One the many challenges facing small business owners is health insurance and out-of-pocket medical bills. Generally speaking, self-employed health insurance premiums, including dental and vision, are directly paid by the business and are deducted as Officer Compensation on a business tax return That’s good. Health Savings Account (HSA) contributions are also directly paid by the business and are deducted as Officer Compensation. More good news!
As we stated elsewhere, these fringe benefits inflate Officer Compensation but are later deducted on the owners’ individual tax returns. We call this an “in and out” since the net change on the individual tax return is zero and the actual deduction takes place on the business tax return. But what about out-of-pocket medical expenses like co-pays, lab fees, prescriptions, etc.?
Health Reimbursement Arrangements (HRA) have been around since the 1960s and became very popular in the 1990s, but they recently went through a transformation as a result of the Affordable Care Act. The 21st Century Cures Act and H.R. 34 established the Qualified Small Employer HRA (QSEHRA, pronounced “Q Sarah” opposite of “Suzie Q”). Beginning in 2017, qualified businesses with fewer than 50 employees who did not offer group health plans could use a QSEHRA to reimburse for health insurance premiums and out-of-pocket medical expenses.
There is a catch! A greater than 2% shareholder of an S corporation cannot participate in a QSEHRA. They can, however, participate in a garden variety Section 105 HRA but still do not enjoy the income tax deduction of HRA reimbursements. Huh? If an S Corp reimburses a shareholder, that amount is added to Box 1 of the W-2 as Officer Compensation just like self-employed health insurance premiums and HSA contributions. The huge difference is that HRA reimbursements are not later deducted on the owners’ individual tax returns as they are with self-employed health insurance premiums and HSA contributions. Instead, they are reported on Schedule A as medical expenses subject to all the usual limitations.
There is still a savings however! As we will reiterate many times throughout the book, self-employed health insurance, HSA contributions and HRA reimbursements can be leveraged into providing a lower yet reasonable S Corp shareholder salary.
Let’s assume that data support an $80,000 Officer Compensation as reasonable.
As you can see, we are “building” Officer Compensation by adding wages, health insurance, HSA and HRA components together. How does this help?
Here is a quick table that illustrates how leveraging the non-salary components of Officer Compensation reduces Social Security and Medicare taxes-
Recall that earlier we determined $80,000 was considered a reasonable amount of Officer Compensation (of course, yours will vary). But because of other components, we were able to pay a salary of only $51,000. This $29,000 reduction in salary saved $4,437 in Social Security and Medicare taxes. In the absence of other components, we would have had to pay $80,000 in wages. Yuck.
Back to the HRA. In our example, the S Corp reimbursed $10,000 in out-of-pocket medical expenses. Unlike self-employed health insurance and HSA contributions, there is not an income tax savings, but there is a Social Security and Medicare tax savings as you see above. Specifically, $10,000 x 15.3% or $1,530 was saved by having an HRA.
TASC charges $475 for HRA plan administration (2019 rates). As such, an HRA in this example put a $1,000 in your pocket. Not too shabby for very little effort.
How could we get an income tax deduction using an HRA? Good question. That is where a C corporation comes into play. A C Corp is not a pass-thru entity and therefore it does not have to worry about the greater than 2% shareholder rules that S Corps face. Therefore, a small business owner could set up a C Corp that offers services to an S Corp in a business to business transaction, and then pays medical bills on behalf of the C Corp employee(s). The S Corp’s income would naturally be reduced by the fees paid to the C Corp which would have a double benefit; lower income taxes and a possibly reduced shareholder salary.
You would need a business purpose for the C corporation such as providing marketing or management services. To buttress this, you could identify certain expenses to be paid from the C Corp. For example, you would pay for web hosting, SEO services and other marketing expenses from the C corporation, plus the medical expenses.
The savings might be significant. TASC boasts a 20% add-on to your marginal tax rate; this 20% seemingly represents the Social Security, Medicare and state income tax savings added to your Federal marginal income tax rate. We don’t necessarily agree since the Social Security and Medicare component is already available with an HRA used with a standalone S corporation. But… if we play along… if you spent $10,000 in out-of-pocket medical expenses at a combined marginal tax rate of 30% (24% + 6% for state), then you save $3,000 by using the C corporation entity structure. An additional tax return would be required at around $800 so you pocket $2,200.
If you have $20,000 in annual medical expenses then your savings would be $6,000. Those are real dollars.
What about audits? C Corps with under $250,000 in assets have a 0.5% audit rate and S Corps have a 0.4% audit rate. Individual tax returns with a small business are upwards to 2%, and even higher with travel, meals and auto expenses (the low hanging IRS fruit). As a side note, if your C corporation has $20B in assets you audit rate in 2017 was 58%.
More discussion is required to ensure the C Corp idea fits your objectives, but you can see the basic arrangement.
Taxpayer's Comprehensive Guide to LLCs and S Corps : 2019 Edition