As a general rule, self-employed people may deduct 100% of their health insurance premiums for themselves, spouses and dependents as an above-the-line deduction from gross income. To receive the deduction you must show a profit on your Schedule C.
A tax planning technique may be available to you if you employ your spouse. Two recent Coordinated Issue Papers outline these ideas, and the IRS has acknowledged their legitimacy.
As a sole proprietor, you have always received a 100% business deduction for furnishing medical fringe benefits to your employees. In “approving” spousal employment with medical fringe benefits, the IRS mentioned the following important conditions:
- The employee-spouse must be a bona fide employee under common law rules.
- A spouse would not be an employee if the facts indicate that the spouse is self-employed and engaged in the same business as a joint owner, as might be the case if there is a significant investment of the spouse’s separate funds in the business or significant co-ownership of assets.
- The health insurance policy must be purchased in the name of the employee-spouse.
A partner can also take advantage of this arrangement if the partnership sponsors the plan and provides family coverage for its employees, including the partner’s spouse who cannot be a direct partner. This is not available to S-Corp owners who hold more than 2% of the corporate stock, as the attribution rules for S-Corps treat spouses as owning the same shares.
If the plan is structured to cover the employee’s family and dependents, the sole proprietor can achieve coverage by having the employee-spouse be the covered employee.
The key is that the spouse of the sole proprietor must be a bona fide employee of the business. The importance of this requirement was tested in a 2000 tax court decision [TC Memo 2001-7 (2000)]:
The taxpayer maintained a law office from his home. The wife answered the phone, greeted clients and cleaned the offices, as well as the house. The taxpayer decided to start paying her a salary. But rather than pay her based on the hours worked or services performed, he based the amount on the maximum amount an individual could deduct for an IRA contribution – $2,000 per year. Further, rather than paying the $2,000 to her, he directly deposited the funds in her IRA account.
The Tax Court found that the spouse did not provide services as the taxpayer’s employee during the years in issue:
- The spouse did not testify regarding the extent or nature of any services she rendered in connection with the taxpayer’s law practice, and the record contained no specific or convincing evidence on the clerical or secretarial services she actually performed. The record was “devoid of credible evidence establishing that Mrs. H performed any services other than those reasonably expected of a family member.”
- Except for one year, the taxpayer did not issue the spouse a Form W-2.
- The taxpayer did not pay the spouse “wages” on a regular or normal basis nor did he pay those wages directly to her.
- The taxpayer determined the spouse’s “purported salary” on the basis of her maximum allowable IRA deduction.
If properly arranged, a sole proprietor can deduct 100% of the health insurance costs as a business expense and the employee-spouse will receive a tax-free benefit. Keep in mind that the spouse must be a bona fide employee of the business and must provide services for which the compensation and fringe benefits represent reasonable compensation. While part-time work may justify employee status, the performance of nominal or insignificant services that have no economic substance will be challenged.
If you would like any further information regarding this issue as well as any other tax related issue, please contact Henssler Financial at 770-429-9166 or [email protected].