Tax break for self-employeds.

Self-employed individuals have recently gotten nothing but bad news from the IRS. First, the Service practically eliminated the home office deduction with Rev. Rul. 94-24. Then, in Rev. Rul. 94-47, the IRS eliminated the deductibility of work-related daily transportation expenses for taxpayers working out of a home office. Since a taxpayer may no longer have a home office, the Service now says this mileage is commuting. Finally, the selfemployed deduction for 25% of medical insurance expense expired in Dec. 31, 1993 (Sec. 162(1)(6)).

There is some good news, however. In Letter Ruling (TAM) 9409006, the IRS gave selfemployed individuals a tax break when it approved a 100% medical reimbursement plan for a sole proprietor whose spouse was the only employee of the business. A sole proprietor can pay the medical expenses of his employees and their dependents and claim the medical expenses as business deductions. If the spouse is a bona fide employee, even if the only one, a sole proprietor can pay the medical expenses of his spousal employee and dependents. The medical expenses are deductible on Schedule C, which saves both income tax and self-employment tax. The benefits received are tax free.

In the ruling, amounts paid for medical benefits by a sole proprietor to cover a spouse--a bona fide employee of the business--were excludible from the spouse's income as a nontaxable fringe benefit under Sec. 105(b), and deductible as a business expense on the sole proprietor's Schedule C as an ordinary and necessary business expense under Sec. 162(a).

The amounts that may be included in this tax break are those that would be deductible as a medical deduction under Sec. 213(d). This includes amounts paid for the diagnosis, cure, mitigation, treatment or prevention of disease, or for affecting any structure or function of the body (Sec. 213(d)). While this is rather broad, medical deductions are confined to expenses paid to prevent or alleviate a physical or mental defect or illness (Regs. Sec. 1.213-1(e)(ii)). This obviously includes all insurance premiums, deductibles, copayments and any reimbursed medical expense that meets the IRS test.

Example: Husband H and wife W have two children. They file a joint income tax return. H is a plumber operating as a sole proprietorship. He reports his income on Schedule C. H hires W as his first and only employee, and covers her and her dependents (H and the kids) with a 100% medical reimbursement plan. During the year, H spends $25,000 on insurance premiums, deductibles and payments for dental care, nursing services and prescribed drugs. The entire $25,000 is deducted on H's Schedule C.

While a letter ruling may not be used as precedent, the main tax principles underlying Letter Ruling 9409006 have been previously approved. Rev. Rul. 71-588 held that amounts reimbursed under an accident and health plan covering all bona fide employees and their families, including the owner's spouse, were not included in the employee's gross income and were deductible by the owner as business expenses.

Some key points to getting this tax break:

1. Document the employment relationship with a spouse, including:

* Employment contract.

* Hourly rate.

* Hours worked.

* Payment of social security, Medicare and unemployment taxes.

* Preparation of appropriate payroll forms and tax returns.

2. The plan may not discriminate if there are employees besides the spouse (Regs. Sec. 1.105-11):

* The plan should be in writing.

* Covered employees may be anyone who works more than 35 hours a week for nine months a year, or any lesser amount desired (Regs. Sec. 1.105-11(c)(2)(B)(iii)).

* Document what is covered under the plan.

* Document the inclusion or exclusion of all employees, with employees' acknowledgment as to determination.