Self-Employment Tax on Health Insurance Premiums

March 28, 2009

The NASE Position:

The current inequality 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 be able to exclude health insurance premiums from self-employment tax regardless of the entity form under which they choose to operate.

Background:
All employees who receive compensation from employers pay FICA taxes. FICA comprises Social Security (6.2 percent) and Medicare (1.45 percent) taxes. Employers are required to withhold from gross compensation 7.65 percent 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 percent of compensation (subject to applicable annual limits).

The self-employed (and others who have “earned income”) also pay into the 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 percent) 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.

Also, one hundred percent deductibility of health insurance premiums for the self-employed, which was phased in during 2003, 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 health 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 premiums 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 percent). For example:

Premium 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 their 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:
The Opportunity for Family Farms and Small Businesses Act of 2009 (H.R. 533), introduced in the 111th Congress, would allow the deduction of health insurance costs for self-employment tax purposes.

The NASE heads up the coalition supporting Equity for Our Nation’s Self-Employed, which brings together over 40 small business organizations, working to remove this unfair tax burden on the self-employed. For more information, please visit our coalition website at www.setaxequity.org.

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