Section 105 Plans: A Tax-Smart Spousal Strategy

Are you married and run your family business as a sole proprietorship or single-member limited liability company treated as a sole proprietorship for federal tax purposes? If so, it can be a tax-smart move to hire your spouse as an employee and then pay most or all of your significant other's compensation from a medical expense reimbursement arrangement called a Section 105 plan.

Under this compensation strategy, you can claim business write-offs — on Schedule C of your Form 1040 — for the reimbursements paid under the Sec. 105 plan to your employee-spouse. Those payments can cover your family's health and dental insurance premiums, as well as out-of-pocket medical, dental and vision care expenses. This can be valuable because:

• Schedule C deductions lower your federal income tax bill and your self-employment tax bill,
• Sec. 105 plan reimbursements aren't subject to Social Security and Medicare taxes, and
• The reimbursements aren't subject to tax at the federal level to your employee-spouse because they're considered a tax-free fringe benefit.

How Much Compensation Can Be Paid Through a Sec. 105 Plan?

The IRS has stated that you may be able to provide your employee-spouse's total compensation in the form of Sec. 105 plan reimbursements, which could be the best of all worlds from a tax perspective. When that's the case, there's no need to provide your significant other with an annual Form W-2 wage statement or withhold or pay any federal payroll taxes.

In contrast, paying your spouse "regular" cash wages triggers the W-2 filing requirement, as well as Social Security and Medicare taxes. The wages also have to be reported as W-2 income earned by your employee-spouse, though that income would be neutralized on your joint return by the offsetting Schedule C wage deduction.

Naturally, the amount of compensation paid to your employee-spouse under this strategy must be reasonable in relation to the work performed for your family business. Therefore, your formally written Sec. 105 plan document should include a maximum annual reimbursement cap to prevent exceeding the reasonable compensation standard. At the same time, your employee-spouse's compensation shouldn't be ridiculously low either. Your tax advisor can help you decide whether you need to pay some cash wages if the Sec. 105 plan reimbursements aren't enough.

Important: If you decide to adopt this strategy, it's advisable to pay your employee-spouse's Sec. 105 plan reimbursements with checks drawn on a separate business account. That way, there's no blurring of the lines between business and personal expenses.

An Example of a Sec. 105 Plan in Action

In one case decided by the U.S. Tax Court, an individual operated a sole proprietorship daycare business and employed her husband on a part-time basis. His entire compensation was in the form of Sec. 105 plan reimbursements. The compensation arrangement was supported by written documents signed by the proprietor and her husband. The plan specified that reimbursements would be limited to no more than $6,500 annually. For the two tax years in question, the wife's Schedule C reported deductible reimbursements of $3,279 and $4,539, respectively.

In spite of the good documentation, the IRS disallowed the write-offs. The tax agency claimed:

• The Sec. 105 plan wasn't set up properly,
• The husband wasn't a legitimate employee of his wife's daycare business,
• The Sec. 105 plan reimbursements weren't an "ordinary and necessary" business expense of the daycare business, and
• The reimbursements weren't reasonable compensation for the husband's duties.

The verdict? The IRS lost on all counts. The defendants planned wisely and, in the end, won their case. (Source: Speltz v. Commissioner, Tax Court Summary Opinion 2006‑25.)

Five Smart Steps for a Successful Sec. 105 Plan

Rather than going into all the details behind the Tax Court's decision in favor of the taxpayers, let's look at what the husband and wife did right in the case above. They're the same things that you should do to successfully implement a tax-smart Sec. 105 plan compensation strategy:

1. ‍Establish an employment agreement. The proprietor and the employee-spouse entered into a formal employment agreement describing the husband's job duties. The court found the employee-spouse was clearly qualified to perform the work assigned.‍
2. Put the plan in writing. The Sec.105 plan was also put in writing, and reimbursements from the plan were designated as a form of compensation for the employee-spouse. (They were the only form of compensation in this case.)‍
3. Document labor hours. It was further established in writing that the employee-spouse would work a certain number of hours per week on average. Those hours were properly documented with written records. (Tip: It's a good idea to require employee-spouses to turn in weekly time sheets.)‍
4. Set compensation limits. There was an annual cap on reimbursements from the Sec. 105 plan, and the actual reimbursements paid to the employee-spouse weren't excessive compensation for the work performed.‍
5. Keep records of medical expenses, too. The employee-spouse turned in adequate evidence for the medical expenses that were reimbursed to him under the Sec.105 plan.

Conclusion: Having done all of these things, there was essentially no chance the taxpayers would lose — and they didn't. If interested and eligible, talk with your tax advisor about implementing a Sec. 105 plan for your family business.