporations are not pass-through entities, owners do not have to worry about an additional self-employment tax unless they receive self-employment income on a 1099-MISC form.

However, since this is not tax-advantageous, most C-Corporation owners choose to receive their income through a W-2 or dividend distribution. 

Since owners of C-Corporations are recognized as employees, there is no need to employ a family member (or anyone else) to qualify for a Section 105 plan and realize its benefits. There are also no limitations on contributions made to the plan if contributions follow the Section 105 plan documentation.

C-Corporations must follow the IRS and Department of Labor rules to create the Section 105 plan. In general, they must abide by the following:

Create a written legal plan document that includes:

  • Name of the plan administrator
  • Description of plan benefits
  • Standard of review for benefit decisions
  • Eligibility criteria
  • Amount the participant must pay towards coverage
  • Plan sponsor amendment and termination procedures
  • Any waiting period required before eligibility for the plan begins
  • A statement of how the plan is funded

How Does a Section 105 Plan Work with a C-Corporation?

Ensure that the plan complies with COBRA, HIPAA, ERISA, and ACA requirements. 

– COBRA – if the plan has more than twenty participants, it must offer continued medical benefits to terminated employees for a set period. The terminated employee must pay for their benefits with their funds. Still, the employer cannot drop them from group coverage until the time limit is reached or the terminated employee becomes eligible for another medical insurance plan (whichever occurs first). 

– HIPAA – HIPAA requirements require that protected health information should be given to the company processing reimbursement claims and should be held confidentially.

– ERISA – Under ERISA, Section 105 plans are included as employee welfare plans. Summary plan descriptions and information must be provided to each employee. Employers cannot endorse any specific health insurance plan and must not directly pay for a particular plan.

– ACA – The ACA requires that no annual or lifetime limits be placed on essential health benefits. Employees also cannot wait over 90 days for health care reimbursement, and plans must allow coverage for individuals up to age 26 under their parents’ plans.

C-Corporations may choose any type of Section 105 plan they like – a self-insured plan, group-integrated HRA plan, a Health Savings Account (HSA), or stand-alone one-person HRA. Expenses for the Section 105 plan are deducted on Form 1120 directly from taxable income. Premiums and reimbursement payments flow through to the owner’s and employee’s W-2 forms as fringe benefits and are not subject to further taxation.

Section 105 Plan Savings Under a C-Corporation: An Example

C-Corporations are perhaps the best legal structure to enact a Section 105 benefit plan. There are virtually no limits on the amount of contributions that can be made to an employee (if the same benefits are available to all employees of the same class), and they are fully tax-deductible to both the corporation and the business owner, even if the owner’s spouse does not work for the company.

Let’s look at ABC Corporation, whose sole shareholder, Alex, owns 100% of the company. ABC Corporation has no employees besides Alex, and he decides to enact a Section 105 plan for himself.

He requires a lot of medical care throughout the year due to a chronic back problem he has had since he was a child. He also has diabetes and requires expensive medication to maintain his health. He is married and has four children, including a newborn.

He estimates his family’s medical premiums and out-of-pocket expenses to be $30,000 per year. At the advice of his CPA and a qualified plan administrator, he sets up a stand-alone one-person HRA. The plan administrator ensures the plan is set up to follow Department of Labor and IRS regulations. He sets the contribution limit to be $30,000 per year.

After searching through the marketplace, he finds a plan that he feels will suit his and his family’s needs. He purchases the plan and submits his qualified receipts on a timely basis to the plan administrator throughout the year. 

Alex has used the entire $30,000 contribution at the end of the year, and ABC Corporation has $250,000 of earnings. Alex earned a regular salary the year of $75,000. Using this information, we can calculate ABC Corporation’s taxable income below:

$250,000 earnings

($75,000) W-2 earnings to Alex

($30,000) HRA contributions

 $145,000 taxable income 

Under the Tax Cuts and Jobs Act, tax rates for corporations were lowered to a flat amount of 21%. Thus, ABC’s tax due is $30,450. Alex’s wife does not work, so she has no taxable income. Therefore, Alex’s income is taxed in the 12% bracket for a total expense of $9,000. The contribution he received is entirely tax-free for both the corporation and him.

Had Alex not elected the Section 105 plan, he would have had to pay for his health expenses using after-tax dollars and would only have been able to itemize them, not deduct them directly, for amounts exceeding his AGI above 10%. Let’s compare. 

For ABC Corporation, taxable income would be $175,000:

$250,000 earnings

($75,000) W-2 earnings to Alex

$175,000 taxable income 

The tax due for ABC Corporation would be $36,750. Alex would have a salary of $75,000 to include on his W-2. However, his family’s health care expenses would be paid with after-tax dollars and would only be deductible on their 1040 to the extent that they exceed 10% of his AGI.

Therefore, $22,500 would be deductible from taxable income ($75,000 AGI x 10% = $7,500 minimum expense; $30,000 total medical expenses – $7,500 cap = $22,500 deduction from taxable income). His final taxable income would be $52,500 at a rate of 12%, or $6,300. 

It is beneficial for Alex to adopt the Section 105 plan. It increases the amount of income available to spend on his family for their day-to-day expenses and decreases the tax owed by ABC Corporation by $6,300 for the year.