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