After working through the math in Part 2, we determined that our fictional couple of John and Joan would owe the following amounts of tax with and without an HRA:
- Without: $31,846
- With: $30,645
But let’s look at cash flow to determine how much they’re really saving.
$135,000 net business income – $6,000 medical expenses – $25,000 itemized deductions – $31,846 taxes = $72,154 ending cash
$122,868 net business income + $5,000 Jane’s salary – $382.50 for Jane’s FICA withholdings ($5,000 x .0765) – $25,000 itemized deductions – $30,645 taxes = $71,840
Actual savings = $313.50.
Now, most people will look at this and say “$313 in my pocket plus less money to the government is a good thing!”
And I would agree with that.
BUT — I have had proprietors say no to an HRA after I’ve done this analysis because the savings of a few-hundred dollars wasn’t worth the hassles of setting it up, and the very real threat of being audited.
- The proprietor has to find legitimate work for his or her spouse to do.
- There has to be payroll — a lot of small business owners are Joe the Window Washers who cringe at the thought of payroll. Payroll, even a small, simple payroll, brings paperwork and compliance burdens.
- The HRA itself has paperwork and compliance burdens.
- The IRS could always audit the HRA, and if the spouse isn’t doing any real work or the HRA hasn’t dotted all of its “i’s” and crossed all the “t’s”, the plan could get disallowed.
HRAs will save money, but perhaps not as much as you might think.
I generally encourage a sole proprietor to form an HRA, as long as they know what they’re getting into.
But a good analysis of an HRA (or any tax move) will go beyond the tax savings and look at total cash flow.
Sometimes the proprietor might decide that saving a few-hundred bucks isn’t worth the headaches involved with getting there.
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