Under Utilized Deductions
In this free tax strategy update, I limited how much free advice I would provide. Instead of just throwing a bunch of bullet points together, I decided to get into some specifics around two areas that are likely to save you real money – Business Travel and Healthcare. In future editions, I will discuss other areas based on feedback from my clients.
Business Travel Deductions
If travel occurs purely for business purposes, the travel expenses (including transportation, lodging, meals and reasonable entertainment) are either fully or partially deductible. Business meals and entertainment expenses are only 50% deductible, but almost every other travel related expense is fully deductible. Even if the travel includes both personal and business components, as long as the trip is primarily for business, the full cost of the trip is likely deductible.
The phrase, primarily for business is generally based on a 50% rule. For example, if you have meetings in Orlando for two days, and decide to stay an extra day to play golf or hit a theme park – you’ve spent 2/3 of the trip working and can deduct the entire trip. To be able to deduct the golf or theme park, you need to make sure that you are entertaining a current or prospective client or business partner.
In Flowers vs. Commissioner, the Supreme Court identified three requirements to deduct expenses for business travel:
- Expenses occurred away from home (preferably a different MSA);
- The expenses relate to the operation of your business;
- The expenses are necessary and the amount is reasonable.
Like all deductions, you must be able to defend any deduction to an IRS examiner, but determining reasonable travel expenditures takes into account the cost of the trip, the benefits received from the trip and the relative cost of the trip compared to the other expenses of the firm. A small coffee shop will have a harder time defending a global trip to visit different coffee shops to Japan than Starbucks.
If you combine business and personal travel but your trip isn’t primarily for business, you can’t deduct any of your transportation expenses. Furthermore, you can only deduct as travel expenses the amount you incur on days that are purely business.
Travel time (driving or flying) is excluded from the work-personal days formula. If you had three days of business and added two personal days, two days of traveling keeps the trip primarily business, but two days of travel, one business and two days personal would fail the test. However, many tax accountants extend the logic of IRS Letter Ruling 9237014, and advise clients that they can extend a stay over a weekend with the express purpose of getting cheaper airfare and lower hotel rates for an extended stay. In other words, the extension has to make economic sense.
You may also deduct travel expenses for family members if the family member is an employee and there’s a business reason for the person to be travelling. Traveling with a spouse who also works in the family business is usually deductible. A spouse who works for the business and drives you to a convention so that you can focus on work, can stay with you at the convention and typically have their expenses be deductible. Foreign travel expenses may also be deducted, but the rules are more restrictive. If you travel internationally and your trip lasts a week or less, the trip needs to be primarily (50%) for business in order to be fully deductible. For trips longer than a week, the trip needs to be more than 75% business in order to be fully deductible. In making your percentage calculation, you must include your travel days, weekend days and holidays. If you work the day before and the day after a weekend or holiday, then the weekend or holiday days count as business days, too.
It should be noted that excessive travel deductions are a sure ‘red-flag’ for IRS examiners. As with all deductions, it is important to do good planning and even better documentation. Keep a copy of your schedule, conference schedules and details that demonstrate that you have met the 50% rule for business. It’s one thing to take advantage of the rules as written, but you have to at least be able to demonstrate that you at least met the requirements of the law.
People often think you can easily deduct medical expenses as a personal tax deduction, but that usually doesn’t work. Taxpayers only get the deduction if they itemize–and only 35% of the population itemizes. But it gets worse because taxpayers who do itemize can only deduct medical expenditures in excess of 7.5% of their adjusted gross income (AGI).
If you own a small business you can much more easily deduct your healthcare expenses through the self-employed health insurance deduction and the health savings account option. If you run a one-person business, you can even double-deduct your healthcare expenses by using S corporations or a healthcare reimbursement arrangement.
The self-employed health insurance deduction works like this: If you’re self-employed as a sole proprietor, a working partner in a partnership, or a shareholder-employer who owns 2% or more of an S corporation, you can probably deduct your health insurance premiums on the first page of your 1040 tax return. In other words, your health insurance premiums probably become a tax deduction in their entirety.
There are a handful of rules for taking the self-employed health insurance deduction. You’ll need sole proprietorship profits, a partnership income share, or S corporation shareholder-employee wages at least equal to the self- employed health insurance deduction you want to take.
Another rule is that someone else, such as your spouse’s employer, cannot subsidize the health insurance. With partnerships, the health insurance needs to be a group health insurance policy paid for by the partnership. And with S corporations, the health insurance premiums either need to be paid directly by the S corporation or the S corporation needs to reimburse the shareholder-employee.
Health Savings Accounts
The self-employed health insurance deduction is a good deduction. But it doesn’t help out much with the stuff that’s not covered by your insurance: deductibles, copayments and so on. However, you can use another tax strategy to convert these costs into income tax deductions: the health savings account (HSA).
As long as your health insurance policy is prepared a specific way, you can contribute money to a special bank account called a “health savings account” or “HSA” and take an income tax deduction for the contribution.
In 2012, a single person can contribute $3,100 to the savings account and a family can contribute $6,250. If you’re 55 or older, you can add $1,000 to these values. Depending on the taxpayer’s top income tax rate, these contributions should save $1,000 to $2,000 a year in income taxes.
You can spend the money in your HSA on deductibles, copayments and most other “not covered by your health insurance” medical expenses. The only downside is that if you withdraw money from your HSA or spend the money on something other than healthcare before you’re age 65, you pay regular income taxes on the withdrawal and also a 20% additional tax.
To use the HSA, your health insurance policy must qualify as a high deductible health plan (HDHP). In a nutshell, a HDHP is a catastrophic health insurance policy that conforms to the rules that Congress created. To know whether a particular health insurance policy qualifies as a HDHP, you need to ask the insurance agent or insurance company.
With an HDHP, you get a self-employed health insurance deduction, thereby turning your health insurance into an income tax deduction. With an HSA account, you get a health savings account deduction, thereby turning your deductibles, copayments and other uncovered healthcare expenses into deductions. These deductions should save you thousands of dollars a year.
Double Deducting Healthcare Expenses
For many small business owners, the combination of a self-employed health insurance deduction and a health savings account will be the optimal solution. But some small business owners who employ only themselves or only family members may be able to do even better. These only-family-employee businesses may be able to deduct healthcare expenses as income tax deductions and employment tax deductions – a double deduction.
If you operate your business as an S corporation, treat health insurance premiums paid by the S corporation as wages. Treat any HSA contributions made by the corporation as shareholder-employee wages. When you do this, the health insurance and HSA amounts are reported on the shareholder-employee’s W-2 as wages subject to income taxes, but they aren’t reported as wages subject to Social Security and Medicare taxes. This means you save Social Security and Medicare taxes—the first deduction. When you later prepare your 1040 tax return, the health insurance and HSA amounts get treated as income tax deductions. This is the second deduction.
To get the double-deduction calculations to work right, you need to pay the shareholder-employee reasonable compensation. You must pay real wages at least equal to the wages that appear because the health insurance counts as wages.
S Corp Example – In order to double deduct $15,000 of self-employed health insurance and HSA contributions, the shareholder-employee should be paid another $15,000 in wages. The shareholder-employee’s total wages in this case would be $30,000 (the $15,000 in regular wages plus the $15,000 in health insurance and HSA contributions), but only the first $15,000, however, would be subject to Social Security or Medicare taxes.
An unincorporated one-person business run by someone who’s married has another way to double deduct: The owner can create a healthcare reimbursement arrangement (HRA), also known as a Sec. 105(b) plan, and then employ the spouse. The owner must set up an HRA for employees. The HRA says the business will pay $5,000 or $10,000 or $20,000 of any employee’s family healthcare expenses (including insurance). As the owner, you can’t be covered directly. However, when you hire your spouse, the HRA may provide coverage to your spouse-employee and to his or her family (which will include you).
If you set up an HRA, the healthcare expenses you reimburse become an employee fringe benefit expense on your business’s tax return. And that means you get the double deduction.
You save both income taxes and employment taxes.
One note of caution: the IRS tends to be pretty suspicious of sole proprietorship
Sec. 105(b) plans. You must ensure that your spouse’s job is real, well documented and paid at market rates. A one-hour a week job, for example, will not support a $20,000 a year HRA benefit.
Using HRAs and HSAs to get a double deduction doesn’t work as well for businesses with non-family-employees because you have to provide the HRA or HSA to all your employees. You can’t provide the benefit just to the owner or the owner’s spouse and kids. You can terminate a healthcare reimbursement arrangement. But terminating something like an HRA right before you hire a non-family-member employee probably violates the fringe benefit rules that say you can’t discriminate in favor of owners. A HRA works best for stable, two-employee husband-and-wife businesses.
If you or your spouse owns another business, that business needs to have the same HRA plan, too. You can’t create two businesses and have you and your spouse work in the “good fringe benefits” business. And then put all the employees into the “bad fringe benefits” business. That also violates the rules.
The healthcare legislation that became law in 2009 has minimal affect on healthcare deduction rules.
The most controversial aspects of the law affect businesses with over 50 employees.
If your firm employs fewer than 50 employees, you don’t have to offer insurance. The penalties for not offering insurance kick in when your head count rises above 50. If you employ 25 or fewer people and they earn minimum or modest wages, you can get a tax credit for the first two years you offer workers insurance. The credit runs as much as 35% to 50% of the insurance premiums you pay, but the calculations are tricky.
As a tax planning issue, most small businesses don’t need to get hung up on the politics around Obamacare. Focus on your business; let the politicians focus on the politics.