How to Calculate Health Insurance Deductions

A number of readers have written in this past week about the health insurance deduction for self-employed individuals. You’d think this would be a fairly straightforward issue: You’re self-employed, you pay for health insurance, and you enjoy the deduction. It’s not. Turns out, it is a bit tricky.

Health insurance refers to health insurance, dental insurance and long-term care insurance (subject to limitations) you pay for yourself, your spouse and your dependents. It also includes payments for these insurances on behalf of your child under the age of 2--even if that child is not a dependent on your income tax return. Medicare premiums you pay voluntarily to obtain insurance that is similar to private health insurance can also be included as self-employed health insurance.

The health insurance must be established either in the name of your business or in your own name, and payments can come from either the business bank account or from personal funds.

One reader inquired as to whether or not his spouse has to be on his same plan, to qualify for the self-employed health insurance deduction. She was denied insurance under his plan, and he had to purchase separate coverage for her. According to the IRS, as long as all other rules are followed, the premiums paid for her health insurance qualify.

Keep in mind that premiums paid for health insurance are not a deduction on your Schedule C, your partnership income tax return, or your Sub S income tax return (if you were a shareholder owning more than 2% of the outstanding stock). The only time it is deductible by the company is when your company is incorporated as a C corporation. Otherwise, the deduction is taken as an adjustment to income on Line 29 (2011) of Form 1040.

Your business must have shown a profit in order to claim a health insurance deduction as an adjustment to income on Line 29. If your business shows a loss for the year, you don’t miss out: You may take the deduction on Schedule A under medical expenses. The benefit of taking the deduction as an adjustment to income, is that you enjoy the full write off. If you must take the deduction on Schedule A, you must subtract 7.5% of your adjusted gross income from your combined total of medical expenses. What remains is the amount you may deduct.

There is a lot of confusion about pre-tax dollars and after tax dollars in regards to health insurance deductibles. Here’s how the numbers crunch whether you are self-employed or if you are an employee:  If you’re an employee who enjoys health insurance as a fringe benefit, the value of the health insurance is shown on your W2 in box 12, code DD, but it is not added to taxable wages. Because it is not included as wages, it is not allowed as a deduction. For all practical purposes, it has already been deducted. If the monies funding it are not taxable, then it’s not deductible.

When you are self-employed filing a Schedule C or if you are a partner in a partnership, you do not receive a W2. Therefore, the health insurance is not deducted at the source. That is why Line 29 on Form 1040 allows for the deduction for the self-employed.

As a partner in a partnership, the amounts paid for your health insurance must be included on Schedule K-1 as guaranteed payments. This holds true even if the policy is in the partner’s name and she paid the insurance premiums from personal funds. In that case, she must seek reimbursement from the partnership, or else the plan won’t qualify. The same holds true if a more than 2% owner of an S Corporation has a plan in his own name and pays the premium from personal funds. The difference is that instead of reporting the health insurance on the K-1, it is included as wages on Form W-2 then backed out on Line 29 of Form 1040.

In 2010 only, health insurance premiums were subtracted from profits before calculating and paying self-employment tax (15.3% Social Security and Medicare). This brought an element of fairness to the self-employed that was previously lacking. As an employee working for the ‘man’, your fringe benefit of health insurance was not subject to federal income taxes, Social Security or Medicare taxes. But as a self-employed individual, you had to pay the Social Security and Medicare tax. Well, they did away with the tax break on it for 2011.

Note that health insurance provided for your employees can be deducted on your Schedule C or your other business income tax return if you are not a sole proprietor. Furthermore, Obamacare provided a tax credit for providing health insurance for your employees.

Also note that if you are self-employed and receive health insurance benefits from an outside job, you hold in which you receive a W2, you cannot take the self-employed health insurance deduction because the plan is not established in your name or in your business’ name.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook