All tax practitioners have their fair share of stories about clients expecting things to go one way when the tax code goes another direction. When taxpayers and the tax code collide, it’s never fun. We’ve all experienced the headache of having to explain to clients that they aren’t eligible for the deduction or credit they thought they could take. Difficult conversations like these often arise when explaining the health insurance deduction to self-employed taxpayers.
The self-employed health insurance deduction under IRC §162(l) allows eligible taxpayers to deduct health insurance premiums “above the line,” reducing adjusted gross income (AGI). However, eligibility rules are applied strictly, and qualification is determined on a month-by-month basis.
Self-employed taxpayers are notorious for trying to claim as many expenses as possible, and health insurance premiums are a large-ticket item. Needless to say, having to tell a client that they can’t deduct their health insurance premiums because of their spouse’s plan they don’t even use is not something to look forward to. However, having a complete and thorough understanding of the statute will make these conversations easier, and hopefully your clients will feel less frustrated afterward.
IRC §162(l) outlines the health insurance deductions for self-employed individuals. It allows a deduction for amounts paid during the taxable year for insurance that constitutes medical care for the individual, their spouse, dependents, or children under the age of 27.
IRC §162(l)(2)(B), however, provides a critical limitation: that the deduction does not apply for any month that the taxpayer is eligible to participate in a subsidized health plan of any individual for whom the taxpayer may claim a deduction, including their spouse.
This means that even if the taxpayer is not using their spouse’s health insurance plan, being eligible to participate in it makes them ineligible for the self-employed health insurance deduction for that month. The criteria under this section is evaluated monthly, so it’s possible for the taxpayer to qualify in some months and not others, depending on their spouse or other qualified individual’s access to a health insurance plan.
For example, if a taxpayer is eligible for a spouse’s employer plan from January through June but not from July through December, the deduction is disallowed for the first six months and allowed for the remaining six months.
The conversation explaining the self-employed health insurance deduction can become increasingly difficult when the client raises a valid affordability concern. If the taxpayer can purchase their own health insurance for a fraction of the cost it would be to join their spouse’s plan, why is the tax code penalizing them for making a sound financial choice?
The reality is that § 162(l) does not contain an affordability safe harbor. If the taxpayer is eligible to participate in their spouse’s plan, they do not qualify for the deduction for that month, even though they made the economically logical decision to purchase the cheaper plan. End of story. For purposes of §162(l), a taxpayer is considered “eligible to participate” if they could enroll in the plan, regardless of whether they actually elect coverage.
This rule differs from the Affordable Care Act’s (ACA) rule for the Premium Tax Credit (PTC), which does consider eligible taxpayers’ household income when calculating the credit. The second post in this series will cover the interaction between the § 162(l) deduction and the PTC in more detail.
Once the conversation has cleared the affordability hurdle, the next argument taxpayers tend to raise is regarding the definition of a “subsidized” plan. The client may argue that their spouse’s employer pays for their own employee’s coverage but does not contribute toward spousal or dependent coverage. Since the client would be paying 100% of the premium, it may not seem “subsidized” to them.
Practitioners need to explain to clients that the IRS does not evaluate employer-sponsored plan subsidies on a dependent-by-dependent basis. If an employer subsidizes any portion of the employee’s coverage, even if it only subsidizes its own employee’s portion, the IRS considers the plan subsidized for purposes of the self-employed health insurance deduction.
Accordingly, a self-employed taxpayer may be paying out of pocket for the full cost of their spouse’s plan but are still disqualified from claiming the self-employed health insurance deduction because they are eligible for a plan that is subsidized for their spouse.
As the tax code messengers for clients, tax practitioners are often left delivering unwelcome news such as informing clients they do not qualify for the self-employed health insurance deduction. During conversations like these, it’s always helpful to understand the reasoning behind why Congress wrote legislation the way it did, especially when it ends up being unfavorable to taxpayers.
IRC §162(l) was enacted to level the playing field between employees with access to employer-sponsored health insurance and self-employed individuals without it.
Traditional employees could exclude the cost of their employer-provided health insurance from their taxable income. Prior to this deduction, self-employed taxpayers could deduct their health insurance costs only as an itemized deduction, which, given the AGI floor, often yielded no tax benefit. The deduction was a means to promote fairness so self-employed taxpayers weren’t left with the only option of paying for health insurance with after-tax dollars.
When Congress enacted the self-employed health insurance deduction decades ago, it intended it as a last resort for self-employed taxpayers who had no other option but to purchase their own insurance. They did not write it as a means of tax optimization for taxpayers with access to health insurance through other private means because Congress did not want to subsidize households’ private-market choices. It was not written for today’s high-deductible and high-premium environment, where the more economic choice may not result in a tax benefit for the self-employed taxpayer.
Conversations with clients about the self-employed health insurance deduction can prove challenging, especially if the taxpayer does not qualify for this deduction. Alleviate some of the headache that comes from conversations like these by preparing reality checks for common taxpayer arguments and understanding the rationale behind why the tax code was written the way it was. Even though they may be disappointed by the outcome, taxpayers will likely appreciate the explanation and hopefully better accept the not-so-great news about their non-deductible expenses.
In Part 2 of this series, we will explore more complex scenarios, including the interaction between the §162(l) deduction and the premium tax credit, where the analysis becomes even more nuanced.
By Ashley Akin, CPA
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