by Tony Novak, CPA, MBA, MT updated 2/11/2016
This article was originally published in 2003 has been revised multiple times; most recently to reflect changes triggered by the Affordable Care Act.
Until recently, the tax-favored status of health insurance was a stable and relatively simple principal of federal income tax law. But recent changes triggered by the phased-in implementation of the Affordable Care Act are now creating confusion. This article is meant to summarize the basic principles of taxation of health insurance and touch on a few of more complex or still partially unresolved issues regarding the taxation of health insurance for 2015.
Health insurance paid by an employer for coverage on an employee or the employee' s dependents is usually deductible as a normal business expense under IRC Section 162. Health insurance benefits are not wages and therefore are not subject to wage taxes. For this purpose, the term "employee" includes an owner/employee of a C-corporation but does not include owner employees of other types of businesses.
Restrictions on use of individual insurance - The federal government, through the Department of Labor and the IRS, issued a series of restrictive announcements and regulations from 2013 through 2015 designed to discourage employers from assisting employees with the purchase of subsidized insurance through the individual health insurance exchange. The purpose of these restrictions is to discourage employers from sending employees to the exchange to seek government-subsidized insurance. As a result, the employer's contribution to subsidized policies is no longer a tax-free benefit to employees. In addition the use of qualified individual health insurance (the type offered through the exchange) insurance in an employer plan after June 30, 2015 may trigger severe excise tax penalties. The most recent guidance on this topic is IRS Notice 2015-17. Yet, for lower income employees who qualify for the insurance premium subsidy, the value of subsidized coverage exceeds any benefit the employer can provide through commercial markets. As a result, a growing number of employers, large and small, are choosing to cancel employer-provided primary health insurance. As a result of all of these changes, employers are increasingly focusing their efforts on providing non-qualified employee health insurance benefits.
Small Business Health Insurance Options Program (SHOP) - Tax credits are available for up to two years to some small businesses that elect to provide group health insurance coverage to modest income employees. More information is available on the IRS Web site. It is clear that the government prefers small businesses to follow this route but market forces dictate that there are usually better ways to provide the best overall health insurance value to employees. Consequently, the small business tax credit program is relatively unpopular compared with other options. It may be significant to note that small business accountants, including myself, report that few if any of their clients actually qualified for the tax credit.
Cafeteria style and voluntary health benefit plans - The ideal solution may be a flexible benefit plan that allows for the possibility of both qualified tax-free benefits and supplemental voluntary after-tax benefits including employer contributions to help with the cost of employee health benefits. Small businesses may get help with setup of this type of flexible health plan at a modest cost. This type of benefit plan is often available directly to small businesses or through agents and brokers who handle the insurance. Alternately, assistance with plan design and setup is available through my company Freedom Benefits. One advantage of this approach is that it allows for the possibility of using different types of health insurance policies and adapts the tax treatment as laws are clarified in the future.
ACA market reforms - The ACA added severe excise taxes on certain types of employer-provided health benefits that are not covered in this article. These penalty taxes were designed to ensure smooth implementation of the changes created by ACA with regard to individual insurance and employer reimbursements. See "Novak’s 2015 small business health plan tax article bibliography" for more information.
Self-employed individuals may deduct 100% of the cost of health insurance as an "above the line" expense on the front page of their Form 1040. The deduction is available to all qualifying taxpayers, regardless of whether they choose to itemize their other expenses. Direct deductions from gross income are allowed only to the extent of the amount of net self-employment income. Excess amounts, if any, may be deducted of Schedule A as listed in the "Individuals" section below.
The term "self-employed person" for this purpose includes non-salaried owners of S-corporations, LLCs, partners and sole proprietors under IIRC Section 162(l).
Owner/employees - Except for salaried owner/employees, health insurance paid by a business on behalf of a self-employed person is not a deductible business expense. For example, if an S-corporation that pays for health insurance for its non-salaried owner/employee, this expense is not listed as a business expense on the Form 1120 but rather the deduction flows directly through the Form 1120S to the individual owner' s Form 1040. Health insurance for salaried owner/employees is treated the same as regular employees except that an adjustment for self-employment tax is made. The IRS publishes detailed instructions on this topic in the instructions for Form 1120S. IRS Code section 36B, Revenue Procedure 2014-41, and 2014-33 I.R.B. 364, provide additional guidance on computing the deduction and the credit with respect to the 2-percent shareholder.
Individual tax credits - See the IRS Web site for more information on individual health insurance tax credits that may also apply to self-employed individuals.
Health insurance benefits provided by an employer are not taxable income under IRC Section 106. This includes amounts paid by the employer to reimburse the employee for the cost of health insurance. Of course, the employee may not "double-dip" by deducting the cost of these tax-free benefits on an individual tax return. Additionally, for 2014, the benefit provided to an employee who obtains reduced cost health insurance coverage through an exchange with the use of a tax credit may not be a tax free benefit.
The cost of health insurance paid by individuals is tax deductible only to the extend that the cost of coverage they paid, in combination with some other specified expenses, is more than 10% of adjusted gross income (7.5% for those over age 65 through 2016 under temporary rules). For most people, this 10% or 7.5% threshold limitation effectively means that they do not get a tax deduction for the cost of health insurance paid. Fortunately few tax-paying Americans have chronic medical expenses that exceed 10% of gross income. This would likely be financially devastating over the long-term and the individuals affected typically wind up on Medicaid and without substantial taxable income (since evidence suggests that a serious long-term medical condition is typically accompanied by a loss in earnings capacity).
The cost of health insurance paid by an employer is a deductible personal expense if the amount is included as wages in Box 1 of Form W2, but this is a relatively rare situation.
Tax treatment is normally not affected by the type of health insurance; it may be an individual insurance plan or a group insurance or any other type of health insurance.1 The exception to this rule is that beginning in 2014 and continuing until corrective or clarifying regulations are issued, the employer may not contribute to the cost of individual health insurance purchased through an exchange. Tax penalties for employer participation in this type of individual insurance after June 30, 2015 could be as high as $36,500 per employee (See IRS Notice 2015-17).
Changes triggered by the Affordable Care Act require separate tax reporting of health insurance benefits by the employer. Reporting the cost of health care coverage on the Form W-2 does not mean that the coverage is taxable. Implementation of these reporting rules was delayed and generally is not required of small business employers unless the health benefits were not integrated with the employer's group health insurance policy. See the IRS Web site for more information.
A self-employed person deducts health insurance on the Form 1040. A business deducts health insurance for employees as a regular business expense on Schedule C or the applicable business tax return. An individual who is not self-employed who intends to deduct the cost of health insurance on an individual tax return must file a Schedule A with their tax return.
The tax treatment of uninsured health benefits is not covered in this article. In general, changes triggered by the Affordable Care Act mean that self-employed individuals may not receive uninsured health benefits on a tax-free basis, except through a Health Savings Account. Employees may receive uninsured tax-free health benefits only if the benefits are provided through a documented benefit plan that conforms with a series of requirements including coverage under an employer-provided qualifying insurance and a claim validation process. Health benefits not meeting these requirements may still be exempt from FICA and FUTA taxes but are subject to federal income taxes according to IRC 3121(a)(2)(B).
See IRS Code section 105 and related regulations for further tax details and "Taxation of small business health plans" and Freedom Benefits web site for more information on running an uninsured business health plan for a small business and for information on health savings accounts.
Effect of the Affordable Care Act - Health insurance paid through a Flexible Spending Account plan, Section 125 cafeteria benefit plan, 401(k) plan, Health Reimbursement Arrangement, Health Savings Account or other tax-qualified benefit plan is subject to additional tax rules that are primarily designed to make sure that the tax-free status of the benefit plan is not abused and that benefits are provided fairly to all participating employees. Additionally, new rules for 2014 substantially changed the tax treatment of these plans to discourage employers from redirecting employees to obtain tax credit subsidized individual health insurance through the insurance exchanges.
Planning for the future - Health insurance in qualified employee benefit plans remains deductible to the business and tax-free to employees, as long as the benefit plan meets all of the operating requirements of such plans. But as a practical matter, free-standing Health Reimbursement Arrangements (HRAs) are no longer a viable option for plans starting after January 1, 2014. While it might be possible in the future to arrange such benefits as a qualifying Medical Expense Reimbursement Plan (MERP), it makes more sense to be prepared for the likelihood that employee health benefits paid by an employer will be subject to taxation in the future.
1 There is a known conflict in language between the wording of some earlier IRS publications and previous tax court decisions with regard to the issue of how the titling or ownership of insurance policies may affect deductibility of the expense, especially with regard to a self-employed person. The tax courts have more recently clarified that titling and ownership of a health insurance policy does not affect the deductibility of premium payments by the business notwithstanding the new restrictions imposed by the Affordable Care Act.
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Opinions expressed are the solely those of the author and do not represent the position of any other person, company or entity mentioned in the article. Information is from sources believed to be reliable but cannot be guaranteed. Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues or a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties. Tony Novak operates as an independent adviser under the trademarks "Freedom Benefits", "OnlineAdviser" and "OnlineNavigator" but is not a representative, agent, broker, producer or navigator for any securities broker dealer firm, federal or state health insurance marketplace or qualified health plan carrier. He has no financial position in any stocks mentioned. Novak does work as an accountant, agent, adviser, writer, consultant, marketer, reviewer, endorser, producer, lead generator or referrer to other companies including the companies listed in the articles on this web site.