Chief Counsel Advice 2000524001 recently reminded self-employed individuals of a fine point that some apparently have been missing lately. The earned income (net earnings) limitation for above-the-line medical premium deductions must be applied on a business-by-business basis for sole proprietors.This is not welcome news for the many individuals who cobble together a variety of jobs, none of which is a principal source of income but which, together, had been assumed to form a tax-advantaged way to cover a family's health insurance costs.
At the same time, the Chief Counsel Advice provided relief to those who worried that, because of the single business requirement for testing earned income, health insurance must be carried in the name of the business rather than that of the self-employed. The IRS has made it clear that it will allow health insurance to be taken in the name of the sole proprietor, as long as there is a designation as to which business the insurance relates.
Within the confines of the new Chief Counsel Advice, self-employed individuals have several tax planning alternatives, all focused on the general goal of spreading policies among separate businesses to avoid the net earnings limitation.
Ground rules
When calculating their adjusted gross income for the year, self-employed individuals may deduct 100 percent of the amounts paid for health insurance for themselves, their spouses and their dependents. It has only been a few years since self-employed individuals have earned the right to a 100 percent above-the-line deduction for medical insurance, after undergoing an especially long phase-in period from 1989 to 2003 that started at 25 percent and moved up gradually and on-and-off over those years.
As the recent Chief Counsel Advice indicates, however, the elimination of the percentage restriction does not free the deduction of other limitations.
The deductible amount is limited to the individual's net earnings from self-employment with respect to a trade or business in which his personal services are a material income-producing factor.
Further, no deduction is permitted for any month in which the self-employed person is eligible to participate in any subsidized, employer-sponsored health plan (either as the employee, an eligible spouse or dependent). Amounts allowable as deductions may not then be double-counted as medical expenses when applying the 7.5 percent of adjusted gross income threshold for the itemized medical expense deduction.
Separate trade or business
The deduction for a self-employed individual is limited to the income earned from the trade or business for which the insurance was purchased. The individual cannot aggregate the profits and losses of several businesses to establish the net income ceiling.
However, the sole proprietor can establish another plan under a second business and deduct the insurance premiums for a plan established under that specific trade or business, up to the net earnings of the second business. Multiple businesses may be used similarly.
Some flexibility also may be possible in determining what constitutes a separate trade or business. Generally, the business categories from Schedule C, Form 1040 are used to determine what constitutes a separate trade or business. For example, a painter and a plumber might combine self-employment income in a single general handyman or contracting business category, or may choose to separate each business, depending upon the overall tax advantages that may be gained.
While the Chief Counsel Advice allows a health insurance policy to be taken out in the name of the individual, it requires that a particular business be designated as the one for which the policy is established. Although some ambiguity may exist over when the designation must be made, it appears to be required on an annual basis before the start of the year. A wait-and-see approach on net earnings until the close of the year is not permitted.
However, on an annual basis, nothing appears to prevent an individual from switching designations for one business to another based upon business conditions and profit expectations.
Dental and long-term care
Health insurance for purposes of the above-the-line deduction includes not only medical insurance policies, but also dental care and long-term care premiums.
Since dental insurance is considered a policy separate from medical insurance, there is the opportunity for the self-employed individual to maximize deductions by taking a dental policy out based on the profit of one business and a medical policy based on the profit of another.
A similar strategy applies to long-term care insurance. Despite proposed legislation to make long-term care insurance premiums deductible above the line for all taxpayers, the premiums, within certain limits adjusted annually, are generally deductible only as an itemized medical expense deduction. However, a self-employed individual may treat long-term care as a separate plan, and use earned income from a separate business to cover it under the income test.
Many employers do not yet offer long-term care coverage. Self-employed individuals eligible for a spouse's employer-subsidized health insurance that does not include coverage for qualified long-term care services, therefore, should consider using long-term care premiums for both spouses as deductions from gross income.
Health savings accounts
Since a medical insurance policy must be measured against the net earnings of a single trade or business, a self-employed individual may need to reduce premium payments to get them completely deductible. One way is to combine a high-deductible policy with a health savings account.
There are no income limitations for contributions made to HSAs. An unemployed person may contribute to an HSA, and another individual may contribute on behalf of the taxpayer. Contributions may be made in excess of earned income, although the deduction may be limited to overall gross income net of other deductions. According to Notice 2004-50, HSA contributions are not expenses attributable to a self-employed person's trade or business.
Conclusion
The rising costs of health insurance, when combined with the recent Chief Counsel Advice, present a danger for certain self-employed individuals - those who don't show significant net earnings in any one business. With planning that revolves around careful selection of a "sponsoring" trade or business, spreading coverage for dental and long-term care among other businesses, and using HSAs to supplement health insurance costs, the sole proprietor can continue to maximize the deductible benefits of health insurance for herself, her spouse and her dependents.George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a WoltersKluwer company.
