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Section 105 MERP Plans for the Self-Employed

What is a Section 105 MERP?

A Section 105 MERP for the self-employed can reduce the high cost of health insurance and out-of-pocket medical expenses is to establish a Section 105 MERP plan. Section 105 MERP plans are Medical Expense Reimbursement Plans (MERPs) that allow you to save substantial tax dollars on insurance premiums and out-of-pocket medical expenses not covered by insurance.

Section 105 MERP plans are designed specifically for small business owners that legitimately employee their spouse. Because the spouse/employee can be reimbursed for family expenses the employer indirectly benefits as well. This type of plan is made possible by Section 105 of the Internal Revenue Code, Revenue Ruling 71-588 and IRS Letter Ruling 9409006.

For C corporation owners it will not be necessary to use the spouse/employee method. The corporation becomes the employer and the owner is an employee as long as they are an employee receiving a regular paycheck.

Section 105 of the Internal Revenue Code has been around since 1954. Soon thereafter Section 105 plans gained popularity in the agricultural industry as farmers utilized the plans to provide these tax deductions to their family members employed on the farm. Today Section 105 MERP plans are widely accepted with over 50,000 small business owners taking advantage of the tax deduction. Average tax savings are approximately $3,500 per year. Savings may be more or less depending on the amount of deductions.

Who Can Participate

Section 105 MERP plans are best suited for employees of sole proprietors, corporations, limited liability companies, and partnerships. Business owners generally can't participate in a Section 105 MERP plan. This is why the spouse/employee approach has become so popular. However, C corporation owners may participate as long as they're receiving a regular paycheck as an employee.

Aren't These Expenses Already Deductible by the Self-Employed?

Good question. The answer is yes, however the deductions are limited as outlined below.

Self-Employed Health Insurance Deductions without a Section 105 MERP.

Effective in 2003 and thereafter 100% of health insurance premiums became tax deductible for the self-employed. The self-employed can take this deduction whether they itemize or not. However, most people are unaware that the 100% health insurance deduction only affects income tax and does not reduce income when calculating Social Security taxes (Self-Employment Tax). The 15.3% Self-Employment tax is still paid on insurance premiums. If an employer elects to establish a Section 105 MERP for a spouse/employee the Social Security taxes are eliminated for the employee as well as the employer. The Section 105 MERP allows employers to take this additional 15.3% deduction.

Self-Employed Medical Expense Deductions without a Section 105 MERP

Medical expenses are already tax deductible for the self-employed, aren't they? Yes, they are, if they itemize deductions, however, they can only write-off medical expenses that are in excess of 7.5% of Adjusted Gross Income (AGI).

Example: If AGI is $50,000 and you have $5,000 in out-of-pocket medical expenses, you can only deduct $1,250 ($50,000 X .075 = $3,750, and $5,000 - $3,750 = $1,250). With a spouse/employee Section 105 MERP, the employer can deduct the entire $5,000 as a business expense.

Establishing a Section 105 MERP And Employ Your Spouse

Care must be taken when establishing a Section 105 MERP to ensure that a legitimate employer/employee relationship exists with the family member. In 1999 the IRS Industry Specialization Program offered a coordinated issue paper regarding Section 105 and the spouse/employee issue that said:

"The extent and nature of a spouse's involvement in the business operations is critical. Although, part-time work does not negate employee status, the performance of nominal or insignificant services that have no economic substance or independent significance may be challenged. Merely calling a spouse an "employee" is not sufficient to qualify a non-working spouse as an employee".

The question is, does the spouse provide meaningful services to the company, and would the employer have to hire someone else to provide the same services if the spouse was not available for employment? If the answer is yes, then you qualify to establish a Section 105 MERP plan for your spouse.

How To Establish a Section 105 MERP and Employ Your Spouse?

You will need a 1) a Resolution, 2) a Plan Document, 3) a Summary Plan Description, and 4) proper Forms.

When hiring your spouse you need a formal hiring process that should include the completion of a standard Employment Application, W-4 form, and an I-9 form. It's important to have a job description outlining the duties and responsibilities of the spouse employee, plus details of the total compensation package.

Next, and very important, is developing a reasonable compensation for the services provided. Some factors to consider would be wages paid for similar services, experience, qualifications, complexity of the job, and responsibilities. Once you've established a reasonable wage, then determine which insurance and medical expenses that can be deducted. The difference is the reasonable salary that should be set up on a systematic payroll either bi-weekly, monthly or quarterly.

Notify your health insurance carrier that you will be changing the name of the primary policyholder to the spouse/employee.
Your spouse should set up a separate checking account to deposit earnings and medical expenses you've reimbursed. The paycheck and the medical expense reimbursements should be in the employee's name and deposited into their individual or joint account. Don't deposit payroll checks into the business account.
You should keep records of the hours worked and jobs performed for all employees.

 

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Information is provided for review and consideration only. Please consult legal and tax advisors for practical advice pertaining to your business and personal situations.

This page was last reviewed and/or updated on Friday, July 03, 2015 05:21 PM

 

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