04 Feb IRS Victory–Section 105 Medical Reimbursement Plan—Must Read
We have good news. Milo and Sharlyn Shellito won their case thanks to the merits of their case and the good work of their lawyer, Reggie L. Wegner.
Interestingly, the court did not publish a revised or new opinion showing that the Shellitos won. Perhaps being embarrassed by the appeals court, the tax court decided to hide its reversal in docket number 10223-06.
And the court’s decision does not confess or tell what happened. It simply gives the result. Further, the court did not make the stipulations viewable at its site (perhaps somewhat hiding the results). We had to order the stipulations from the court.
Meanwhile, we spoke with Mr. Wegner, the lawyer for the Shellitos, and obtained from him the stipulations of the IRS and the Shellitos where you can see that the Shellitos won everything for 2002.
That’s good news for the Shellitos. They gained $20,208 in Section 105 plan deductions for 2002.
The Shellitos victory also is good news for you because their win further clarifies how you can take advantage of a Section 105 medical reimbursement plan when you the meet the profile.
The Section 105 plan is best for C corporations and proprietorships, including single-member LLCs and husband-and-wife LLCs taxed as proprietorships.
- If single, you need to use the C corporation to profit from the 105 plan
- If married, you can profit when you use either the proprietorship or the C Corporation.
You may have noted the absence of the S corporation. The significant benefits of the Section 105 plan do not accrue to the owner of an S corporation.
Employees complicate your Section 105 plan. First, if you can’t discriminate in coverage as we explain below, your cost of covering the employees may prove too expensive for you to adopt the plan.
And you may have far more employees than you think. For purposes of the Section 105 plan, you must provide the same benefits to
- all your employees in all your businesses regardless of business entity, and
- all your spouse’s employees in all of his or her businesses, regardless of business entity.
With the Section 105 plan, the law allows you to discriminate in three ways by excluding from the plan:
- Employees who have not completed three years of service
- Employees who are under age 25
- Employees who are seasonal part-time workers
Caution. Make sure you get what you want before you discriminate
Example. Your plan has been in place for a year. You are going to hire a new employee. You could grandfather your employee-spouse under the old plan and then add the three-years-of-service requirement before you hire the new employee.
We think this is going to be your favorite part of the Section 105 plan because the 105 plan can
- create tax deductions where none existed before, and
- increase the tax savings from deductions you already claim.
The 105 plan takes personal itemized medical deductions that were being destroyed the 7.5 percent of adjusted gross income floor and turns them into business deductions. This is one of the cases where the 105 plan creates new deductions where none existed before.
By moving the deductions to a Schedule C, you save self-employment taxes, gaining another benefit. And next year, you might add another layer of savings if the new deductions help you save on the new 3.8 and/or 0.9 percent Medicare taxes.
Here’s another example of how the 105 plan creates deductions.
Say that you, or if married, you and/or your spouse get your medical insurance from a full-time job outside your business. Let’s say further that you pay $5,000 a year for family coverage under that employer’s plan. In this situation, you get no Form 1040 page 1 tax deduction for self-employed health insurance because you are covered by an employer plan.
With no page 1 deduction, your next choice is to take the $5,000 as an itemized deduction. Here it likely produces no tax benefits because of the 7.5 percent of adjusted gross income floor.
But when you establish a Section 105 plan, you create a new business deduction for that $5,000.
Long-Term Care Insurance
You win when you claim a business deduction for long-term care insurance. The big difference: The business deduction produces a deduction for the full amount paid. This beats the long-term care limits on the personal itemized deduction and eliminates the problem of the 7.5 percent floor. (Note: The floor jumps to 10 percent in 2013 for taxpayers under age 65 on December 31, 2013.)
Your long-term care insurance deduction fits nicely in the Section 105 medical reimbursement plan.
Avoid Payroll Taxes
If you are married and operate a Schedule C, Schedule E (rental properties), or Schedule F business, you can use the Section 105 plan as the sole source of remuneration to your spouse. Result: Neither you nor your spouse pays federal payroll taxes. Thus, with the 105 plan as compensation, you save money and have your spouse as a bona fide employee.
Putting the Plan in Place
Your first step: Create a Section 105 plan document, sign it, and keep it in your tax files. A sample document in Microsoft Word for my clients only is available, simply contact me.
If you operate as a C corporation, make the Section 105 plan cover you with single or family coverage. Then either submit your medical bills to the corporation for reimbursement or have the corporation pay the medical bills directly. That’s it.
If married and operating as other than a corporation, say a proprietorship, you need to hire your spouse to have the 105 plan cover both you and your spouse.
Make sure that you have proof that the spouse is doing the work. The simple and easy way to prove that work is to require that your employee-spouse give you a time sheet with hours worked and descriptions of the tasks performed.
We think you should avoid a formal employment contract because most people get this wrong and/or don’t live up to its terms. Further, the employment contract does not prove that any work was done, whereas a good time sheet does.
Get the checking accounts and reimbursements right:
- The employer-spouse should have a separate business checking account.
- The employee-spouse should have a separate personal checking account from which he or she pays all the family medical expenses. We want every penny of medical paid by the spouse. If health insurance for the employer-spouse is in the employer-spouse’s name and taken from his or her 1099 pay, the employee-spouse should reimburse the business (employee-spouse) for those premiums.
- Once a month, the employee-spouse should submit the health insurance payments, medical bills, co-pays, etc., to the employer-spouse for reimbursement.
- The employer-spouse should reimburse the employee-spouse’s receipts and other documents submitted on a monthly basis. (With monthly submissions and payments, you make the plan look and feel like what it is – a business fringe benefit plan.)
Make sure that the reimbursements to the employee-spouse represent reasonable compensation. For example, if the medical reimbursement equals $20,000 for the year and the employee-spouse works 1,000 hours, that’s $20 an hour in compensation. Is that reasonable for the work performed? Do you have proof?
When establishing dollar amounts, look for salary and wage guides online, articles, interviews with others, signed affidavits, newspaper clippings – you get the idea…whatever it takes to get decent proof.
Don’t skimp on the documentation parts of the plan.
The Section 105 medical plan can reimburse all health and long-term care insurance costs for the family, including health plans purchased separately by the spouses.
The easy way to identify other types of expenses eligible for reimbursement is to refer to the IRS’s handy publication on deductible medical and dental expenses, which you can access by clicking endnote number 3 below.
One caution: The IRS medical and dental expense publication applies to individual tax payers. The 105 plan may reimburse all of those expenses.
But in the 105 plan, you get two bonus deductions:
- Unlike individuals, the 105 plan may deduct the full amount paid for long-term-care insurance. Individuals have limits.
- Also, unlike individuals, the 105 has an enhanced prescription-drug rule.
The prescription rule for the 105 plan allows for reimbursement of a medicine or drug if the medicine or drug:
- Requires a prescription;
- Is available without a prescription (an over-the-counter medicine or drug) and the individual obtains a prescription; or
- Is insulin.
Besides the usual medical insurance, drugs, and co-pays, keep the following medical expenses in mind for reimbursement.
Equipment purchased to treat medical conditions
Home improvement to treat medical conditions, but only to the extent they do not add value to the home
Mileage at the medical mileage rate for trips to and from doctors’ offices and other medical appointments
Actual travel expenses of getting to and from out-of-town medical providers and institutions
Lodging at the tax-law limited rate
If you fit the profile for the 105 plan, you can sit back, relax, and smile, knowing that you are creating deductions where none existed before.
And it’s likely that your new 105 plan gives a boost to any previous tax deductions for medical expenses, as now with the 105 plan they reside in the tax-favored business category. If you are receiving this additional benefit too, you have yet another reason to smile.
1.Tax Court Docket 10223-06 Decision (03/1/2012).
2.Tax Court Docket 10223-06 Stipulation of Settled Issue (2/24/12).
3.IRS Publication 502, Medical and Dental Expenses (2011), updated Feb. 9, 2012
4.Notice 2010-59, modified only as to use of debit cards by Notice 2011-5