I’m Darrin Mish. Tampa tax attorney, 32 years in, more than $100 million in IRS debt resolved. What follows isn’t theory – it’s what I’ve actually watched work.
If you run a small business and your spouse helps out – even part-time – you might be sitting on one of the most powerful tax deductions available to business owners. I am talking about the Section 105 Health Reimbursement Arrangement, and it can turn your entire family’s medical expenses into a fully deductible business expense.
But there is a question that comes up constantly: does your spouse actually need to be on a W-2 for this to work?
The short answer is no, a W-2 is not strictly required. The longer answer is that issuing one might save you a lot of headaches. Let me explain.
What Is a Section 105 HRA and Why Should You Care?
Under IRC Section 105(b), an employer can reimburse an employee’s medical expenses on a tax-free basis. The employer gets a full deduction under Section 162(a). The employee does not include the reimbursement in income. Everybody wins.
Now here is the play. You hire your spouse as a bona fide employee of your sole proprietorship. You establish a Section 105 HRA plan that covers the employee and their family. Since you are your spouse’s family, the plan reimburses medical expenses for both of you – and your children.
Health insurance premiums, dental work, vision care, prescription medications, copays, deductibles, long-term care insurance – all of it becomes a deductible business expense. We are talking about potentially tens of thousands of dollars per year in deductions that most business owners leave on the table.
The W-2 Question: What the Law Actually Says
Here is what trips people up. The IRS does not specifically require a W-2 wage for a Section 105 plan to be valid. The legal requirement is that your spouse must be a bona fide employee performing real work for your business. How you compensate that work – hourly wages, salary, or solely through the 105 reimbursement – is technically up to you.
But there is a practical reality that matters more than the technical rules.
When the IRS audits a spouse-employee arrangement – and they do – the first thing they look at is whether the employment relationship is real. A W-2 creates an immediate paper trail of employee status. It tells the auditor right away that you treated this person as an employee, withheld taxes, paid FICA, and reported it all properly.
Without a W-2, you are asking the auditor to take your word for it. And in my experience, IRS auditors are not in the business of taking anyone’s word for anything.
The Shellito Case: A Cautionary Tale
The case that illustrates this best is Shellito v. Commissioner, decided by the Tenth Circuit Court of Appeals. Milo and Sharlyn Shellito set up a Section 105 plan where Sharlyn, as spouse-employee, received only medical reimbursements – no W-2 wages.
The Tax Court initially denied their deductions. Why? Because the reimbursements were paid from a joint checking account and deposited back into the same joint checking account. The court said the money was just going in a circle.
The Tenth Circuit reversed that decision and ruled in the Shellitos’ favor, finding that a proper employment relationship did exist. But the case went all the way to a federal appellate court before they won. That is years of litigation and significant legal fees – all because the arrangement lacked the clean documentation that a W-2 and separate bank account would have provided from day one.
The lesson from Shellito is not that you can skip the W-2. The lesson is that the closer you get to a clean, well-documented arrangement, the less likely you are to spend years in court defending it.
My Recommendation: Issue a Small W-2
Here is what I tell my clients. Issue your spouse a modest W-2 – even $1,000 to $3,000 per year is enough. Yes, you will pay FICA taxes on that amount. At 15.3% combined (employer and employee shares), a $2,000 W-2 costs you $306 in FICA taxes.
In exchange, you get bulletproof audit protection for a Section 105 plan that might be reimbursing $15,000, $25,000, or even $40,000 per year in medical expenses. That is a phenomenal return on a $306 investment.
Think of the W-2 as an insurance policy. You are paying a small premium to protect a very large deduction.
Setting Up the 105 HRA Correctly
The plan itself needs to be done right, or none of this works. Here are the requirements.
Written plan document. You need a formal, written Section 105 plan. This is not optional. The plan document should describe who is eligible, what expenses are covered, reimbursement procedures, and plan administration. You can find templates online, but having a tax professional review your plan document is worth every penny.
Bona fide employment. Your spouse must perform real, meaningful work for your business. Answering phones, managing appointments, bookkeeping, inventory management, customer service – these all qualify. “General consulting” where your spouse does nothing does not qualify and will not survive an audit.
Separate bank accounts. This is the Shellito lesson. Never reimburse medical expenses from a joint account back to the same joint account. Use a separate business account to pay reimbursements into your spouse’s individual account. The money needs to move in one direction, and the accounts need to be distinct.
Documentation of expenses. Keep receipts, EOBs (Explanation of Benefits), and records of every medical expense that gets reimbursed. The plan should have a formal claim and reimbursement process – your spouse submits a claim, you (as the employer) approve it and issue the reimbursement.
Consistency. Administer the plan consistently from year to year. Do not set it up in December to reimburse a full year of expenses retroactively. Start the plan, follow the procedures, and keep records throughout the year.
What Expenses Can the 105 HRA Cover?
This is where the deduction gets powerful. Under IRC Section 213(d), qualified medical expenses include a very broad range of costs. Here is what your 105 HRA can reimburse tax-free:
Health insurance premiums for your spouse and their family (that includes you). Dental insurance and out-of-pocket dental work. Vision insurance, exams, glasses, and contacts. Prescription medications. Copays and deductibles for any medical care. Mental health services and counseling. Chiropractic care. Physical therapy and rehabilitation. Long-term care insurance premiums (subject to age-based limits). Medical equipment and supplies. Lab work, imaging, and diagnostic testing. Mileage to and from medical appointments at the IRS medical mileage rate.
There is no dollar cap on Section 105 reimbursements for expenses defined under Section 213(d). If your family has $35,000 in qualifying medical expenses and your plan covers them, you can reimburse all $35,000 tax-free.
The Math That Makes This a No-Brainer
Let me run through a typical scenario. A sole proprietor and spouse have the following annual medical costs: health insurance premiums of $18,000, dental work of $3,500, prescription medications of $2,400, and various copays and deductibles totaling $1,600. Grand total: $25,500.
Without a 105 HRA, these are personal expenses. The business owner might deduct the health insurance premiums on Schedule 1, but dental, prescriptions, copays, and deductibles? Those only get deducted on Schedule A if they exceed 7.5% of adjusted gross income. For a business owner making $250,000, that means the first $18,750 in medical expenses gets you nothing. Most of those costs just disappear into the void.
With a properly structured 105 HRA: every dollar of that $25,500 is a deductible business expense on Schedule C. At a 32% marginal tax rate, that is $8,160 in federal income tax savings. Add self-employment tax savings of roughly $3,600 and potential state tax savings, and you could easily be looking at $12,000 or more per year in total tax reduction.
The cost? A $2,000 W-2 for your spouse generates about $306 in FICA taxes. You spend $306 to save $12,000. I do not know a better return than that in all of tax planning.
Common Mistakes That Kill the Deduction
I have seen these mistakes sink spouse-employee 105 HRA arrangements in audit after audit.
No evidence of actual work. The spouse is on the books but cannot describe what they do for the business. Keep a simple job description on file and maintain some form of work documentation – even a brief weekly log is better than nothing.
Joint account reimbursements. Money goes from joint checking to joint checking. The IRS sees this as no economic substance – no real transaction occurred. Use separate accounts. Every time.
No written plan. An informal verbal agreement is not a plan. The IRS requires a written document that establishes the HRA, and they will ask for it during an audit. If you cannot produce it, the deduction is gone.
Reimbursing non-qualifying expenses. Cosmetic surgery (unless medically necessary), gym memberships (without a doctor’s prescription), over-the-counter supplements, and spa treatments generally do not qualify under Section 213(d). Know what qualifies and stick to it.
Wrong entity structure. This strategy works best for sole proprietorships and single-member LLCs taxed as sole proprietorships. If your business is an S-Corp and you own more than 2% of the stock, the rules change significantly. C-Corps have their own set of rules. Make sure your entity structure supports this arrangement before you invest time setting it up.
No substantiation of medical expenses. You cannot just estimate your medical expenses and reimburse a round number. Each reimbursement needs to be supported by a receipt, EOB, or other documentation showing the date of service, provider, amount, and nature of the expense.
Get Help Now
If you are a business owner paying for health insurance and medical expenses out of pocket, you might be leaving thousands of dollars on the table every year. A properly structured spouse-employee 105-HRA arrangement can change that. Contact the Law Offices of Darrin T. Mish, P.A. at (813) 229-7100 for a free consultation.