Beware of the Medical Expenses Trap!

 A great way to deduct your medical expenses through your business has been around since 1954, but hasn't garnered much publicity until about the last ten years or so.

A Medical Expense Reimbursement Plan (MERP), also known as a Health Reimbursement Account (HRA) can save a self-employed person several thousands of tax dollars each year, but if it's not documented properly can result in reclassification of the deducted expenses as wages (subject to 15.3% FICA taxes as well as income taxes), penalties, and interest.

In most cases, the average taxpayer cannot take advantage of the legal deduction for qualified medical expenses. First, you have to be able to "itemize" your deductions on Schedule A of your 1040. This means that for 2008, things like your state income taxes, property taxes on your house, value-based taxes on vehicles, and mortgage interest, and some other items, need to total up to more than $5450 if you're single or $10,900 if you're married. Once you've determined that you're close to clearing that hurdle, you need to total up your qualified medical expenses. But you're not finished yet: now the government wants you to REDUCE those medical expenses by 7.5% of your adjusted gross income (AGI). This means you'll take the total of all your wages, business income, interest and dividends, capital gains, retirement income, social security income, alimony, jury duty pay, etc., subtract out a few adjustment items such as alimony you paid, IRA contributions, student loan interest, self-employed health insurance, etc. and subtract 7.5% of THAT total from your qualified medical expenses. So, for example, if your total AGI is $50,000, then the first $3,750 of medical expenses don't even count as a deduction reimbursement of medical expenses!

Now, let's take a look at what happens if you have a qualified business and set up a Health Reimbursement Account. First, the $3,750 you couldn't deduct before becomes a business deduction. You don't have to adjust it by any percentages of AGI or any other number. This becomes a tax-free fringe benefit through your business. Second, as a deductible business expense, if you are a sole proprietor or farmer or other "flow-through" business, you have probably saved around $1050 in income taxes (assuming a 28% tax bracket.) Then, if you are a sole proprietor, farmer, or partner in a general partnership, you've just saved 15.3% self employment tax, or $547. If you're total medical expenses (including medical mileage for trips to the doctor, dentist, and pharmacy) are more than $3,750, your tax savings increase accordingly.

These plans are a great tool, but you have to have a legitimate business AND the plan MUST be properly documented. This is one of the areas that IRS reviews for abuse and incorrect procedures. If you do not follow the documentation requirements, that $3,750 in legal business expenses just turned into taxable wages, and added over $1,600 to your tax bill, plus interest and penalties. This is an expensive mistake for overlooking three simple documents: a plan adoption agreement, a plan summary, and an employer-employee agreement including job descriptions and compensation plan.

If you are self-employed or own your own business and are not taking advantage of an HSA, you are leaving money on the table that could help you personally and provide an incentive plan to attract and retain quality employees.