Wednesday, September 19, 2007

ASK THE TAX PRO – SELF-EMPLOYED HEALTH INSURANCE DEDUCTION

Q. Thanks for your great blog.
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My spouse (Age 67) is retired from the US Government, receiving a federal retirement check, and is also drawing Social Security. Her retirement payment is reduced by an amount for Federal Blue Cross-Blue Shield health insurance for both of us. Her Social Security payment amount is reduced by a different amount for her Medicare coverage. We have to report both her full federal retirement allowance (before the insurance premium deduction) and Social Security benefits (before the insurance premium deduction) as taxable income - hence we get to pay taxes on the retirement and social security money spent for this insurance. Finally, I am retired but operate a single person LLC consulting business providing abut $60K taxable income (after minor business expenses).
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Since my only health coverage is that provided by my wife's BCBS, can I deduct the above costs (around $4500) as an "above-the-line" medical expense on my 1040?
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Sincerely,
Martin
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A. You have posed a very interesting, and controversal, question. In order to respond properly I have done extensive research on this question.

Before going on allow me a comment on the description of your situation – you are not, or should not be, reporting your wife’s full Social Security benefits as taxable income on your 1040. At most you are paying tax on only 85% of the gross benefit.
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The issue in question is whether you can deduct insurance premiums for a policy issued in a name other than that of the sole proprietor, or if the policy must be purchased in the name of the business or the business owner.

First, the results of my research -

(1) There is nothing I could find in the Internal Revenue Code to provide specific quidance. The Code itself does not say that in order to qualify for the special deduction the policy must be in the name of or set up by the Schedule C business.

According to Internal Revenue Code Section 162 (l)(1)(A) – “In the case of an individual who is an employee within the meaning of section 401(c)(1)
, there shall be allowed as a deduction under this section an amount equal to the applicable percentage of the amount paid during the taxable year for insurance which constitutes medical care for the taxpayer, his spouse, and dependents.” Section 401(c)(1) concerns a "self-employed individual treated as employee". The “applicable percentage” is 100%.
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(2) However, IRS Publication 535 (Business Expenses) says – “The insurance plan must be established under your business. Partners and more-than-2% S corporation shareholders can claim the self-employed health insurance deduction only if the policy is in the name of the partnership or S corporation. For sole proprietors, the policy does not have to be in the name of the business if it is in the name of the sole proprietor.”
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(3) IRS Headliner Volume 163 (May 15, 2006) reports - “In many solely owned businesses, the owner of the business will purchase health insurance in his or her own name versus the name of the business. The type of entity may greatly affect where this insurance premium expense may be deducted on the individual’s personal income tax return.
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In Chief Counsel Advice (CCA) 200524001, it was held that a self-employed individual who is a sole proprietor and who purchases health insurance in his or her own name may treat that as health insurance purchased in the name of the sole proprietor business. As such, the insurance would qualify under the provisions of IRC §162(l). Assuming the self-employed individual meets the other provisions of IRC §162(l), the individual may claim a deduction for the insurance premiums in arriving at his or her adjusted gross income; also referred to as an above-the-line deduction.”
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(4) Chief Counsel Advice (CCA) 200524001 says - “A self-employed individual who is a sole proprietor may deduct medical care insurance costs of the sole proprietor and his or her family from the earned income of his or her trade or business when the health insurance policy purchased by the sole proprietor is issued in his or her individual name and not in the name of the sole proprietor’s trade or business.”
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Under the heading of “Discussion” in CCA 200524001 it says that “the statute has always required that a plan be established under a trade or business”, although the reference prior to this comment says that the Code Section that indicated such coverage is treated as an “employer-provided benefit” was retroactively deleted. As stated above I could find nothing in 162(l) that specifically said the insurance had to be established under the Schedule C trade or business.
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A Chief Counsel Advice (CCA) is considered to be “administrative authority”. Like a General Counsel Memoranda it explains the legal reasoning behind a specific IRS position. Similar to a Technical Advice Memoranda and a Field Service Advice it cannot be relied on or cited as precedent.
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(5) Let us look at the reasons behind why Congress created this special above-the-line deduction. As CCA 200524001 states, “One of the reasons for enacting the Section 162(l) deduction was that the existing rules relating to the exclusion from gross income for benefits under employer accident or health plans created unfair distinctions between self-employed individuals and the owners of corporations. Owners of corporations could exclude from gross income health benefits provided by the corporation, whereas no similar exclusion was available to self-employed individuals.”
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Basically, prior to the enactment of Section 162(l), the owner of a one-man corporation could treat himself as an employee of the corporation and receive all the benefits, and the corresponding business tax deductions, allowed for employees, including employer-provided health insurance – but self-employed business owners who filed a Schedule C did not receive an equal tax benefit. Congress wanted to correct this inequity and provide the self-employed individual with a deduction that was the equivalent of that for the employer-provided health insurance coverage available to the corporate employee.
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One could argue that Congress may have “intended” that the policy be issued in the name of the business. But this possible “intention” did not make its way into the Code.
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(6) I have not found any Tax Court decisions that specifically address this issue.

(7) While it does not pertain directly to the issue at hand, I found a statement online from a non-IRS source that said “health insurance through COBRA is considered to be held under your former employer’s name. This twist means you cannot claim COBRA payments as a deduction.”

Now, to answer your question -

In your situation the health insurance policy under which you are covered is neither in the name of your Schedule C business nor in your individual name. It is in the name of your spouse, or perhaps in the name of the federal pension.

I think it is clear from the above that it is the “official” position of the Internal Revenue Service that the policy should be issued in the name of your Schedule C business, or in your individual name. Meaning that you must go out and actually purchase the policy yourself. An above-the-line deduction for the $4,500 in health insurance premiums deducted from your spouse’s federal pension might not survive an IRS audit.

However, as I have indicated above, I have found nothing in the Tax Code or the Tax Court that specifically disallows the special deduction for self-employed health insurance premiums on a policy that is not issued in the name of the business or the business owner. This is your only source of health insurance, and, as a self-employed individual, you are entitled to an above-the-line deduction for “the amount paid during the taxable year for insurance which constitutes medical care for the taxpayer, his spouse, and dependents.”

The rule of thumb is “when in doubt – deduct”. So if I were preparing your tax return I would claim an “adjustment to income” for the $4,500 in premiums withheld from your spouse’s pension.

If you are audited by the IRS on this issue and the deduction is disallowed you will then have to decide how far “up the line” you are willing to go.

I would go one further and also claim a deduction for a self-employed individual who was making COBRA payments, contrary to the online advice I found.

You can also try to get the deduction allowed through the “back door”, as a deduction on the Schedule C itself (which will reduce your self-employment tax as well), under IRC Section 105 by (1) approving a “medical reimbursement plan” for the employees of your business (stating, for example, that the business will reimburse all employees for medical expenses, including health insurance premiums paid, up to a maximum of $5,000 per year as an employee benefit) and (2) hiring your spouse as an employee of your business. I am assuming your business has no other employees. Of course to do this your wife would have to become a bona fide employee of your company and actually perform legitimate duties. However, that is a topic for another posting.

Hey fellow tax bloggers and tax professionals – do you agree with me on this issue, or am I way off?

TTFN

3 comments:

Will said...

Your research is very impressive. In this case, since you can't find anything that specifically prohibits, and since they are filing a joint return, I would absolutely take the deduction.

chuck said...

Read your post of 19 Sept 2007. My situation is similar but not identical to the scenario you decribed. I am a retired federal employee carrying Blue Cross Blue Shield insurance as a retiree. I have formed an LLC (Johnson Ordnance Engineering)in Arizona. My CPA tells me that neither my health insurance premiums nor my out-of-pocket medical expenses are above-the-line tax deductible. Is she correct?
Thanks!

Robert D Flach said...

Chuck-

Your out of pocket medical expenses are certainly not an "above-the-line" deduction - they would go on Schedule A.

Actually there are ways of getting either a Schedule C or above-the-line deduction for medical expenses.

If your wife is a legitimate employee of your business you can reimburse her for family health insurance coverage and medical expenses under a Medical Reimbursement Plan and claim it as an employee benefit deduction. Of course you must provide the same benefit to all other full-time employees.

You can perhaps have an HSA for out of pocket medical expenses.

No time to discuss in detail the above ideas - you should consult a competent tax professional (perhaps your CPA).

The health insurance may be an above-the-line deduction. I would need more info. Frankly I do not have the time to look into it any further at this time of the year.

TWTP