8803 / How is health insurance coverage for partners and sole proprietors taxed?

Partners and sole proprietors are self-employed individuals, not employees, and the rules for personal health insurance, rather than employer-provided health insurance, usually apply. Partners and sole proprietors, are, therefore, entitled to deduct 100 percent of amounts paid during a taxable year for insurance that provides medical care for the individual, spouse, and dependents during the tax year.

The insurance can also cover a child who was under age 27 at the end of the tax year, even if the child did not qualify as the taxpayer’s dependent. A “child” for this purpose is defined to include a taxpayer’s child, stepchild, adopted child, or foster child. A foster child is any child placed with the taxpayer by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction.

In additional, certain premiums paid for long-term care insurance are eligible for this deduction.¹

A partner or sole proprietor is not entitled to this deduction for any calendar month in which the partner or proprietor is eligible to participate in any subsidized health plan maintained by any employer of the self-employed individual or spouse. This rule is applied separately to plans that include coverage for qualified long-term care services or are qualified long-term care insurance contracts, and plans that do not include that coverage and are not those kinds of contracts.²

The deduction is allowable in calculating adjusted gross income and is limited to the self-employed individual’s earned income for the tax year that is derived from the trade or business with respect to which the plan providing medical care coverage is established. Earned income means, in general, net earnings from self-employment with respect to a trade or business in which the personal services of the taxpayer are a material income-producing factor.

Any amounts paid for this kind of insurance may not be taken into account in computing:

(1)  the amount of a medical expense deduction under IRC Section 213; and

(2)  net-earnings from self-employment for the purpose of determining the tax on self-employment income.³

Additional considerations may apply in the case of a partnership. If a partnership pays accident and health insurance premiums for services rendered by partners in their capacity as partners and without regard to partnership income, premium payments are considered to be “guaranteed payments” under IRC Section 707(c). As such, the premiums are deductible by the partnership under IRC Section 162, subject to IRC Section 263, and must be included in partners’ income under IRC Section 61.

A partner is not entitled to exclude premium payments from income under IRC Section 106 but may deduct payments to the extent allowable under IRC Section 162(l), as discussed above.⁴ For partners, a policy can be either in the name of the partnership or in the name of the partner. The partner can either self-pay the premiums, or the partnership can pay them and report the premium amounts on Schedule K-1 (Form 1065) as guaranteed payments to be included in the partner’s gross income. However, if the policy is in the partner’s name and the partner self- pays the premiums, the partnership must reimburse the partner and report the premium amounts on Schedule K-1 (Form 1065) as guaranteed payments to be included in the partner’s gross income. Otherwise, the insurance plan will not be considered to be established under the business.

The IRS has found that the cost of consumer medical cards purchased for partners is not deductible by the partners under either IRC Section 162(l) or IRC Section 213. This conclusion was based on the rationale that consumer medical cards that provide discounts on certain medical services and items are not actually insurance products.⁵

The IRS has also concluded that payments from a self-funded medical reimbursement plan set up by a partnership, and made to partners and their dependents, are excludable from partners’ income. Premiums paid by partners for coverage under a self-funded plan are deductible, subject to the limits of IRC Section 162(l).⁶

There is no limit on the amount of benefits a partner or sole proprietor can receive tax-free.⁷

The IRS has also found that coverage purchased by a sole proprietor or partnership for non-owner-employees, including an owner’s spouse, generally are subject to the same rules that apply in any other employer-employee situation.⁸

The IRS has issued settlement guidelines addressing whether a self-employed individual (“employer-spouse”) may hire his or her spouse as an employee (“employee-spouse”) and provide family health benefits to the employee-spouse, who then elects family coverage including the employer-spouse. The IRS position is that if an employee-spouse is a bona fide employee, the employer-spouse may deduct the cost of the coverage and the value of the coverage also is excludable from the employee-spouse’s gross income.

However, the IRS will closely examine the situation to determine whether an employee-spouse qualifies as a bona fide employee. Part-time employment does not negate employee status, but nominal or insignificant services that have no economic substance or independent significance will be challenged.⁹