If you own a small business, can you use it to pay for health expenses and deduct these expenses on your business books? This way, you could reduce your business profits and pay less tax on your business income. Is this tax strategy even possible? In this article, we will explore the tax laws and definitions around reimbursing medical expenses through a business and the limitations that may apply based on the type of business entity.
To answer this question, we must start with general definitions and dig further into the tax code. How does tax law define a reimbursement for medical expenses by a business? The proper definition is "fringe benefit." In a recent tax court case, Deal Santos v. Commissioner, a judge explained fringe benefit as an additional benefit an employee receives from their employer that isn't a direct salary or compensation. The employer can always deduct fringe benefits on their tax return, and the employee MAY exclude this fringe benefit income on their personal tax return as long as the IRS qualifies this particular fringe benefit as excludable. IRM 22.214.171.124.1 does confirm that reimbursed medical expenses are nontaxable to employee fringe benefits.
We should all be good here, right? Let's start writing off our medical expenses! Unfortunately, their is a catch: you don’t always qualify for the definition of an employee.
For example, the IRS says that sole proprietors who file Schedule C are not employees of their own business. They are owners. And being an owner, and not an employee, disqualifies you from getting fringe benefits from your business. Darn it! No fringe benefits means no deduction.
However, sole proprietors can still make an adjustment to their income for self-employed health insurance premiums paid for themselves, their spouse, and dependents. This adjustment will be for the cost of health insurance premiums only. Medical expenses that are not covered by insurance cannot be deducted as business expenses.
And here is well-hidden secret: IRC code §105. Under this code, you can hire your spouse to work in your business. In this case, your spouse will be your employee. This would allow you to take medical expenses in the form of fringe benefits as a direct expense on Schedule C. This is a huge tax savings! However, this arrangement will involve some paperwork and compliance fees. You would need to issue your spouse a proper W-2, and also find an administrator for your HRA plan. On top of that, your spouse would have to perform work for you, and you will pay their self-employment taxes. It is also important to note that due to Affordable Care Act restrictions, traditional §105 plans are generally restricted to businesses with one employee. So, you won't qualify for this plan unless you have other employees besides your spouse.
Moving on to partners and their partnerships, the same rules apply. Partners cannot be employees of their own partnership. Any fringe benefit paid to a partner in a partnership is considered a guaranteed payment and is subject to income tax and self-employment tax. Therefore, if a partnership pays for medical expenses for its partner, these payments will be taxed at the partner’s personal level. However, the partner is still allowed a health insurance premium deduction, similar to a sole proprietor, which we discussed earlier, on their personal return. The partner will not be able to deduct medical expenses, only health insurance premiums.
Regarding S Corporations, can their owners enjoy tax-free fringe benefits? Unfortunately, not many. If an S corporation owner is a "2-percent shareholder," the S corporation is treated as a partnership, and the owner is treated as a partner of the partnership. Thus, the owner cannot benefit from any tax-free fringe benefits that are usually available to regular employees.
A "2-percent shareholder" of an S corporation refers to someone who owns more than 2% of the outstanding stock or stock possessing more than 2% total voting power on any day of the S corporation's tax year. The constructive ownership rules also apply. Therefore, even someone who does not directly own S corporation stock may still be considered a 2% shareholder for fringe benefit purposes, if they are related to the owner. This means that non-taxable fringe benefits will not be available to the shareholder's spouse, children, and parents, even if they are officially employed as employees in the S corporation.
However, health insurance premium payments can still be deducted. The S corporation can deduct the amounts paid on its tax return, and the shareholder must report the amount of health insurance in box 1 of their form W-2. The 2% shareholder can later claim this deduction on their personal return as an adjustment to income.
Finally, let's discuss C Corporations. C Corporations are separate legal entities, and thus, constructive ownership rules do not apply to them, even if the shareholder and the employee are the same person. Therefore, owners can typically be employees and have no general limitations on receiving fringe benefits or taking advantage of fringe benefit exclusions. This is great news! It means that you can create a C Corporation where the company pays for various medical expenses and health insurance premiums, deducts them on its tax return, and minimizes its tax burden. As a result, the employee of the company won't have to pay any taxes on these benefits. However, it is crucial to plan carefully as C Corporations are subject to a 21% tax rate. Additionally, it is advisable to research and comprehend the definitions of excludable fringe benefits to ensure compliance with tax regulations.
In summary, the tax rules around deducting medical expenses and health insurance premiums can be complex and depend on the type of business entity. Sole proprietors can deduct self-employed health insurance premiums but cannot receive fringe benefits from their own business. However, they can hire their spouse as an employee to receive tax-free medical expense reimbursements under IRC code §105. Partners are also out of luck as they cannot receive fringe benefits and can only deduct health insurance premiums on their personal tax return. 2% shareholders in S corporations also cannot receive tax-free fringe benefits but can deduct health insurance. C corporations have the most flexibility in offering fringe benefits to their employees, including health insurance and medical expenses, but are subject to a 21% tax rate. Business owners should carefully plan and research to ensure compliance with tax regulations and maximize their tax savings.