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?
The short answer is sometimes. The long answer: it depends on whether the IRS considers you an employee of your business. Ugh. I know, it got complicated really fast.
If you're up to spending 3 minutes of your attention on the blog, here’s a long answer in detail:
Generally, there are two types of medical deductions for business owners:
Health Insurance deduction - Health insurance deductions are allowed for most business owners, but how you claim this deduction depends on your type of business.
Deduction of actual medical expenses - This deduction is more complicated and depends on whether the IRS considers you an employee of your business.
But let's dig into some tax rules:
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 that a fringe benefit is an additional benefit an employee receives from their employer that isn’t direct salary or compensation. The employer (business) can 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 1)they are considered an employee and 2) that particular medical expense is not taxable by the IRS
So, if you are an employee of your business, the IRS gives you a green right to deduct many medical expenses. If you're not an employee, I’m sorry, no deductions for medical expenses are allowed.
Let’s start by reviewing the four types of business entities to see when the IRS considers a business owner an employee of their own business:
Sole Proprietors (Schedule C filers): In the 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 as a deduction on their personal returns. But remember, this only covers health insurance premiums, not other medical expenses.
But here’s an HRA loophole for married individuals: a business owner can hire their spouse to work for them. In this case, your significant other will be your employee. Your spouse can set up an HRA account for themselves and be reimbursed for medical expenses for the whole family, including yours. This setup would allow you to deduct medical expenses as a direct expense on your business Schedule C. This is a huge tax savings! However, please note: this arrangement will involve some paperwork and compliance fees. You’d need to issue your spouse a proper W-2 and find an administrator for your HRA plan (there are companies that specialize just in HRA plans). On top of that, your spouse would have to perform work for you, and you’ll pay their self-employment taxes. For more detail on this loophole you can read here.
Partnerships: the same rules apply. Partners cannot be employees of their own partnership and cannot deduct their medical expenses on the business tax returns. 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.
However, the partner can also hire their spouse as a W-2 employee and deduct expenses through an HRA plan, similar to the sole proprietor.
S Corporations: The tax rules for 2-percent shareholders in S Corporations add specific restrictions for their owners. If an S Corporation owner is a "2-percent shareholder," the S Corporation is treated like 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 S Corps, non-taxable fringe benefits will not be available to the shareholder's spouse, children, and parents, even if they are officially employed 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 shareholder can later claim this deduction on their personal return as an adjustment to income. We wrote in detail about this process here. When it comes to deducting medical expenses, the S Corporation is the least advantageous tax entity.
The C Corporation Advantage: Medical expenses for C Corporations are 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 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’s crucial to plan carefully, as C Corporations are subject to a 21% tax rate. Besides, you’d also have to pay for the preparation of a C Corp tax return.
Just to Recap:
- Sole Proprietors: Deduct health insurance premiums only; no fringe benefits unless you hire your spouse in a W-2 position and set up an HRA plan.
- Partnerships: Same as sole proprietors; deduct health insurance premiums on the personal return, no fringe benefits for partners unless you hire your spouse in a W-2 position and set up an HRA plan.
- S Corporations (2-percent shareholders): Health insurance premiums are deductible, but no tax-free fringe benefits, even for spouse-employees.
- C Corporations: Full fringe benefits for medical expenses and health insurance, with a corporate tax rate of 21%.
C Corporations could be organized as standalone business entities specifically for the deduction of medical expenses. However, this tax-saving strategy requires accurate tax planning.
In short, the ability to deduct medical expenses as a business owner depends on your entity tax type. If you’re interested in exploring tax savings through medical deductions, contact us—we’ve helped countless business owners make the most of these strategies. Check out our services here.