Self-employeds: Keep your healthy deductions

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in Small Business Tax,Small Business Tax Deduction Strategies

The cost of health insurance keeps escalating. At least you can usually deduct 100% of your health insurance expenses if you’re self-employed. But you may do even better tax-wise.

Strategy: Hire your spouse to work for the business. Then cover the spouse under your health insurance plan as an employee. As a result, your spouse can cover other dependents under the ­policy—including you!

Here’s the whole story: Prior to 1986, self-­employed individuals were at a severe tax disadvantage. Reason: They weren’t able to deduct any of their health insurance costs. Then the Tax Reform Act of 1986 allowed a partial deduction. The deduction amount was gradually increased until it finally reached the 100% level in 2003.

That’s all well and good. But health insurance costs must be claimed as an above-the-line de­duction on your personal tax return instead of a business expense on Schedule C. There’s a specific line on Form 1040 for this purpose. Under a recent IRS ruling, it’s clear that self-­employeds can’t offset health insurance costs against other business income. (IRS Chief Counsel Advice 200623001)

Don’t dismiss this technicality as “small potatoes.” It means your net income is higher for other tax purposes, including state income taxes. Even worse: Besides the income tax consequences, the health insurance premiums are subject to self-employment tax. Generally, you’re required to pay 15.3% tax on self-employment income (13.3% for 2011 thanks to a one-year 2% payroll tax holiday—see box below) up to the Social Security wage ceiling ($106,800 for 2011) and 2.9% on income above that. However, you’re entitled to a partial “payroll tax holiday” in 2011.

In any event, you can increase your deduction by obtaining “back-door coverage” through your spouse’s employment. This maneuver still makes sense under the current tax rules.

Tip: Your spouse must be a legit employee and be compensated for actual services rendered.

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