How Your Business Entity Type Affects The Way You Deduct Health Insurance

There are various entity types available for business. Your business may be structured as a sole proprietorship, partnership, S corporation or C corporation.?As I’ve mentioned before, there are also LLCs and also LLPs (limited liability partnerships) but these are generally taxed as one of the first four entities I mentioned and are usually formed for legal liability, not tax issues.

Believe it or not, when discussing the tax treatment of health insurance deductions for the owners, each of the four entities has a different tax treatment. I’ve always found it a bit strange, but nonetheless, the law is the law. I am now going to explain the treatment under each structure type.

C corporation. The treatment of health insurance paid for the owner(s) of a C corporation is very straightforward and simple. It is deducted as an expense of the corporation no different than health insurance premium payments paid for any employee. The owner gets no deduction on their personal income tax return and they do not have to report payments made on their behalf as income. They are treated exactly the same as any other employee of the corporation.

S corporation. The treatment of health insurance paid on behalf of S corporation shareholders if they own 2% or less of the company is exactly the same as it is for owners of a C corporation. If, however, the shareholder owns more than 2% of the corporation, then there is a different treatment. For these individuals, premiums paid on their behalf are treated as wages to the shareholder for income tax purposes, but are not however, subject to Social Security, Medicare or FUTA taxes. The amount reported as compensation is the total amount paid for the shareholder, spouse and dependents.

There are limitations to this deduction. The first limitation is the deduction is not available for calendar months that the shareholder or spouse are eligible to participate in another employer-subsidized health insurance plan. The second limitation is that in order to deduct the expense on his/her personal return “above the line” he/she must have taxable social security wages from the S corporation equal to or greater than the medical deduction. Above the line means the taxpayer is able to deduct the medical insurance before Adjusted Gross Income (AGI). The advantage to this is that the taxpayer receives the deduction whether or not they itemize their deductions.

I mentioned that wages added because of medical insurance premiums paid are not subject to payroll taxes but there must be payroll wages subject to these taxes in order to get the deduction. This means the shareholder must have wages outside of those added for medical insurance, paid to him/her by the S corporation in order to receive the deduction. For example, let’s say we have a 100% owner of an S corporation. Additionally, let’s say medical expenses paid on behalf of this shareholder, spouse and dependents is $18,000. The $18,000 added to the shareholder’s wages would not be subject to payroll taxes and therefore, the shareholder would have to have additional wages equal to or greater than $18,000 from the business in order to receive the deduction.

The health insurance plan must be owned and paid by the S corporation or the S corporation must reimburse the shareholder or pay the insurance company for a policy in the shareholder’s name in order for the taxpayer to receive the above-the-line deduction.

Payments made to a more than 2% shareholder’s HSA plan are also treated as wages and added to the shareholders' wages.

Partnership. Payments made by a partnership on behalf of a partner that provides services to the partnership are treated as guaranteed payments. Guaranteed payments are deducted by the partnership and reported as income by the partner on his/her tax return. Guaranteed payments are subject to self-employment tax, thereby satisfying the rule that the individual taking an “above the line” deduction on their personal income tax return has paid social security tax on an amount of income equal to or greater than the medical insurance premiums being deducted. The health insurance policy must be established under the name of the partnership or must be a direct reimbursement to the partner for a premium being paid. If this condition is not met, the partner will not receive an “above the line” deduction. Similar rules apply in the case of HSA payments. The payments for partners that provide services are included as guaranteed payments. If the partner is not providing services, then it is considered a distribution (not deductible by the partnership, not included as income by the recipient. However, keep in mind, since the partnership did not deduct the expense, the partnership income will be higher and lastly, the partner can deduct the HSA contribution on their individual tax return).

Sole proprietorship. Sole proprietors can deduct premiums paid on behalf of themselves, their spouse, dependents and nondependent children under age 27. The individual must not be eligible to participate in a subsidized plan (one which an employer pays a portion of) from an employer of the individual or their spouse. The sole proprietor must have earned income from their business equal to or greater than the medical insurance being deducted. Once again, the government wants to make sure that in order to allow an “above the line” deduction, social security tax must have been paid on income equal to or greater than the medical insurance premiums being deducted.

The policy may be in the name of the business or the individual.

As you can see, the type of entity that you operate your business under can have a significant impact on how and when medical insurance premiums are deducted. I caution you here, as I do with many complicated areas of taxation. If you are an owner of a business and you would like to take an above the line deduction, please seek the help of a tax professional familiar with these rules.

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Hang in there and stay safe,

Jeff Skolnick, CPA, M.S. Taxation