I.R.C. § 162(l)(1)(A) allows an individual who is an employee within the meaning of I.R.C. § 401(c) to deduct amounts paid during the taxable year for insurance which constitutes “medical care” for the taxpayer and the taxpayer’s spouse and dependents. Subject to certain limits, self-employed individuals can deduct 100% of health insurance costs in determining adjusted gross income. This above-the-line deduction, reported on Schedule 1, IRS Form 1040, is generally available to sole proprietors, partners in a partnership, and more than 2% shareholders in an S corporation.
Note: The SEHD is not an “ordinary and necessary business expense.” Rather, it is special deduction allowed to the self-employed. For this reason, the SEHD does not reduce a taxpayer’s SE income or SE tax liability. As will be seen below, sole proprietors and partners in partnerships must pay SE tax on their health insurance premiums. S corporation shareholders, however, are exempt from FICA for their premiums.
The SEHD has several important limitations and requirements.
- The deduction is allowed only for “insurance which contributes to medical care.”
- The deduction is not allowed for costs incurred in any month where the taxpayer is eligible to participate in a “subsidized health plan” maintained by any employer of the taxpayer or the spouse.
- The deduction may not exceed “earned income from the trade or business” establishing the plan providing the coverage
- The deduction is limited by a PTC received on the Marketplace
Insurance Which Constitutes Medical Care
The SEHD applies to health insurance costs equal to the amount paid “for insurance which constitutes medical care” for the owner, spouse, dependents, and any child who has not reached age 27 as of the end of the year, whether or not the child is a dependent. This includes medical, dental, Medicare, and qualifying long-term care insurance premiums for the self-employed, their spouses, and their dependents. Long-term care insurance contracts must meet certain consumer protection standards to be “qualified.” The deduction for long-term care premiums is limited to “eligible long-term care premiums,” indexed yearly for inflation. The 2021 eligible long-term care premiums are shown below:
Eligible Long-Term Care Premiums (2021) (Source Rev. Proc. 2020-45)
The SEHD applies only to insurance premiums. The SEHD can be taken for amounts required to be repaid when reconciling the APTC with the PTC. In that case, the SEHD is taken for the year of the coverage. The SEHD does not apply to out-of-pocket expenses that are not reimbursed by insurance. Nor does it apply to the cost to belong to a health sharing ministry or to purchase any health plan that—under current law—does not constitute insurance. This includes association plans like those offered in several states by Farm Bureau.
Not Available if Eligible for Subsidized Health Plan
No SEHD is allowed for any month during which the self-employed taxpayer is eligible to participate in any subsidized health plan maintained by any employer of the taxpayer, the taxpayer’s spouse, the taxpayer’s dependent or any child who hasn’t attained age 27 as of the end of the tax year. This rule applies separately to (1) plans providing coverage for qualified long-term care and (2) other health plans. [I.R.C. § 162(l)(2)(B))]. In other words, taxpayers eligible to participate in a subsidized health insurance plan, but not a subsidized LTC plan, may take the SEHD for the cost of the LTC plan, but not the health insurance plan.
No court opinion or rule defines “subsidized” for purposes of the SEHD. While I.R.C. § 35(f)(1) (health coverage tax credit) defines a subsidized health plan as one where at least 50% of the cost of the coverage is paid by the employer, I.R.C. § 162(l) includes no such definition. In the absence of further guidance, it would appear that most any employer-provided plan would be “subsidized,” making the person to whom it was offered ineligible for the SEHD.
Plan Must Be Established under a Trade or Business
To qualify for the SEHD, a taxpayer must have a health plan “established” under a trade or business.
- For a sole proprietor, the plan can be established in the name of the business or in the owner’s individual name.
- For a partnership, the policy can be in the name of the partnership or in the name of the partner.
- If the partnership pays the premiums, the partnership deducts the payment and reports the amounts paid to the partner on the K-1 as a guaranteed payment. If the partner pays the premium, the partnership must reimburse the partner for the premium and include the reimbursement as a guaranteed payment.
- For > 2% shareholders of an S corporation, the policy can be in the name of the S corporation or the shareholder.
- If the corporation pays the premium, the S corporation deducts the payment and reports the premium amount on the W-2 in Box 1 as wages to the shareholder. If the shareholder pays the premium, the corporation must reimburse the shareholder for the premium and report the amount on the W-2 in Box 1 as wages. These premium payments, however, are not wages subject to Social Security and Medicare taxes if the requirements for exclusion under section 3121(a)(2)(B) are satisfied. See I.R.C. § 3121(a)(2)(B); Ann. 92-16, 1992-5 I.R.B. 53. [IRS Notice 2008-1]. This means the wages are not reported in Boxes 3 and 5 of the W-2.
- In CCA 201912001, IRS ruled that family members employed by the corporation and deemed to be > 2% shareholders under the attribution rules of I.R.C. § 318 (spouse, children, parents, and grandparents) may claim the SEHD in their own right if they otherwise qualify.
Note: Although the Affordable Care Act restricted the ability of employers to reimburse employees for the cost of insurance without violating the market reforms of the law, IRS Notice 2015-17 provided relief. The notice states that, unless and until additional guidance provides otherwise, S corporations and their shareholders may continue to rely on Notice 2008-1 with regard to the tax treatment of > 2% shareholder-employees. No additional guidance has issued. This means that >2% shareholders may be reimbursed for the cost of insurance without violating ACA.
Limited to Earned Income from the Trade or Business
The amount of the SEHD may not exceed an eligible taxpayer’s net earned income from the trade or business in which the health plan was established, less the deductions for 50% of the self-employment tax and contributions to certain pension plans. These plans include Keogh plans or simplified employee pension plans for the self-employed. For this purpose, earned income is defined in I.R.C. § 401(c) and generally means the individual’s trade or business income, reduced by business expenses.
Taxpayers may deduct the costs of the health insurance plan established for the trade or business only up to the net earnings of the specific trade or business that established the plan. They may not add the net profits from all trades and businesses to determine the deduction limit. [CCA 200524001].
For S corporation shareholders, the deduction is limited to W-2, Box 5 (FICA) wages paid by the corporation. For a partnership, it is limited to the net earnings from self-employment reported on the K-1 by the partnership.
Interaction Between the PTC and the SEHD
Self-employed taxpayers who receive their insurance on the Marketplace may not receive the benefit of both the PTC and the SEHD for the same premium. This is complicated by the fact, however, that the PTC is determined by the MAGI, and the SEHD reduces MAGI. Rev. Proc. 2014-41 provided optional instructions to resolve this difficulty. Taxpayers are allowed, however, to use “any computation method,” as long as the sum of the SEHD claimed for the premiums and the PTC computed, taking the SEHD into account, is less than or equal to the enrollment premiums.
Publication 974 implements Rev. Proc. 2014-41 by allowing taxpayers to choose from a simplified calculation method and an iterative calculation method. Although the simplified method is easier to calculate, the iterative method may lead to a more favorable result.