Getting a Tax Deduction for Health Insurance as a Small Business Owner
Health insurance isn’t cheap and can be a huge burden if you are running a small business and don’t have another resource for obtaining it (i.e., an employer or a spouse with an employer who offers health benefits).
I know this because when I decided to leave the security of full-time employment and start focussing on my small business it was the one thing that caused me to think twice about my decision.
I have a wife and two young kids and my wife doesn’t have an employer.
So, when I learned that with no help from my former employer the premium cost for our mediocre, high-deductible health insurance was over $1,000/ month, I had to think twice about making the move into self-employment.
Fortunately, there is a deduction available for self-employed health insurance premiums for many small business owners.
Unfortunately, it isn’t available for all small business owners and, even if you are eligible for the deduction, some inequalities exist in how much of a deduction you receive compared to how health insurance premiums are handled for traditional employees.
There are also some special rules and record-keeping requirements you need to keep in mind if you take advantage of this deduction.
The Self Employed Health Insurance Deduction
Businesses are generally allowed to deduct from their business income any expenses that are “ordinary and necessary” to operate their business.
Unfortunately, the IRS doesn’t view the cost of medical, dental or long-term care insurance (referred to as “health insurance” throughout the rest of this post) for a business’s owners as “ordinary and necessary”.
Only health insurance premiums paid for employees of the business can be deducted as a business expense.
For a long time (prior to 1986) there was no deduction available for this expense.
Today, if you own and operate a small business, you may be eligible for a deduction for your health insurance premiums, but it still isn’t a business deduction.
You take this deduction on your individual income tax return as an “above the line” deduction, which means you can take it regardless of whether you itemize your deductions on your individual return or not.
However, there are several limitations and rules that must be filed if you want to take advantage of this deduction.
Limitations
There are two big limitations you must get passed before you can be eligible for the self-employed health insurance deduction:
- You can’t be eligible to participate in any employer subsidized health insurance plan. This includes a subsidized plan of your employer or your spouse’s employer, if applicable.
- Your business has to be showing a taxable profit and your self employed health insurance deduction cannot be greater than your business’s self-employment income.
If your ability to take the self-employed health insurance deduction isn’t eliminated because of these two limitations, you need to understand how to establish and properly pay for your health insurance premiums.
Record-keeping
If you are eligible for the self-employed health insurance deduction, you need to properly:
- Establish the plan,
- pay your premiums and
- report the payments on your business and individual return correctly.
Sole Proprietorships
If your business is a sole-proprietorship (or an LLC treated by the IRS as a sole-proprietorship), record-keeping is pretty simple.
You simply need to establish a plan in your name or in the business’s name and pay the premiums.
Either you or the business can pay the premiums, but the business can’t take a business deduction for the premium payments.
It is reported on your individual tax return as an “above the line” deduction.
Simply make it clear to your tax return preparer how much you paid for health insurance and whether the payments were paid by the business or by you personally and they should know how to account for it properly.
Partnerships
If your business is a Partnership (or an LLC treated as a Partnership by the IRS), you can also have a plan established in your name or in the Partnership’s name.
If the plan is in the Partnership’s name, the Partnership needs to pay the premiums and report the payments as “Guaranteed Payments” to you on the Partnership return.
The Partnership should not report the Partner’s premiums as an insurance deduction, which is how it would deduct other employees’ health insurance premiums.
You may also pay the premiums yourself, but the Partnership should reimburse you for these premium payments and classify the reimbursements as “Guaranteed Payments”.
Why do you have to do this way?
The explanation may confuse you, but the ultimate reason is that you still need to pay self-employment tax on your health insurance premiums.
The Partnership gets a deduction on their return, you report it as self-employment income on your individual return but get a subsequent income tax deduction on your individual return.
Again, the net result is that you get an income tax deduction for the premiums you pay, but you don’t get to deduct it from the amount that self-employment tax is calculated on, which I discuss a bit more later in this post.
As I mentioned for Sole Proprietorships, the most important thing to do is to make sure you are clearly identifying for your tax preparer amounts that are paid for Partner health insurance.
They should know how to properly handle reporting the deduction.
S-Corporations
If your business is treated by the IRS as an S-Corporation and you own more than 2% of the business, the treatment and rationale for owner health insurance premiums is similar to how it is for Partnerships.
The plan needs to be established in your name or the business’s name.
If the business pays the premiums, they should include the premium payments in your W-2 and properly account for them as wages.
If you pay the premiums, the business needs to reimburse you and properly include the reimbursement on your W-2 and account for it as wages.
You’ll include the wage in income on your individual return but also take an “above the line” deduction.
Again, make sure your tax return preparer AND payroll company knows how much you paid for health insurance for the business owners before they prepare your W-2s and tax returns each year.
Inequality
Why all the special record-keeping and reporting requirements for the self-employed health insurance deduction?
It goes back to the fact that the IRS does not consider health insurance for business owners an ordinary and necessary business expense.
While there is some relief offered with the self-employed health insurance deduction, this only reduces your income tax liability.
You still pay self-employment tax on this income (unless you’re an S-Corp).
For example, if your business had a taxable profit before taking the self-employed health insurance deduction of $50,000 and you paid $10,000 for health insurance for the year, you would pay income tax on $40,000 and self-employment tax on the full $50,000.
Self-employment tax is 15.3%, so this is a pretty material inequality compared to how this deduction is treated for other traditional employees.
For employees, the business gets to deduct the premiums from income for income tax and self-employment tax purposes.
And employees get to deduct the premiums they pay from both income and payroll tax (one of the easy tax breaks offered to traditional employees).
While it could be worse; business owners used to not even have the self-employment health insurance deduction, the inequality in how this deduction is treated does leave some small business owners who understand it scratching their heads.
What if I Don’t Qualify?
Earlier in the post, I pointed out that in order to qualify for the self-employed health insurance deduction, you can’t be eligible for any employer subsidized health insurance and your business has to have taxable self-employment income.
What if you don’t qualify for the self-employed health insurance deduction due to one or both of these limitations but you still pay for health insurance on your own?
You may still be eligible for a deduction if you itemize your deductions on your individual income tax return.
If all of your out-of-pocket medical expenses, including premiums and out-of pocket costs for prescriptions and services, exceed 10% of your income, you can report any expenses that aren’t deducted anywhere else on Schedule A of your individual income tax return and any amount over 10% will be deducted from your individual taxable income.
10% of income is often a high threshold, but with the cost of health insurance constantly rising, it is not unreasonable if this is the only option you have for getting a deduction.
Obamacare’s Impact
The Affordable Care Act (a.k.a. Obamacare) had, and continues to have, a serious impact on American small business owners.
Insurance premiums continue to rise and if you don’t have at least “minimum essential coverage” for you and your family you will be penalized.
For 2017, the penalty is the higher of 2.5% of household income (capped at cost of the national average for a bronze plan on the health insurance marketplace) or $695 per adult and $347.50 per child under 18 (capped at $2,085).
I agree with the spirit of Obamacare.
Everyone should have access to affordable, quality health insurance.
But I think most people can agree that, in its current state, American small business owners are not being offered affordable, quality health insurance.
It’s expensive and, in most cases, isn’t any good.
Fortunately, for those that aren’t restricted by the limitations mentioned above, there is a bit of a tax break available to small business owners who do have to purchase health insurance in the form of a self-employed health insurance deduction.
For small businesses that are able and willing to, Obamacare also introduced a credit for providing and subsidizing health insurance to your employees.
This credit is beyond the scope of what I want to discuss in this post, but you can learn more about it here.
Next Steps
Understanding the vast number of tax rules can seem overwhelming.
Just the self-employed health insurance deduction alone has a ton of rules.
And if you haven’t heard, there was a major re-write of the tax code that is effective starting in 2018.
As a small business owner, you need to have at least a basic understanding of all of this.
My advice?
Stay up to date by signing up for my email list or by connecting with me on Facebook or Twitter.
And if you have questions about the new tax laws, I’ll be answering them throughout 2018 here.
