Medical Coverage Can Influence Your Entity Choice

There are many factors that go into selecting the type of business organization to use, including concerns for personal liability protection, tax treatment of profits and losses and dealings with co-owners, if any. But another often overlooked factor that can prove to be signification in some cases is medical coverage. The cost of medical coveragefor small businesses is high and the ability to write off this expenditure in a tax-effective way is highly influenced by how a business is organized. Here are key points to consider.

Limits on Medical Deductions
Company-paid medical coverage for rank-and-file employees, their spouses and dependents is a fully-deductible business expense, regardless of how a business is organized. Thus, a sole proprietorship can write-off premiums it pays for employees in the same way in which a C corporation can.

However, premiums paid by the business for sole proprietors, partners and limited liability company (LLC) members are not deducted as a business expense. Generally, the owner can deduct 100% of the premiums as an “above-the-line” deduction--the deduction is subtracted from gross income and does not require the owner to itemize deductions.

For S shareholders who own more than 2% of their corporations, different rules apply. The corporation can pay for coverage and deduct it--but not as an employee fringe benefit. The corporation deducts the coverage as compensation to the shareholders, who must report this as taxable compensation on their personal returns.

Shareholders can, however, usually deduct coverage an as above-the-line deduction, in effect claiming an offsetting write-off to their compensation. However, the coverage may be subject to Social Security and Medicare (FICA) taxes by the corporation and shareholders, an additional tax cost to the parties.

Impact: For self-employed owners, the inability to reduce business income by these premiums means they effectively pay self-employment tax (to cover Social Security and Medicare taxes) on the premiums. Take this example: The sole shareholder of a C corporation is covered by a company health policy, the premiums of which total $10,000 per year for him. The C corporation can subtract $10,000 from its income, cutting the tax it pays on its profits. In contrast, the same premium payments that a sole proprietor pays cannot reduce his business income. While he can deduct the $10,000 premiums from his personal income on Form 1040, he cannot reduce his profits reported on Schedule C. This means he must pay self-employment tax on the premiums, which is up to 15.3% on $10,000, or $1,530.

Note: Bills have been introduced in Congress to treat an owner’s health coverage as a fully-deductible business expense, which would eliminate the self-employment tax cost of this expenditure.

Strategy for transforming personal medical deductions into a business expense
A sole proprietor or other business owner may be able to obtain medical coverage and a business deduction for it by using a well-approved strategy. If the owner hires his or her spouse in the business and the spouse is a bona fide employee, the business can offer fully-deductible health coverage to employees and their spouses. By covering the spouse, the owner obtains coverage as the spouse of the spouse-employee. By deducting the premiums as a business expense, the owner effectively avoids self-employment tax on the cost of the coverage.

Caution: Make sure the document carefully the hours and type of work performed by the spouse to prove the employment arrangement is legitimate.

Special concerns for single-owner businesses
While S corporation shareholders are allowed to deduct their personal health coverage as an above-the-line deduction, use care in arranging coverage. The IRS says that this deduction treatment applies only if the corporation (and not the shareholder individually) purchases the policy.

Dilemma: In some states, corporations with a sole owner and no other employees is barred from purchasing a “group” policy; the insurer issues the policy in the owner’s name. According to the IRS, this means the shareholder can only deduct the premiums as an itemized medical deduction rather than as an above-the-line deduction. Itemized deductions are limited to amounts that exceed 7.5% of adjusted gross income, so high earners may be barred from claiming any itemized medical expenses.

For sole proprietors, the IRS does not care whether the policy is purchased in the owner’s or business name. As long as there is sufficient income from the business to which the policy relates, the owner can claim an above-the-line deduction.

Medical reimbursement plans
Insurance may only go so far. Companies can pay some of an employee’s out-of-pocket health costs. As long as the plan is provided on a nondiscriminatory basis to staff, the business deducts the payments and the employees receives them as a tax-free fringe benefit.

There are various plans that can be used for this purpose:

Important: Only owners of C corporations can enjoy the benefits of an HRA or medical reimbursement account. While other types of entities can provide these plans for rank-and-file employees, owners are barred from receiving tax-free treatment. Thus, owners who think they may need company-paid medical assistance might want to use a C corporation as their entity choice.

One consultant in New York City who suffered as a child with polio was concerned about his potential medical bills in coming years. He set up a C corporation and adopted a medical reimbursement plan with a generous reimbursement amount. As a consultant he could easily have opted to remain a sole proprietor, but medical issues dictated that he use the type of entity that would afford him this tax-favored health coverage.

Health options open to anyone
Small businesses continually face rising health care costs. Projections for premium increases in 2007 range from 7% to 12%, depending on the insurer and type of plan. One solution to keep costs down that can be used by any type of entity is a health savings account (HSA). This type of arrangement combines a high-deductible health plan (HDHP) with a savings account, called an HSA. The HDHP, which contains deductibles at least as large as amounts fixed annually by the IRS, are significantly lower in cost than traditional policies--they only pay for medical costs after the insured satisfies the deductible. (The tax treatment of premiums for HDHPs is the same as for any other medical coverage, as explained above.)

The savings component of an HSA operates much like an IRA. Annual contributions (within limits also fixed by the IRS) are fully deductible. Funds in the HSA are invested and grow tax-deferred. Money in the account can be tapped tax free to pay medical costs not covered by insurance. Unused amounts can continue to grow tax-deferred and, after age 65, can be used for any purpose without penalty (earlier withdrawals for non-medical reasons are subject to income tax and a penalty).

HSAs can be used by any type of business and funding can be done in a variety of ways. The business can pay the premiums and make fully-deductible contributions on behalf of employees, including owners who are self-employed. Or businesses can arrange to share the cost of insurance with employees. As long as there is an HDHP in place, employees can make their own HSA contributions and deduct them on their personal returns if the company does not make contributions on their behalf. It has been estimated that a company with 15 employees that adopts an HSA arrangement can save 40% on health care costs, even though the company pays the full cost of premiums and HSA contributions on behalf of employees.

This article was written for BizFilings by Barbara Weltman, a popular guest speaker on small business issues. She has lectured at national and regional conferences sponsored by prestigious forums such as SCORE, Barnes and Noble, The Learning Annex, and the U.S. Small Business Administration.

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