HRAs are often — but not always — a good strategy for sole proprietors. Here are some numbers that lay it out.

Assumptions

• John is a sole proprietor with \$135,000 of net income from his proprietorship
• His wife Joan does not work outside the home and has no income
• Insurance premiums total \$5,000, and they have another \$1,000 of other medical expenses
• Their itemized deductions total \$25,000
• Assume that John wants to be a sole proprietor and that incorporation is not on the table
• For the sake of this example, let’s also assume that John has no interest in funding a SEP or other type of retirement plan

Without an HRA

Self-employment tax calculations:

• \$135,000 x .9235 = \$124,673
• \$124,673 x .029 = \$3,616 Medicare self-employment tax owed
• \$3,616 + \$14,508 Social Security self-employment tax owed = \$18,124 total self-employment tax owed
• \$18,124 x .5 = \$9,062 front-side deduction for self-employment taxes

• *\$14,508 is the maximum amount of Social Security tax that can be assessed (using 2014 figures). \$117,000 maximum Social Security wage base x .124 = \$14,508

AGI calculation

• \$135,000 net income from sole proprietorship – \$9,062 for SE tax – \$5,000 of insurance premiums = \$120,938 AGI

Tax calculation

• \$120,938 AGI – \$25,000 itemized deductions – \$7,900 personal exemptions (\$3,950 x 2) = \$88,038 taxable income
• Income tax on \$88,038 = \$13,722
• Plus self-employment tax of \$18,124 = \$31,846 total tax liability

With an HRA

Assume John pays Joan \$5,000 for her work. Assume that John pays his accountant \$500 for filing the payroll reports, and a third-party administrator \$250 to oversee the HRA.

Calculations relating to Joan’s salary:

• \$5,000 x .0765 = \$382.50 employer FICA taxes
• \$5,000 x .0765 = \$382.50 FICA taxes withheld from Joan’s wages

Self-employment income:

\$135,000 – \$5,000 salary to Joan – \$5,000 of insurance premiums paid through HRA – \$1,000 of other medical expenses paid through HRA – \$382.50 employer FICA taxes – \$500 payroll fees – \$250 TPA fee = \$122,868 net income.

Self-employment tax calculations:

• \$122,868 x .9235 = \$113,469
• \$113,469 x .153 = \$17,361 self-employment tax owed
• \$17,361 x .5 = \$8,681 front-side deduction for self-employment taxes

AGI Calculation

• Joan’s salary of \$5,000 + John’s self-employment income of \$122,868 – \$8,681 deduction for self-employment taxes = 119,187

Tax calculation

• \$119,187 AGI – \$25,000 itemized deductions – \$7,900 personal exemptions (\$3,950 x 2) = \$86,287 taxable income
• Income tax on \$86,287 = \$13,284
• Plus self-employment tax of \$17,361 = \$30,645 total tax liability

It appears that John and Joan will save nearly \$1,200 by using an HRA. But I think we need to take cash flow into consideration too. I’ll deal with that in Part 3.

Image courtesy of user jarmoluk on Pixabay.com

“This blog post, along with comments that may follow, should not be considered tax advice. Before you make final tax or financial decisions, please secure a professional tax advisor to give you advice about your unique situation. To secure Jason as your accountant, please click on the ‘Services’ link at the top of the page.”