Are you married and running a business as a sole proprietorship? Maybe you are a single-member LLC treated as a sole proprietorship for federal tax purposes? You might want to consider a Section 105 plan spouse strategy.
In either case, as long as you have a spouse, you may be able to take advantage of one of the best medical expense tax deduction strategies.
For this plan to work, you must:
- Be self-employed and file as a sole proprietor (Schedule C)
- Be married
- Your spouse must work in your business
If so, it can be an excellent tax strategy to hire your spouse as an employee and provide most or all of their compensation as medical expense reimbursements.
Under a Section 105 plan, you can claim business expense deductions on Schedule C of your Form 1040. This is for your employee spouse’s reimbursements paid under the plan. Those reimbursements can cover the family’s health and dental insurance premiums and out-of-pocket medical, dental, and vision care expenses. This can be valuable because:
- Schedule C deductions lower your federal income and self-employment tax.
- Section 105 reimbursements are not subject to Social Security and Medicare taxes.
- The medical reimbursements are tax-free to your spouse because they are a fringe benefit.
How to determine how much compensation to pay through a Section 105 Plan?
The IRS has stated that you can provide your employee spouse’s total compensation in the form of Section 105 plan spouse reimbursements. This is an excellent approach from a tax perspective. Under this scenario, there is no need to provide your spouse with cash wages and issue a W-2. There is no requirement to withhold federal payroll taxes.
Paying your spouse a cash wage will trigger a W-2 filing requirement, along with Social Security and Medicare taxes. The salary will be claimed as W2 income earned by your employee spouse, which will offset the deduction taken on your tax return.
Naturally, the compensation paid to your employee-spouse under this strategy must be reasonable based on the work they perform for the business. As such, the plan should include a maximum annual reimbursement limit to prevent exceeding a reasonable wage. At the same time, your employee spouse’s compensation shouldn’t be meager. Your CPA or tax professional can assist in deciding whether you should pay a cash wage because the Section 105 reimbursements are too low.
If you adopt this strategy, paying your employee spouse’s Section 105 reimbursements with checks from your business bank account is advisable. That way, there are no blurred lines between your personal and business expenses.
The IRS considers a Section 105 plan a self-insured medical and healthcare reimbursement plan. If you have multiple employees, there are adverse tax consequences if you discriminate in favor of your employee spouse. However, the discrimination rules are not applicable if you have no other employees.
In addition, a Section 105 plan that reimburses individual medical insurance along with out-of-pocket medical expenses is typically viable as long as there is only one employee who participates during the plan year.
What does the IRS think?
In one court case, a business owner operated a sole proprietorship daycare business and employed her husband part-time. The wife paid his total Compensation in Section 105 Plan medical reimbursements.
The taxpayer supported the compensation with written documents signed by the business owner and her husband. The plan document specified that reimbursements would be capped at $6,500 annually. The wife reported deductible reimbursements for the two years under review of $3,279 and $4,539, respectively.
Despite the reasonable documentation, the IRS disallowed the write-offs. Here’s what the IRS claimed:
- The wife did not set up the Section 105 plan correctly.
- The husband was not a legitimate employee of his wife’s business.
- The reimbursements were not reasonable compensation for duties the husband performed.
- The Section 105 plan expense reimbursements were not an “ordinary and necessary” business expense.
So what was the result? Thankfully, the IRS lost on all counts. The taxpayer planned wisely and, in the end, won their case. The court case is Speltz v. Commissioner, Tax Court Summary Opinion 2006‑25.
Five Critical Steps for a Successful Section 105 Plan Spouse
Rather than reviewing all the details behind the Tax Court’s decision, let’s look at what the husband and wife did correctly in the case. It would help if you addressed these same criteria should you implement a Section 105 plan strategy successfully:
1. There was a written and documented employment agreement between the business owner and her employee spouse. The court found the employee-spouse was qualified to perform the work assigned.
2. The taxpayer established the Section 105 plan in writing, and reimbursements from the plan were designated compensation for the employee’s spouse. The reimbursement was, in fact, the only source of remuneration.
3. The taxpayer established in writing that the employee-spouse would work a certain number of hours per week on average. The taxpayer documented those hours adequately with written records. The business owner should have the employee-spouse turn in weekly time sheets.
4. The plan specified an annual limit on medical reimbursements, and the actual reimbursements were not excessive compensation based on the services provided.
5. The employee-spouse submitted adequate evidence for the medical expenses reimbursed him under the Section 105 plan.
Is an Employee-Spouse required to have a W2 Wage to Have a 105 Plan?
For example, can the sole source of an employee spouse’s compensation be the reimbursements under the Section 105 medical plan?
Yes. You are not required to pay your spouse on a W2 based on the following:
- The IRS’s litigation settlement guidelines (ISP)
- The Speltz case
On page 3 of the ISP, the IRS states that its litigation position is that the costs of health coverage, including medical expense reimbursements, are deductible by the employer-spouse as long as the employee-spouse is a bona fide (actual) employee of the business under the common law rules or otherwise provides services to the company for which the accident and health coverage is reasonable compensation.
To meet the IRS position, your spouse must be a bona fide employee, and the 105 plan reimbursement must represent reasonable pay.
In the Speltz case, the IRS made many assertions about why the court should disallow the Section 105 plan, but Mrs. Speltz proved to the court that the plan reimbursements were reasonable Compensation to Mr. Speltz. She paid Mr. Speltz no W-2 wages, only the 105 medical reimbursements.
Exempt from W-2 Reporting
For information purposes, the Affordable Care Act requires employers to report on Form W-2 the value of employer-provided health care.
In future guidance, the IRS could require filing W-2s to report the value of small-employer-provided medical plans. But the IRS says, “Any such future guidance will be prospective only and will not be applied earlier than January 1 of the calendar year beginning at least six months after the date of issuance of the guidance.”
This means that a sole proprietor, including the single-member LLC, taxed as a sole proprietor, who meets the small-employer definition, can hire their spouse and have as the spouse’s sole remuneration a Section 105 plan that’s not reportable on a W-2.
| Step | Action | Details |
|---|---|---|
| 1 | Hire Your Spouse | Spouse must be a legitimate W-2 employee performing real business tasks (e.g., admin, bookkeeping, marketing). |
| 2 | Set a Reasonable Wage | Pay your spouse a fair wage based on their work; this can be modest but must be justified. |
| 3 | Set Up Payroll | Use a payroll provider or file manually. You must withhold and pay employment taxes (FICA, FUTA, etc.). |
| 4 | Purchase a Family Health Plan | Your spouse (the employee) should be the policyholder; the plan must cover both spouse and you (the owner). |
| 5 | Draft a Section 105 Plan Document | Create a written HRA plan that details reimbursement terms, limits, procedures, and eligible expenses. |
| 6 | Reimburse Medical Expenses | The business reimburses the spouse for out-of-pocket costs and premiums (tax-free to them, deductible to business). |
| 7 | Maintain Proper Records | Keep timesheets, payroll stubs, W-2s, receipts for medical expenses, and copies of the plan document. |
| 8 | File Required Tax Forms | Issue a W-2 for the spouse. Deduct reimbursements as a business expense on Schedule C (Line 14 or Line 24). |
| 9 | Avoid Hiring Other Employees | The plan must remain a one-employee plan to avoid triggering ERISA or nondiscrimination testing requirements. |
| 10 | Review Annually | Reassess wage, coverage, and medical costs. Update the plan document if benefits or participants change. |
Takeaways
- You can use a Section 105 plan as the sole remuneration to your employee spouse.
- You don’t need to pay cash wages to your spouse to make your spouse an employee.
- You don’t have to disclose the value of Section 105 medical reimbursement plan on a W-2 if you are a small employer.
