A common piece of advice that gets thrown out to sole proprietors is to hire their spouse and form a health reimbursement arrangement.
This way, medical expenses can be run through the spouse and become deductible business expenses.
Is this always the best advice?
Brief Overview of HRAs
Tax law is not kind to sole proprietors when it comes to medical expenses. Insurance premiums of the proprietor are generally deductible on the front side of the proprietor’s personal tax return. This is better than claiming those premiums as an itemized deduction, but not as good as claiming the premiums as a business expense.
The reason is: self-employment tax. A front-side deduction on the personal return reduces income tax, but not self-employment tax. A deduction on the business tax return reduces both income tax and self-employment tax.
Other medical expenses (such as co-pays, deductibles, prescription drugs) are deductible only as itemized deductions, which is even worse because medical expenses must exceed 10% of a taxpayer’s income in order to be deductible.
With an HRA, the proprietor hires his or her spouse and creates an HRA to cover the spouse (proprietors themselves are not eligible to participate in an HRA).
All medical expenses get run through the spouse, who gets reimbursed by the proprietorship via the HRA. Those reimbursements are deductible as a business expense, which results in a reduction of both income taxes and self-employment taxes.
Is This Always a Good Strategy?
HRAs for sole proprietors are often a good strategy for maximizing the tax benefits of medical expenses.
But not always. I’ll explain in Part 2.
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