ABA Special Report:

Health Insurance and the Self-Employed A New Wrinkle

The Self-employed, whether as sole proprietors, partners in a partnership, or members in a limited liability company are limited to the tax benefits they can claim for health insurance vs. those same benefits provided to employees. Employees can pay for insurance entirely with pre-tax dollars, considerably lowering the cost of premiums that seem to always spiral upward.

The Self-employed are treated, tax wise, far from equal in this area. While it is true that congress recognized this unfairness and allows 60% deduction from adjusted gross income^[1] for health insurance premiums (slated to grow up to 100% by 2003) for the self-employed, there is a hidden tax which may never go away. The health insurance premiums are not deductible for self-employment tax purposes. Consequently, the health insurance premiums may in effect be taxed up to approximately 15%. In addition, other limitations may prevent the self-employed from benefiting from this deduction at all.^[2]

The Internal Revenue Service (IRS) recently blessed an arrangement which under the right circumstances will allow self-employed taxpayers who are married to not only get an immediate 100% deduction for their health insurance, but also have the deduction count against the self-employment tax. The self-employment taxpayer hires their spouse as a bona fide employee of the business. The employee spouse receives, as a fringe benefit employer paid health insurance premiums, which is for family coverage covering the self-employed spouse and their children. As long as the compensation paid to the spouse including any fringe benefits (eg.- health insurance premiums) is reasonable based on the services^[3] provided by the spouse, the IRS says it works. The business gets a 100% deduction for the health insurance premiums paid and the employee spouse does not have to pick up this fringe benefit as a taxable compensation.

The IRS has said in order for them to bless this arrangement the health insurance coverage must be taken out in the business name, rather than as an individual policy. Also, the premiums should be paid out of a business account to avoid controversy. In addition, the IRS would assert that if the employee spouse has made a significant investment in the business with his/her own funds or had co-ownership of the business assets, they are themselves self-employed and therefore not eligible for this arrangement because they are subject to the same rules as the self-employed business owner.

Finally, more than 2% owners of a S corporation cannot take advantage of this tax saving opportunity as the attribution rules treats the employee spouse the same as the more than 2% owner for fringe benefit taxation purposes.

In conclusion, today there is a valuable tax saving opportunity to be taken advantage of if the employee spouse can provide bona fide services as an employee of the business. While the benefit of using this arrangement will be greatly reduced in 2003 when the deduction for health insurance of the self-employed will increase to 100%, there will still be a benefit due to the additional tax on self-employment attributable to the health insurance premium.

Source:
Anchin, Block & Anchin LLP, Accounts & Consultants, New York, NY

[1] The remaining 40% can be taken as an itemized deduction with other medical costs, which is deductible to the extent that the total medical costs exceeds 7.5% of adjusted gross income.

[2] No deduction is allowed to extent there is no net income from the business or any month the taxpayer or his/her spouse is eligible to participate in a subsidized health plan maintained by his or her employer or the spouseis employer.

[3] The spouse can be employed part-time as long as the services provided are not nominal or insignificant

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