Self-Employment Tax on Health Insurance Premiums
The NASE Position:
The current inequity in the Internal Revenue Code as it relates to the self-employed and their health insurance premiums must be corrected. To achieve tax equity between all forms of business entities, the self-employed must receive exclusion of health insurance premiums from self-employment tax regardless of the entity form under which they choose to operate. Possible ways to achieve equity:
1. Internal Revenue Code Sec. 162(l)(4) Code Sec. 1402(a) currently exclude the self-employed health insurance deduction from net earnings from self-employment. If these code sections were eliminated then health insurance premiums would be a deduction for purposes of computing the self-employment tax while leaving the self-employed deduction for insurance premiums as an above the line deduction on Form 1040. Alternatively, a line item deduction for the same amount as the self-employed insurance deduction on page 1 of 1040 could be added to Schedule SE.
2. Health insurance premiums of the self-employed could be deductible on Schedule C or E as an ordinary and necessary business expense rather than the deduction above the line on Form 1040.
3. The group health insurance benefit provisions of the Internal Revenue Code could be expanded to include individuals who have “earned income” and/or the provisions of IRC Section 105 (medical reimbursement plans) could be expanded to include self-employed owners. This change would have the effect of making the insurance premiums deductible at the entity level (Schedule C, Form 1065 or Form 1120S) thus eliminating the need for the self-employed insurance deduction on page 1 of 1040 or on Schedule SE.
Background:
All employees who receive compensation from employers pay FICA taxes. FICA comprises Social Security (6.2%) and Medicare (1.45%) taxes. Employers are required to withhold from gross compensation 7.65% for FICA. In addition to the FICA withheld from the employee, the employer is required to “match” the FICA withholding. Therefore, the employee and employer contribution for FICA is 15.3% of compensation (subject to applicable annual limits).
The self-employed (and others who have “earned income”) also pay into Social Security Fund at a rate equivalent to employees and employers. FICA tax for the self-employed is called “self-employment tax”. The self-employment tax is computed at the same rates (15.3%) as employee/employer FICA and is subject to the same annual limits.
Prior to 1986, an inequity existed which related to the deduction of the insurance premiums for business owners. If the entity operated as a C corporation, the premiums were fully deductible by the corporation, were not income to the owner, and therefore were fully tax deductible for both income tax and FICA tax. If the same entity operated exactly the same in every detail, except the entity was not a C corporation, the health insurance premiums for the sole-proprietor were not deductible for either income tax or FICA tax.
The Self-Employed Health Insurance deduction, authorized by the Tax Reform Act of 1986, began to address this inequity, but the legislation was flawed. Since the self-employed health insurance deduction was (and is) not considered an ordinary and necessary business expense for the self-employed, as it is for the corporate entity, the premiums are still subject to the self-employment tax.
Scheduled to phase in during 2003 is 100% deductibility of health insurance premiums for the self-employed. However, this does not solve the tax inequity. 100% deductibility of health insurance premiums for the self-employed relates to income tax and not self-employment tax. The self-employed are required to pay two types of taxes on their returns: income tax and self-employment tax.
The tax inequity faced by the self-employed when purchasing health insurance lies in the fact that Schedule C filers (sole-proprietors) and Schedule E filers (partners in partnerships with earned income and 2% owners in S Corporations) do not receive a “business deduction” for heath insurance premiums. The deduction for their health insurance premiums, on page 1 of form 1040, is authorized under the rules for the “self-employed health insurance deduction” and is not included on Schedule C, Schedule E or Schedule SE. Therefore, the premiums are not deducted for purposes of the self-employment tax and, accordingly, the sole proprietor(s), partners in partnerships and S corporation owners pay self-employment tax (15.3 percent on self-employment income up to $86,000) on the insurance premiums.
C corporations, on the other hand, receive a deduction for health insurance premiums as an ordinary and necessary business expense for all employees including owners. Since the premiums paid for health insurance are not considered compensation to the employee or employee owner, they are not subject to FICA (Social Security and Medicare) for either the employee or the employer.
EXAMPLE: Self-Employment Tax on health insurance for Mr. Smith, a self-employed individual.
Mr. Smith pays $5,000.00 per year in health insurance premiums.
The tax detriment for the sole proprietor, Mr. Smith, is the annual insurance premiums multiplied by the-self employment tax rate (15.3%). For example:
Amount X .153 = self-employment tax on that premium
$5,000 X .153 = $765
It can be seen from this calculation that Mr. Smith is paying an extra $765.00 in taxes on his insurance each year. No other owner or employer in the U.S. pays this additional tax on his health coverage.
The health insurance premiums of the self-employed should not be subject to self-employment tax regardless of the entity form under which the business is operated.
Legislative Activity:
House Small Business Committee Chairman Donald Manzullo (R-IL) and Ranking Member Nydia Velazquez (D-NY) have introduced the Self-Employed Health Care Affordability Act of 2003 (H.R. 1873). The Senate companion bill, S. 2433, the Equity for Our Nation's Self-Employed Act of 2004, was introduced by Senator Jeff Bingaman (D-NM) and Senator Craig Thomas (R-WY). These important pieces of legislation would eliminate strong cost penalties on health insurance imposed on the self-employed and make quality health care more affordable for millions of Americans who now make up the majority of the working uninsured.
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