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Self-employed? Follow this tax Rx for health insurance

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Self-employed people can now deduct 100 percent of their health insurance expenses. But you can still do better tax-wise if you don’t pay for your own coverage.

Strategy: Hire your spouse (if your business is a sole proprietorship). Then, cover him or her under your health insurance plan as an employee. Your spouse, in turn, can cover other dependents— including you—under the policy.

Isn’t the result the same as if you were paying for your own health insurance? Not under a new advisory letter from the IRS—IRS Chief Counsel Advice 200623001 —explained the critical tax difference.

Here’s the whole story: Prior to 1986, self-employeds could not deduct any health insurance costs. But Congress authorized a partial deduction, which gradually rose to 100 percent in 2003.

That’s all well and good. But you must claim health insurance costs as an above-the-line deduction on your personal tax return instead of a business expense reported on your Schedule C. (A line on Form 1040 specifically serves this purpose.)

Now, the new IRS pronouncement makes it clear that self-employeds can’t offset health insurance costs against other business income on Schedule C, unless you use the employee-spouse strategy.

Tax impact: Don’t dismiss this technicality as small potatoes. It means that your net income is higher for other tax purposes, including state income taxes.

Another point: Besides the income-tax consequences, the health insurance premiums are, in effect, subject to self-employment tax. For 2006, you must pay 15.3 percent tax on the first $94,200 of self-employment income; 2.9 percent on income above that.

Thus, if you pay $10,000 in annual health insurance premiums, it could cost you as much as $1,530 more (15.3 percent of $10,000) in self-employment tax.

Note: You can deduct half of the self-employment tax paid as an above-the-line deduction.

Caution: Your spouse must be a legitimate employee and be compensated for actual services rendered.

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