There is a not-so-secret but often overlooked tax-savings strategy that allows sole proprietors to turn their family’s medical expenses into a business deduction. To take advantage of this strategy, you’ll need to hire your spouse and set up a Section 105 medical reimbursement plan. In this post, I’lll walk you through exactly how you can take advantage of this strategy and how pairing it with an HSA might save you even more.
Can I hire my spouse to deduct family medical expenses?
Whether you can legitimately hire your spouse is the first question you’ll need to answer to move forward with using this tax-saving strategy.
I recently wrote a detailed post about hiring your spouse that discusses all of the benefits of doing so. The long and short of it is that to make the health reimbursement strategy work, your spouse does not have to work full time for you, but they must check all of these boxes:
- Perform real work for your business,
- Be paid a reasonable amount for their work,
- Not be a partner in your business, and
- Be treated like an actual employee and included in payroll, record-keeping, and so forth.
For instance, some common jobs that small business owners hire their spouses to complete are:
- Bookkeeping
- Invoicing
- Scheduling
- Social media management
- Marketing
- Office or admin work like answering emails
Keep in mind that when a sole proprietor hires their spouse, the spouse’s wages are subject to income tax as well as Social Security and Medicare taxes. However, the IRS doesn’t require a sole proprietor to pay a certain amount of taxable W-2 wages to their spouse, and this is why providing your spouse with a fringe benefit like a health reimbursement plan can lead to big tax savings.
What is a Section 105 medical reimbursement plan?
Once your spouse becomes an employee of your sole proprietorship (or LLC taxed as a sole proprietorship) the next step is to set up a Section 105 medical reimbursement plan. You may also hear this referred to as a health reimbursement arrangement (HRA), which is a popular type of medical reimbursement plan.
You’ll also want to determine the best type of plan to use. For instance, if your spouse is your business’ only employee, then there are special plans you can choose that may not be subject to certain health care policy restrictions that other plans types may have.
No matter the type of plan you go with, Section 105 medical reimbursement plans work like this once you hire your spouse:
- The business agrees to reimburse the employee (spouse) for medical expenses.
- Those reimbursements are tax-free for the spouse.
- The business deducts the reimbursements as a Schedule C expense.
Important: I want to be clear that if you own an S-Corporation, although you can still set up a medical reimbursement plan for your employees, because of the different tax rules for S-Corps, your spouse won’t qualify for the tax-free HRA benefits. In other words, S-Corp owners can’t hire their spouse and use a medical reimbursement plan as a way to deduct their family’s medical expenses.
Which medical expenses can be reimbursed by a Section 105 medical reimbursement plan?
If your medical reimbursement plan or HRA is written correctly, it can cover all of these medical expenses:
- Family health insurance premiums
- Dental and vision insurance premiums
- Deductibles
- Copays
- Prescription costs
- Other out-of-pocket medical expenses
And here’s the really cool part: Even though the plan is in the spouse’s name, the business owner and their dependent children can be covered by the plan because they are part of the employee/spouse’s family.
How does creating a Section 105 health reimbursement plan help save taxes?
There are several tax benefits that come from setting up a Section 105 health reimbursement plan for your employee/spouse:
- Your spouse receives reimbursements that aren’t subject to federal income tax.
- The reimbursements are also free from employment taxes.
- The business deducts 100% of the reimbursements on the Schedule C.
The business deduction reduces your federal income tax and self-employment tax, so what you’ve done is created a double tax break for yourself!
How can I deduct my family’s medical expenses if I hire my spouse in my business?
Now that you understand how this works, let’s look at an example of how this is done (using real numbers).
Sara is a freelance graphic designer and a sole proprietor who made $85,000 last year. She hired her husband, Mike, to help her business handle creating invoices, answering client emails, and updating her website.
She then put Mike on the payroll as a part-time employee and paid him a reasonable wage for the work he does for her business. She also worked with me and an HRA vendor to correctly set up a Section 105 medical reimbursement plan.
Using the plan, here’s what happened:
- The business reimbursed Mike for all of their family’s medical expenses, including health insurance premiums and out-of-pocket costs, which totaled $16,000.
- Mike did not pay taxes on those reimbursements.
- Sarah deducted 100% of the reimbursements as a business expense on Schedule C.
Here’s what Sarah and Mike saved:
- Sarah’s business income was reduced by $16,000, which resulted in $3,520 in income tax savings and $2,448 in self-employment tax savings for a total tax savings of $5,968.
You can see from this example that this tax-saving strategy isn’t aggressive or complicated. Even though Sarah and Mike’s family spent the same amount on healthcare for the year, they were able to reduce their overall tax bill by about $6,000.
Can my family have a Health Savings Account with our health reimbursement plan?
Yes, not only can you have a Health Savings Account (HSA) with a health reimbursement plan, but having both can amp up your tax savings even more! The way this works is if your family has a high-deductible health plan, you can:
- Use your Section 105 HRA to reimburse premiums and many out-of-pocket costs, and
- Use an HSA to save and pay for additional medical expenses tax-free
This is a winning combination because your Section 105 lets the business deduct your family’s medical costs and your HSA contributions are tax-deductible (or pre-tax), which means your HSA withdrawals for medical expenses are tax-free as long as the same medical expense isn’t reimbursed by both plans.
What other rules do I need to follow when I hire my spouse and deduct family medical expenses?
There are a few other important rules to keep in mind when setting up an HRA, hiring your spouse, and deducting your family’s medical expenses:
- Your Section 105 plan must be set up correctly in writing. I highly recommend working with a CPA and a company that specializes in creating HRA plans. In other words, this is not a DIY strategy.
- Your plan must be set up before expenses are reimbursed. Retroactive reimbursements aren’t allowed.
- Many plans include an annual reimbursement cap, and sometimes those can be adjusted each year.
- Your family’s medical expenses need to be documented through receipts or medical bills. If you don’t have a document proving the expense, then no reimbursement should be given.
Abridged by Amy
If you’re a sole proprietor paying high medical costs each year, then creating a health reimbursement plan, hiring your spouse, and deducting your family’s medical costs can be a real game changer. And, if you can couple this strategy with an HSA, the tax savings can really add up.
Just remember that your HRA should be set up properly so that it can be tailored to your specific situation while also meeting all compliance requirements. If you think you may be interested in using this strategy to drastically reduce your tax bill, consult a CPA to discuss your options and your goals.
Take a moment to read some of my other posts for small business owners interested in reducing their tax bill (pretty sure that’s all of us!):
