Taxation of health insurance benefits

by Tony Novak, MBA, MT, OnlineAdviser at Freedom Benefits revised 3/10/2012

The tax-exempt status of health insurance has been a stable principal of federal tax law, but recent changes to tax laws triggered by health reform in 2010 combined with lingering popular misconceptions often cause confusion. This article is meant to summarize the basic principles and address a few of more complex issues regarding the taxation of health insurance.

Businesses

Health insurance paid by an employer for coverage on an employee or the employee' s dependents is deductible as a normal business expense under IRC Section 162. Health insurance benefits are not wages and therefore are not subject to wage taxes. For this purpose, the term "employee" includes an owner/employee of a C-corporation but does not include owner employees of other types of businesses.

Self-employed Individuals

Self-employed individuals may deduct 100% of the cost of health insurance as an "above the line" expense on the front page of their Form 1040. The deduction is available to all qualifying taxpayers, regardless of whether they choose to itemize their other expenses. Direct deductions from gross income are allowed only to the extent of the amount of net self-employment income. Excess amounts, if any, may be deducted of Schedule A as listed in the "Individuals" section below.

The term "self-employed person" for this purpose includes non-salaried owners of S-corporations, LLCs, partners and sole proprietors under IRC Section 162(l).

Except for salaried owner/employees, health insurance paid by a business on behalf of a self-employed person is not a deductible business expense. For example, if an S-corporation that pays for health insurance for its non-salaried owner/employee, this expense is not listed as a business expense on the Form 1120 but rather the deduction flows directly through the Form 1120S to the individual owner' s Form 1040. Health insurance for salaried owner/employees is treated the same as regular employees except that an adjustment for self-employment tax is made. The IRS publishes detailed instructions on this topic in the instructions for Form 1120S.

Employees

Health insurance benefits provided by an employer are not taxable income under IRC Section 104 and 105. This includes amounts paid by the employer to reimburse the employee for the cost of health insurance. Of course, the employee may not "double-dip" by deducting the cost of these tax-free benefits on an individual tax return.

Individuals

The cost of health insurance paid by individuals is tax deductible only to the extend that the cost of coverage they paid, in combination with some other specified expenses, is more than 7.5% of adjusted gross income. For most people, this limitation effectively means that they do not get a tax deduction for the cost of health insurance paid. The cost of health insurance paid by an employer is a deductible personal expense if the amount is included as wages in Box 1 of Form W2, but this is a relatively rare situation.

Type of Insurance

Tax treatment is not affected by the type of health insurance; it may be an individual insurance plan or a group insurance or any other type of health insurance.¹

Tax Reporting

No separate tax reporting of health insurance benefits is required for either the employer or the employee. A self-employed person deducts health insurance on the Form 1040. A business deducts health insurance for employees as a regular business expense. An individual who is not self-employed who intends to deduct the cost of health insurance on an individual tax return must file a Schedule A with their tax return.

Health benefits not paid though insurance

The tax treatment of uninsured health benefits is entirely different and is not covered in this article. In general, self-employed individuals may not receive uninsured health benefits on a tax-free basis, except through a Health Savings Account. Employees may receive uninsured tax-free health benefits only if the benefits are provided through a formal plan that conforms with a series of requirements including, in some cases, claim validation by an independent third party. Health benefits not meeting these requirements are exempt from FICA and FUTA taxes but are subject to federal income taxes according to IRC 3121(a)(2)(B).

See IRS Code section 105 and related regulations for further tax details and "Taxation of small business health plans" at Freedombenefits.org for more information on running an uninsured business health plans and www.healthsavingsaccount-hsa.com for information on health savings accounts.

Qualified benefit plans

Health insurance paid through a Flexible Spending Account plan, Section 125 cafeteria benefit plan, 401(k) plan, Health Reimbursement Arrangement, Health Savings Account or other tax-qualified benefit plan is subject to additional tax rules that are primarily designed to make sure that the tax-free status of the benefit plan is not abused and that benefits are provided fairly to all participating employees. Generally this type of health insurance is deductible to the business and tax-free to employees, as long as the benefit plan meets all of the operating requirements of such plans.

***

Footnotes

¹ There is a known conflict in language between the wording of some IRS publications and previous tax court decisions with regard to the issue of how the titling or ownership of insurance policies may affect deductibility of the expense, especially with regard to a self-employed person. The author' s opinion is that the tax courts have correctly clarified that titling and ownership of a health insurance policy does not affect the deductibility of premium payments.

Status: available for reprint

This article is available for republication in its entirety without charge after obtaining the express written permission of the author.

Please e-mail a request to the author that includes the name of the requestor (individual and corporate) and the intended destination of publication.