Ever wondered if your business can pick up the tab for your health expenses and turn that into tax savings? Imagine deducting medical costs on your business tax return. But—is this tax-saving strategy actually possible?
Fringe Benefit as a Business Deduction.
To answer this question, we must start with general definitions and dig further into the tax code. First off, the IRS defines a medical expense paid by a business for an employee as a “fringe benefit”. In a recent court case, Deal Santos v. Commissioner, the judge explained fringe benefit as an additional benefit an employee receives from their employer that isn't a direct salary or compensation. The employer (business) can always deduct fringe benefits on their business 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.
Does This Mean That Business Owners Can Deduct Medical Expenses on Their Business Tax Returns?
Unfortunately, there is a catch: you don’t always qualify for the definition of an employee.
Let's Start with Sole Proprietors (Schedule C filers). In case of sole proprietors, the IRS does not consider you an employee of your own business, which means fringe benefits are off-limits. That’s right, sole proprietors are owners, not employees—and as much as you might want those perks, the IRS says "no" to deductible fringe benefits.
Still, sole proprietors get a partial win: they can take a deduction for self-employed health insurance premiums covering themselves, a spouse, and dependents. But remember, this only covers health insurance premiums, not other medical expenses. The rest of medical expenses will most likely end up on Schedule A of the personal tax return, subject to thresholds that often mean they’re not deductible.
The Spouse "Secret" Strategy—IRC §105
Under this code, a sole proprietor can hire their spouse to work for their small 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 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 (there are companies that just do that - administration of HRA plans). 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.
How exactly does HRA work? Instead of choosing one expensive policy for all employees, businesses with an HRA offer a monthly allowance of tax-advantaged money. Employees buy the health care products and services they want, and the business reimburses them up and deduct reimbursements on their business tax returns
Moving on to partners and their partnerships, the same self-employed health insurance deduction 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. Again, the partner is allowed to hire their spouse as a W-2 employee and deduct expenses through an HRA plan similar to the sole proprietor.
Regarding S Corporations, 2-percent shareholder health insurance tax rules for S Corporations add specific restrictions for their owners. 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.
Because of the way the IRS views Scorps, 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.Bummer.
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. We wrote in detail about this process here.
The C Corporation Advantage.
Medical expenses for C Corporations is handled completely differently. C Corporations are separate legal entities, and 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, deduct them on the C Corp tax return, and minimize your 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.
Quick Recap
- Sole Proprietors: Deduct health insurance premiums only; no fringe benefits unless you hire your spouse on a W-2 position.
- Partnerships: Same as sole proprietors; deduct health insurance premiums on the personal return, no fringe benefits unless you hire your spouse on a W-2 position.
- S Corporations (2-percent shareholders): Health insurance premiums are deductible, but no tax-free fringe benefits even for spouses-employees
- C Corporations: Full fringe benefits for medical expenses and health insurance, with a corporate tax rate of 21%.
C Corps could be organized as a stand alone business entity that was created for the deduction of medical expenses. However, this tax saving strategy requires accurate tax planning.
If you’re curious how it might apply to your business, reach out to us! We've helped countless business owners find the smartest way to manage their taxes and protect their bottom line. Check out our services here.