HRA Saves Thousands of Dollars in Tax Each Year for Small Business Owners

Small business owners save thousands of dollars every year by using Health Reimbursement Arrangements (HRAs).   The HRA allows business owners who are also employees in their business to deduct medical expenses as a business expense.  This is usually much more valuable than a personal tax deduction, which is frequently limited.  This tax planning idea reduces federal and state taxes, as well as self-employment taxes (sometimes called payroll taxes) for business owners.

In addition, the HRA is an attractive benefit to offer the other non-owner employees of a small business.  Importantly, HRAs provide significant flexibility and cost savings to the business.  In most cases, the HRA replaces the traditional group health insurance plan for small businesses.

Health Reimbursement Arrangement Basics

HRAs are based upon Section 105 of the Internal Revenue Code and are therefore sanctioned by the IRS.

A Health Reimbursement Arrangement, or HRA, enables the small business owner to deduct 100% of family medical expenses.   Typically, the most significant deductible expenses available with an HRA are family health insurance premiums.  In addition, the HRA provides deductions for the out-of-pocket medical, dental, and vision costs, as well as qualified long-term care insurance premiums, of the business owner and his or her family.

Reimbursement from an HRA is tax-free to the business owner and his or her family.  The same is true for all other employees in the business who are covered by the HRA.

An HRA is flexible.  Participating employees have the ability to select whichever health insurance plan they wish, either from the Marketplace or any other source.

The business decides the maximum amount of expenses that may be reimbursed per employee.  Specific types of HRAs allow for different levels of reimbursement in certain situations, which may limit costs for the employer.

HRA and Small Business Entity Types

To participate in an HRA, the business owner, or the spouse of the owner, must be an employee of the business.

Employment status of the business owner is determined by the legal structure of the business and marital status of the owner.   This can be complicated, but the following tax planning ideas offer ways for the business owner to utilize an HRA in various cases:

• If you are single, you will need to use a C corporation to pay yourself W-2 wages, plus an HRA as an employee benefit.   This can be an existing or a new C corporation.   Your other businesses can pay a leasing fee to the C corporation to use your services.  Most other entity types cannot use an HRA for a business owner who is single.
• If you are married, you can hire your spouse, or use an different LLC or sole proprietorship to hire your spouse, with an HRA as an employee benefit.  A married S corporation shareholder will always need to use a separate entity, such as a single member LLC, to provide the HRA.  The reason for this is that S Corporations may not provide an HRA to shareholders with over a 2% interest in the business.  This restriction includes family members of the S corporation shareholder.

Non-owner employees of a business may participate in the HRA however the entity is structured.

HRA Costs

An HRA comes with additional administrative costs.   Costs may include additional tax filings and annual fees to an HRA administration company.  These costs usually make sense when the family medical expenses of the business owner are at least $4,000 or more per year.

Example of Tax Savings for a Business Owner with an HRA

Sam runs a landscaping business as limited liability company (LLC).   Sam’s wife, Liz, provides a valuable service to the landscaping business by keeping the books, scheduling customers and billing.  Sam decides to formally employ Liz and take advantage of an HRA.   When establishing a compensation package for Liz, Sam evaluates her experience and the vital role she plays in the business.   Sam agrees to compensate Liz $19,000 per year in wages and benefits, as follows:

• $9,000 – reimbursed family health insurance premiums (fully deductible to the business and non-taxable to Liz)
• $5,800 – family out-of-pocket medical expenses (fully deductible to the business and non-taxable to Liz)
• $4,200 – W-2 wages (fully deductible to the business and taxable to Liz)

The $14,800 of reimbursed family health insurance premiums and out-of-pocket medical costs may now be deducted at 100 percent as an employee benefits expense.

The tax savings is calculated as follows:  $14,800 is multiplied by a 15% federal tax, a 5% state tax and a 15.3% self-employment tax.  The result is a tax savings of $5,224, per year.

HRA versus Deduction for Self-Employed Health Insurance Premiums

As mentioned above, an HRA may cover both the business owners, if the plan is structured correctly, and the non-owner employees of the business.

When evaluating options, consideration should also be given to the self-employed health insurance deduction.  This is particularly true if there are no other employees to cover, other than the business owner or spouse.

Self-employed individuals may be able to deduct premiums paid for medical, dental and qualifying long-term care insurance coverage for themselves, their spouse and their dependents.  This deduction is allowed whether or not the business owner itemizes deductions on Schedule A.  Also, the deduction cannot exceed the earned income from your business.  So there is no deduction if the business generates a loss.

Unlike the HRA, the self-employed health insurance deduction applies only to federal, state, and local income taxes, not to self-employment taxes.  And also unlike the HRA, the self-employed health insurance deduction does not include out-of-pocket medical expenses.

HRA versus S Corporation Owner Deduction for Health Insurance

Here too, consideration should be given to the S corporation owner deduction for health insurance when evaluating the benefit of an HRA for an S corporation.  This is particularly true if there are no other employees to cover, other than the business owner or spouse.

S corporations are prohibited from giving either tax-free health insurance or an HRA to shareholders who own more than 2% of the business.   As stated above, hiring a spouse through a separate LLC or sole proprietorship and providing that spouse with an HRA is an effective method to work around this restriction.

Alternatively, S corporation owners also have the option to take a personal income tax deduction on the health insurance premiums paid by the company.  To qualify, the S corporation must pay the owner’s insurance premium and include the premiums as gross wages on the owner’s Form W-2.   This must be communicated to your payroll company prior to year-end.  Premium payments may be made directly to the insurance company or the company may reimburse the owner.

The deduction is limited to the owner’s Social Security wages from the S corporation.

Contrary to an HRA, the S corporation owner deduction for health insurance does not include out-of-pocket medical expenses.

Health Reimbursement Arrangement – Next Steps

The HRA is terrific tool for a small business looking to provide health insurance benefits to both employees and business owners in a flexible and cost effective manner.

However, the rules get complicated quickly for business owners, depending on marital status and business entity type.  The best solution is to run the numbers using a “with and without” tax projection, based on your fact pattern to see what makes the most sense.  This calculation will consider:

• entity type
• marital status
• estimated medical costs
• health insurance premiums
• Federal and state income taxes
• self-employment taxes
• administrative costs
• number of employees

You are welcome to call our CPA office and request an HRA tax projection.  Our Tax Department provides tax planning and tax preparation services for clients in Atlanta, Chicago and throughout the country.  We look forward to assisting you with this potentially significant tax planning idea.

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