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 top benefits.
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Section 105 Plan Advantages
Reduction of costs. 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. 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 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.
- 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 company to realize a reduction of federal and state taxes. However, they will still incur FICA taxes (15.3% in 2019, to $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 using a Section 105 plan with this type of company structure.
Section 105 Plan Disadvantages
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 small. This is tremendous for employees who might otherwise seek employment with larger companies that can offer a group health insurance plan.
They also provide some pre-tax advantages to both the employer and the employee. However, a few disadvantages to enacting a Section 105 plan include limited tax benefits under some company structures and the cost and time it can take to administer such plans.
Limited Tax Benefits to Sole Proprietorships, Partnerships, and S-Corporations
Section 105 plans enacted under a sole proprietorship or partnership company structure are generally unable to realize tax-free Section 105 plan benefits unless they can legitimately employ a spouse at least part-time. If they cannot hire 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 more 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 spouses and children, are considered owners of the S-Corporation, even if they have no part in the business whatsoever.
Any Section 105 plan benefits will be subject to the 15.3% self-employment tax. It is also crucial to ensure that any Section 105 plan 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 a qualified plan administrator and their certified public accountant (CPA) to ensure they choose a Section 105 plan to meet the 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, consultation and proper setup must occur to avoid potential pitfalls in the future. A plan that is not set up correctly can result in thousands of dollars in legal fees and penalties, so a few dollars spent at the beginning can do much to ease the business owners’ minds.
Ongoing Plan Administration Requirements
Companies that offer the plan to more than 100 participants must file Form 5500, which is quite complicated and requires outside actuarial valuation that an outside qualified party must do. 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.
Take a look at some of the pros and cons in the table below:
|Great for C-Corps and sole proprietors||Not good for S-Corporations|
|High reimbursement amounts||Subject to discrimination rules|
|Easy plan set up||Not great with many employees|
|Flexible reimbursement frequency||Administration requirements|