Health Insurance Deductions and Health Savings Accounts

Mr. Donald J. Breece, Farm Management Specialist, OSU Extension Center at Lima

Health insurance costs are a major farm family expense. As a result, much attention is focused on adopting a health insurance strategy that will save on taxes. For any given strategy, the effect on Social Security (both Self Employment and FICA tax) must be considered in addition to income tax savings.

Sole proprietorships, partnerships, and LLC's taxed as a partnership, are not allowed to provide tax-free fringe benefits (other than qualified retirement plans) to the proprietor and family. The farm operator is not an employee. However, the farmer can employ the spouse and the dependents. This may be done under IRS Code Section 105. The spouse must be a bona fide employee and must be paid a reasonable salary plus benefits, based upon the duties performed. With this strategy, the farmer may deduct the cost of family health insurance (in the spouse's name) as a business expense, thus saving both income tax and self-employment tax. However, the spouse's wages are subject to Social Security (FICA) and Medicare taxes. If the spouse is not employed by the business, the farmer can claim self-employment health insurance as a deduction on line 28 of the Form 1040. Under this deduction; however, self-employment tax is not reduced.

If a partnership pays the health insurance for the partner, the payment is treated as income to the partner for both income and self-employment taxes. The partner can claim the self-employed health insurance deduction, same as the sole-proprietor. The S Corporation rules for fringe benefits are much the same as a partnership, however, unlike a partnership, no social security (FICA) tax is imposed on the value of the premiums. Thus, the total tax liability is less for an S Corporation shareholder-employee than that for a partner or LLC member receiving the same health insurance benefits.

A farmer can achieve the most favorable tax treatment of fringe benefits by utilizing a C or regular corporation. The corporation furnishes the health insurance and deducts the premiums. However, no income is attributed to the shareholder-employee. Also, no FICA or Social Security tax is imposed on the health insurance benefit.

Health Saving Accounts (HSA) first became available in 2004, under IRC Section 223. The HSA are custodial accounts or tax-exempt trusts that are created to pay qualified medical expenses for the account holder, spouse, and dependents. Contributions to HSA are deductible if made by an eligible individual, an employer, or both. Distributions from the HSA are tax-free if they are used to pay for qualified medical expenses. In addition, investment earnings are not taxable. Distributions used for non-medical expenses are taxable and subject to a 10% penalty.

Eligibility requirements for an HSA include:

1. Must be covered by a high deductible health plan (HDHP). A HDHP must have an annual deductible of at least $1,050 for individual coverage and $2,100 for family coverage, and an annual out-of-pocket expense limit of $5,250 for individual coverage and $10,500 for family coverage.
2. Can not be covered by other health plans that are not a HDHP.
3. Can not be entitled to Medicare benefits.
4. Also, can not be eligible to be claimed by another taxpayer.

The maximum contribution to a HSA is the lesser of the annual deductible of the HDHP or for self coverage $2,700 in 2006 (each year will be adjusted for inflation) and $5,450 for family coverage (also to be adjusted for inflation). Individual policyholders and covered spouses who are 55 or older are allowed a "catch-up" amount of $700 for 2006 (this will increase by $100 per year to $1,000 by 2009).

There is no "use-it-or-lose-it" provision for HSA. Therefore, unused contributions can be carried forward and used for eligible medical expenses after the beneficiary has retired. The beneficiary can also withdraw funds penalty-free after age 65, thus treating the HSA as the equivalent of a traditional IRA.