For a self-employed individual today, whose health insurance premiums may easily exceed five figures annually, one of the most important provisions in the Internal Revenue Code is §162(l), which allows such individuals to deduct, as a business expense, 100% (as of 2003) of premiums they pay for health insurance for themselves, their spouse, and dependents. A recent Chief Counsel Advice (CCA) (No. 200524001, dated May 17, 2005, released June 17, 2005) addresses two noteworthy issues regarding this crucial benefit. The answers are not unexpected but the analysis is valuable.
The fundamental provision with respect to the health insurance deduction is §162(l)(1)(A), which grants the deduction to an individual who is an “employee” under §401(c)(1), i.e. a self-employed individual. As the CCA notes, one purpose of permitting the deduction is to eliminate the unfair distinction between owners of corporations, who could exclude corporate-provided health benefits from gross income, and self-employed individuals, who could not. This purpose is reflected in the fact that the deduction is above the line; like the deduction for corporate owners, it reduces gross income (and is not subject to the 7.5 percent floor for medical expenses treated as a miscellaneous itemized deduction; in fact, under §162(l)(3), health insurance expenses can’t be treated as medical expenses). The critical point, as the CCA puts it, is that “the statute has always required that a plan be established under a trade or business.”
This would seem to raise a problem for a very large number of sole proprietors, who have not incorporated (the very people Congress meant to benefit, according to the CCA), and who, whether incorporated or not, take out health insurance policies in their own individual names. (Such is usually the case, for example, with the very many sole proprietors who obtain their health insurance through membership in a trade association.) Is such a policy “established under a trade or business”?
There is a ceiling for the deduction: under §162(l)(2)(A), it may not exceed “the taxpayer`s earned income . .. derived by the taxpayer from the trade or business with respect to which the plan providing the medical care coverage is established.” This raises the question whether a sole proprietor who operates more than one trade or business may aggregate them to raise the earned income ceiling.
For further, detailed discussion of the §162(l) deduction see Section 19, Subdivision B5, of this Service.
The first issue discussed in the Chief Counsel Advice is whether the sole proprietor may take out the policy in his or her individual name. Does such a policy establish medical care coverage with respect to a trade or business, so as to be eligible for the deduction? As implied above, to deny that it does would be to exalt form over substance and to deprive sole proprietors of the very benefit the deduction was intended to secure for them. The CCA thus does not even really need to argue for its conclusion that “a sole proprietor who purchases health insurance in his or her individual name has established a plan providing medical care coverage with respect to his or her trade or business, and therefore may deduct the medical care insurance costs for himself, his spouse and dependents under I.R.C. §162(l),” subject of course to the earned income limitation.
No more argument was required for the second issue: “a self employed individual may not add the net profits from all his or her trades and businesses for purposes of determining the deduction limit under I.R.C. §162(l)(2)(A).” However, if for some reason a self-employed individual chose to establish separate plans under separate trades or businesses (the CCA gives the example of an individual who establishes a health plan under one business and a dental plan under another), he or she may deduct medical care insurance costs for each plan under each specific business, up to the net earnings of each trade or business (that is, the earned income limitation applies to each business without aggregation).
Although a CCA has no precedential force, it is to be hoped that the clear presentation and reasoning of the issues here will give planners confidence in its answers, which are plainly sound.
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