The HRA (Health Reimbursement Arrangement) Strategy: Deducting Medical Expenses in 2024

Navigating the complexities of deducting medical expenses can often feel like a maze. With healthcare costs rising and insurance premiums skyrocketing, finding effective ways to reduce these expenses is crucial for both individuals and business owners. In this post, we dive deep into the updated 2024 Health Reimbursement Arrangement (HRA) strategy, exploring how you can leverage this tool to maximize your tax savings.

Updated Options for Deducting Medical Expenses in 2024

When it comes to deducting medical expenses, several strategies can be employed. Let's break down the primary options with updated figures for 2024:

1. Itemizing Deductions: You can itemize your medical expenses, but there's a significant limitation. Only expenses exceeding 7.5% of your adjusted gross income (AGI) are deductible. For example, if your AGI is $100,000 and you incur $7,600 in medical expenses, only $100 would be deductible. Given this high threshold, itemizing is often not the most effective method for most taxpayers.

2. Flexible Spending Account (FSA): An FSA is a use-it-or-lose-it plan offered by some employers, allowing employees to contribute pre-tax dollars toward healthcare expenses. The 2024 limit for FSA contributions is $3,100, slightly increased from the 2023 limit. It's crucial to utilize these funds before the year-end to avoid forfeiture.

3. Health Savings Account (HSA): HSAs continue to be a powerful tool for those with high-deductible health plans (HDHPs). For 2024, the HSA contribution limits have been increased to $4,150 for individual coverage and $8,300 for family coverage. These accounts offer triple tax advantages: contributions are tax-deductible, the funds grow tax-free, and withdrawals for qualified medical expenses are tax-free.

4. Health Reimbursement Arrangement (HRA): An HRA is an employer-funded arrangement that reimburses employees for medical expenses. Unlike HSAs, HRAs are not tied to health insurance and can be utilized by small business owners, even if they are not covered by health insurance. This makes HRAs a versatile option for entrepreneurs and small business owners.

What is a Health Reimbursement Arrangement (HRA)?

An HRA is a tax-advantaged benefit allowing business owners to reimburse their employees, including themselves, for out-of-pocket medical expenses. The reimbursement is tax-free, making it an effective tool for reducing taxable income. HRAs are particularly beneficial for small business owners with high medical expenses.

Key benefits of an HRA in 2024 include:

• Reimbursement of health insurance premiums and medical expenses.
• Tax savings based on the marginal tax rate of the taxpayer, potentially reducing federal and state taxes.
• Flexibility in covering a broad range of medical expenses, from acupuncture and chiropractic care to braces and LASIK surgery.

Implementing an HRA Strategy

For business owners, implementing an HRA strategy requires a tailored approach based on their business structure:

Sole Proprietorships and Single-Member LLCs

For sole proprietorships and single-member LLCs, the Health Reimbursement Arrangement (HRA) strategy can be highly effective in reducing taxable income. Here’s how it works:

• Hiring a Spouse as an Employee: The business owner hires their spouse as an actual employee. This is not merely a nominal role; the spouse should have legitimate duties that contribute to the business. The employment relationship must be genuine, and compensation should be reasonable and documented.

• Compensation Through an HRA: The spouse is compensated partly or entirely through a health reimbursement arrangement. This means that the business reimburses the spouse for medical expenses incurred by the spouse, the business owner, and their dependents. The reimbursements made to the spouse under the HRA are tax-free, and the business can deduct these reimbursements as a business expense, thereby reducing its taxable income.

• Documenting Hours Worked and Expenses: It’s crucial to meticulously document the spouse’s hours worked, duties performed, and the medical expenses reimbursed. This documentation is essential to demonstrate the legitimacy of the employment and reimbursement relationship. In case of an IRS audit, detailed records will provide the necessary proof that the employment and reimbursements were legitimate business expenses.

• Benefits: This strategy allows the business owner to convert what would typically be personal medical expenses into deductible business expenses. The reimbursements are tax-free to the spouse and fully deductible by the business, leading to significant tax savings. 

S Corporations

For S Corporations, the HRA strategy requires a different approach due to IRS rules about fringe benefits for more than 2% shareholders.

• Limitations for S Corporation Owners: An S Corporation shareholder who owns more than 2% of the company is treated similarly to a partner in a partnership. This means they are not eligible to receive certain fringe benefits, including HRAs, on a tax-free basis. However, they can still benefit from this strategy with some adjustments.
• Incorporating HRA Contributions into Reasonable Compensation: The key to leveraging an HRA in an S Corporation is to treat health insurance premiums and HRA contributions as part of the owner's reasonable compensation. The owner's salary is reported on a W-2, and the HRA contributions are included as taxable income in Box 1 but excluded from FICA taxes (Social Security and Medicare), as they are not considered wages.
• Tax Savings on FICA Taxes: By incorporating the HRA contributions into the reasonable compensation calculation, the owner saves on the 15.3% FICA taxes. The total taxable income increases by the amount of the HRA contributions, but there are no additional Social Security or Medicare taxes on this amount. This can result in substantial tax savings, especially for those with significant medical expenses.
• Documentation and Compliance: Like sole proprietorships, it's vital to document all expenses and maintain proper records. Since the S Corporation owner is also an employee, the same rules apply regarding reasonable compensation and the justification for expenses.

Medical C Corporation Strategy

For business owners looking to save more than the typical 15.3% on FICA taxes, establishing a Medical C Corporation offers a more aggressive tax-saving strategy.

• Establishing a Medical C Corporation: The business owner sets up a separate C Corporation that provides specific services (such as administrative, IT, or consulting services) to the primary S Corporation or other businesses. The C Corporation acts as a separate legal entity and hires the business owner (or their spouse) as an employee.

• Reimbursement of Medical Expenses: The C Corporation reimburses medical expenses as part of its compensation package to the employee. Since C Corporations are not subject to the same fringe benefit rules as S Corporations, these reimbursements can be entirely tax-free to the employee. This allows the business owner to deduct medical expenses at their marginal tax rate, which can be as high as 37%.

• Tax Benefits: This strategy can result in significant tax savings. Instead of merely saving on FICA taxes (15.3%), the owner saves at their marginal tax rate (which could be much higher, depending on their income bracket). This is particularly beneficial for high-income earners who face higher federal and state tax rates.

• Costs and Compliance: While the Medical C Corporation strategy offers substantial tax benefits, it also comes with additional administrative costs, such as setting up and maintaining a separate legal entity, preparing a separate tax return, and potentially handling payroll. The business owner must perform a cost-benefit analysis to ensure that the tax savings outweigh the additional costs.

• Avoiding Red Flags: The IRS closely scrutinizes arrangements that could appear to be designed solely for tax avoidance. Therefore, the C Corporation should have legitimate business purposes, and the medical expense reimbursements should align with what would be reasonable compensation for the services provided.

New Considerations for 2024

• Increased Contribution Limits: As mentioned, FSA and HSA limits have been increased for 2024. It's essential to adjust your contributions accordingly to maximize your tax benefits.
• Affordable Care Act Compliance: If you're using a Qualified Small Employer Health Reimbursement Arrangement (QSEHRA) or an Individual Coverage HRA (ICHRA), ensure that the plans meet the minimum essential coverage requirements as outlined by the Affordable Care Act (ACA). For 2024, the limits for QSEHRA are $5,850 for self-only coverage and $11,800 for family coverage.
• Tax Planning for High Medical Expenses: If you anticipate high medical expenses, consider setting up a Medical C Corporation to maximize deductions. This strategy is particularly beneficial for those in higher tax brackets or with substantial annual medical costs.

Avoiding Pitfalls and Ensuring Compliance

While HRAs offer substantial tax benefits, it's important to be aware of potential pitfalls:

• Avoid Double Dipping: If you're already receiving tax benefits for health insurance premiums through an employer or another plan, you cannot claim the same expense under an HRA.
• Compliance with Fringe Benefit Rules: Understanding who qualifies as an employee is critical, especially for S Corporation owners. Misclassifying employees or failing to adhere to fringe benefit regulations can result in penalties.