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Deductions for Costs of Health Care: Part 1

The cost of health care in the United States is a frequent topic in the news and in conversations these days, and it’s generally not what you’d call upbeat. The subject  comes up in our household every time we have to pay bills for medical services on top of outrageously high medical insurance premiums (my husband and I both have high-deductible policies). Sadly, it appears that U.S. health care isn’t the best in the world, just the most expensive. The “Affordable Care Act” is going to make the IRS’s job more complicated, since the penalty for not buying required insurance will be assessed on each person’s tax return. But I haven’t seen any convincing proof that it will reduce medical costs for the average U.S. family.

OK, I haven’t forgotten that this blog is about taxes, not the costs of health care. Here’s the connection:  for anyone who pays taxes, a reduction in taxes is the equivalent of a government subsidy. And here in the U.S. we do have several (some might say, a bewildering assortment of) tax deductions and credits for expenses of health care.

I had planned to dive right into health care deductions for small businesses, but when I asked my PhD husband to take a look at the article, he told me he didn’t have a clue what any of it meant. So I think I need to start with the basics.

The simplest situation for a U.S. resident taxpayer is where the person works as an employee and signs up to participate in the employer’s health plan. Let’s look at an example: As a full-time employee of Sweet Mountain Magic Inc, Esther is eligible to participate in the company’s health care plan. The company pays 100% of the cost of medical insurance for Esther, and Esther has signed up for withholding from her paychecks to cover her husband and son under the same company plan.

Esther’s total monthly premium comes to $500, $300 of which is paid by the company and $200 of which is withheld from Esther’s first paycheck of each month. When Esther gets her W-2 at the end of the year, her reported salary is $83,000; but Esther’s total compensation for the year was actually $89,000. The $6000 that went to pay for medical insurance premiums is not included in the figures on the W-2, and thus is not a part of Esther’s gross income for tax purposes. Esther has saved $1500 in income taxes and $459 in FICA taxes (social security and Medicare). Her company has saved an additional $459 on its share of Esther’s FICA taxes, so it can now afford to pay a somewhat higher salary to Esther or provide her with additional benefits.

Like employees, self-employed individuals also get a tax break when they purchase health insurance for themselves, their spouses, and their children (see the definition of “self-employed” at the end of this article). But instead of excluding premiums from gross income as employees do, self-employed people get a deduction. It’s an “above the line” deduction taken on page 1 of Form 1040, so the self-employed person benefits from the deduction even if he doesn’t itemize. This evens up things between the self-employed person and the employee. Right? Well … not really.

Let’s look at an example. Belén owns an interior design business that has net income of $89,000 for 2006. She pays monthly insurance premiums of $500 to cover herself and her husband, a total of $6000 for the year. By deducting the cost of the premiums, Belén saves $1500 in taxes. On the other hand, Esther, whose salary was exactly the same as Belén’s net income, spent $6000 on medical insurance, just as Belén did; but Esther saved $1959 on her taxes, plus her employer saved an addition $459. The difference comes from social security and Medicare taxes. Belén has to pay them on the $6000 used for insurance premiums. Esther doesn’t. Belén’s income from self-employment shown on Schedule C is still $89,000, and that’s the amount used to calculate Belén’s self-employment tax (the equivalent of Esther’s social security and Medicare). Esther and her employer are $918 better off than Belén.

As if it was not already hard enough for the self-employed to pay for medical insurance, IRS recently stated (Chief Counsel Advice  [CCA] 200524001) that if a shareholder of an S corporation purchases an insurance policy in his own name rather than in the corporation’s name, the premiums will not be deductible at all, except as itemized deductions (Schedule A) subject to a floor of 7.5% of adjusted gross income. In some states single-shareholder corporations are not allowed to purchase group policies, so this presents a truly raw deal for some self-employed individuals.

There are things a self-employed person can do to increase their tax benefits for medical expenses. I will look at these next time in Part 3.

Note: for purposes of health care deductions, the self-employed category includes a broader range of businesses than one might expect. In addition to the self employed individual who reports income and expenses on Schedule C of his or her Form 1040, the following individuals are also considered to be self employed: general partners of a partnership, and limited partners who receive guaranteed payments; members of a limited liability company (LLC) taxed as a partnership or disregarded entity; and shareholders owning more than 2% of an S corporation who received wages or a salary from the corporation.