How To Deduct Medical Expenses: A Primer For The Self-Employed

    March 5, 2004

It’s been said that there are Two Sets of Tax Rules: one for employees and one for the self-employed. When it comes to the deductibility of medical expenses, this is certainly the case.

Here’s an overview of why self-employed folks have a better chance of deducting medical expenses than employees.

First, let’s review the plight of the employed.

For W-2 types, medical expenses are not only difficult to pay for, they are even more difficult to deduct.

To deduct medical expenses, you have to itemize deductions. And with the standard deduction now at $9,500 for marrieds, $7,000 for heads of household, and $4,750 for singles, most don’t have enough deductions to itemize.

And if you don’t itemize, you don’t get to deduct your medical expenses. Sorry!

And even if you do itemize, medical expenses are only deductible to the extent they exceed 7.5% of your Adjusted Gross Income — giving you a second hurdle to overcome.

Here’s an example to illustrate:

Let’s say you and your spouse earn $75,000 as W-2 employees. You have a mortgage and so you have enough deductions to itemize. Even though Line 1 of Schedule A has a place for medical expenses, you don’t get to write off any of them because of the 7.5% rule mentioned above.

You have to do this calculation first:

$75,000 x 7.5% = $5,625

Now, focus on the $5,625 number. Why is that so important?

Because the rules say that your medical expenses are only deductible to the extent they exceed $5,625. In other words, your first $5,625 of medical expenses are (drum roll) . . . NON-deductible!

If you have $6,000 of medical expenses, you only get to deduct $375 of them.

Let’s say you had $5,624 of medical expenses. Sorry, your deduction is a big fat zero.

Kind of depressing, isn’t it?

Now let’s look at two strategies for small biz owners and the self-employed to deduct their medical expenses.

STRATEGY #1: How To Deduct 100% of Your Health Insurance Premiums

Self-employeds can now deduct 100% of their health insurance premiums on Form 1040, Line 29 — whether or not you itemize deductions!

For Sole Proprietors, this deduction is limited to your Schedule C profit minus the deductions for Self-Employment tax and Retirement Plans (like a Keogh, SEP or SIMPLE Plan).

So you must have been profitable to take this deduction, and your profit (less the deductions mentioned above) must be greater than your health insurance premium in order for you to get the entire deduction.

Owners of “S” Corporations, Partnerships and LLC’s can take this deduction, too — again, whether or not you itemize on Schedule A.

Not bad, eh?

This is truly a nice tax break for the self-employed.

STRATEGY #2: How To Deduct 100% of All Other Medical Expenses

Here’s where things get a little bit trickier.

One option is to establish what’s known as a “Medical Reimbursement Plan” (MRP) for your small business or self-employment activity.

The ideal scenario for this strategy requires that the Sole Proprietor’s spouse be hired as an employee of the business. The business then reimburses the employee for all medical expenses incurred by the employee and his/her family — and, of course, the Sole Proprietor just happens to be a member of the employee’s family!

End result: ALL medical expenses now become a legitimate business expense. The reimbursement is deducted by the Sole Proprietor on Schedule C, and it is NOT considered income to the employee.

Two important caveats to note: First, since the Sole Proprietor is never considered an employee of the business, the Sole Proprietor must employ his/her spouse in the business for this to work.

Second, the MRP must be offered to all full-time employees of the business. So, if you have other full-time employees (especially non-family ones), then you may not want to put yourself in the position of being required to pay for their medical expenses.

Part-time employees can be excluded from the MRP, so you do have some flexibility here.

The MRP is perfect for some, and just plain impractical for others. For example, what if you are single? Without a spouse (or other immediate family member) to hire as an employee, you are out of luck.

Or maybe you are married, but employing your spouse isn’t practical, especially if the spouse already has a full-time job (and/or has no desire to work for you!)

One solution is to form a corporation.

A regular corporation (also known as a “C” Corporation) works really well for this purpose. If you are a one-person business, you can be the only employee of the corporation and implement the MRP.

Other entities can also implement a MRP, but if you think you have a situation for which a MRP would be applicable, be sure to consult with your tax professional to get details on how to set one up. The MRP must be established according to strict rules of both the tax code and the Department of Labor.

If you’re going to create a MRP, be sure to do it right! Get help from a professional if necessary. For many self-employeds, the cost of creating a MRP is well worth it.

Let’s assume your total tax rate is 35% (15% federal income tax plus 15% self-employment tax plus 5% state income tax). For every $1,000 of currently non- deductible medical expenses, you’ll save $350 by setting up a MRP — another great way for the self- employed to save on taxes.

Wayne M. Davies is author of 3 tax-slashing
eBooks for small business owners and the self-employed. For a
free copy of Wayne’s 25-page report, “How To Instantly Double
Your Deductions” visit