As demonstrated in Part 1, employees get a better deal than self-employed individuals when it comes to tax breaks for health care expenses. As an example, we looked at two women who had the same amount of income and who paid exactly the same amount for health insurance. Esther, an employee, saved $1959 in taxes (and her employer saved an addition $459); Belén, a self-employed individual, saved only $1500.
In Part 3, I said that in some cases an individual might benefit from converting her business to a C-corporation. (Recall that the Tax Code uses a broad definition "self-employed"; in addition to sole proprietors, the category includes partners of partnerships, members of LLC´s taxed as partnerships, S-corporations or disregarded entities, and shareholders of S-corporations).
Suppose Belén´s family routinely has high out-of-pocket medical expenses. Two years ago, when Belén´s business was not yet making much money, her husband Brad lost his job. The family had been living on a tight budget already and they´d used their savings to get Belén´s business going. While they could have kept their coverage through Brad´s employer under the COBRA rules, they’d have been responsible for paying the premiums, but they could not afford the extra expense. Anyway, they expected to be without insurance only for a short time, until Brad found a new job.
Tragically, Brad was seriously injured on his way to a job interview. The driver of a tractor-trailer failed to notice a red light in time to stop. The huge truck plowed over Brad´s car as though it were an aluminum can. Miraculously, Brad survived, but he will have to endure chronic pain in his neck, lower back, and legs for the rest of his life. The trucking company´s insurance paid for the medical expenses Brad incurred immediately after the accident and for a limited amount of physical therapy. After that, Brad was on his own. The family moved to a less expensive house so they could afford to pay for the cost of Brad´s medical care. Belén purchased health insurance at that time, but treatment of Brad´s injuries was not covered fully covered, because the injuries were a "pre-existing condition."
In addition to the $6000 paid for premiums in 2006, the family will have to pay approximately $19,000 in unreimbursed out-of-pocket medical expenses. These expenses are not deductible as a business expense on Belén´s Schedule C. She can take them as an itemized deduction but will lose $6225 because of the threshold of 7.5% of adjusted gross income. Worse still, like the $6000 in premiums, the $19,000 out-of-pocket costs will be subject to the 15.3% self-employment tax.
If Belén were to incorporate her business, she would become an employee. That would permit her to establish a section 105 medical reimbursement plan. With the plan in place, the corporation can reimburse Belén for the $19,000 spent on Brad´s treatment. She can even include the costs of non-prescription medications purchased to treat specific medical conditions, such as Brad´s chronic pain. In addition, of course, the corporation can pay health insurance premiums for Belén and her family. Belén and her corporation will now have the same $2418 in tax savings ($1959 + 459) as Esther and Esther´s employer. Belén´s additional tax savings for the year, as a result of incorporating her business, would be $918 on the insurance premiums and $4563 for the out-of-pocket expenses. This is a total of $5418 more than Belén could deduct if she remained a sole proprietor.
Caution: Converting a sole proprietorship, LLC, partnership, or S-corporation to a C-corporation is not something you´d want to do without the help of a tax professional. The law in this area is complex, and, if the conversion is not done right, you could end up losing money rather than getting the savings you had anticipated.