Section 105 plans are excellent tax planning tools. But did you know that a sole proprietor can set up a section 105 plan?
In this guide, we will show you how this little know tax strategy works and explain some tips and a few pitfalls to avoid. Let’s dive in.
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Sole proprietorships face strict rules when setting up a Section 105 plan. If the sole proprietorship has no employees, it cannot set up a Section 105 plan since the first requirement must be to have at least one employee who is not the business owner.
The best recourse is to hire the sole proprietor’s spouse or family member in this situation. 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 uses 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 business proprietor 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.
Section 105 Plan for Sole Proprietor
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 company’s taxable income. This results in double savings on taxes since medical premiums and expenses are paid for with tax-free dollars—the reduced taxable income results in lower earnings 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 by 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 essential that the spouse’s earnings be small compared 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, eliminating 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:
- The sole proprietor must hire their spouse or family member to work for them in a legitimate capacity on a part-time basis.
- A set of plan documents must be created that comply with IRS and Department of Labor regulations.
- The plan should include a reasonable cap on medical expenses available to the spouse each year for medical expenses. Typical caps are $12,000 – $18,000 per year.
- The sole proprietor’s spouse 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.
- The spouse must keep proper receipts and documentation of insurance premiums paid and submit them to the business for accurate recordkeeping.
Sole Proprietor 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. She earns $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 he, his wife, and their family can pay for their medical plans using tax-free monies. They decide to select 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 $12,000 per year.
Based on prior years’ experiences, they think 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 went into effect on January 1, 2018.
Allison purchased 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 promptly. Here are a few essential points:
- They have spent exactly $15,000 in qualified medical expenses at the end of the year.
- She has earned $23,400 in W-2 wages through 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 can deduct the medical expenses and Allison’s salary directly from the business’s income. Therefore, his taxable income is:
|$150,000 Income before deductions|
|(23,400) Allison’s salary|
|(15,000) Section 105 plan|
|$111,600 taxable income|
Jim must include the taxable self-employment tax in his tax expense is $7,884.50.
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 $7,884.50 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 $8,994.50. Electing a Section 105 plan has saved Jim and Allison $4,410 in tax expenses, 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