Health insurance premiums are one of the biggest expenses that most people pay.
These expenses are going to eat up a bigger part of income in the near future. One recent survey stated that health insurance premiums are expected to increase anywhere from 30% to 100% on average due to the “Patient Protection and Affordable Care Act” passed in 2010, so being able to deduct these expenses is going to be very important for traders going forward.
The good news is that there are several ways that traders can deduct these expenses from their income.
Personal Income Tax Deduction for the Self-Employed
Sole proprietors are allowed to deduct health insurance premiums for themselves, their spouses, and their dependents from their self employed income. This deduction includes dental and long-term care coverage. Partners in partnerships, LLC members, and S corporation shareholders who own more than 2% of the company stock can also use this deduction. The deduction is available whether you purchase the insurance yourself or have the business obtain it. However, it is not a business deduction. It is a special personal deduction (Line 29 of Form 1040) for the self-employed.
Problem for Sole Proprietor Traders
There is one important limitation on the health insurance deduction that sole proprietor traders need to keep in mind: you are only allowed to deduct as much as you earn from your trading business. If your trading business does not earn a profit, you get no deduction. You’ll be forced to carry this expense over to Schedule A, where you are only allowed to deduct the amount that is over 10% of your adjusted gross income (AGI). For example, if your AGI is $100,000 and you have $15,000 in health insurance premiums, you’d only be able to deduct $5000 off of your taxes because of the 10% floor on health care deductions. You lose $10,000 worth of deductions because the health insurance premiums are being reported on Schedule A.
The problem sole proprietor traders run into is the nature of their income. The IRS classifies trading gains as unearned income, meaning that even if a trader is profitable, they still cannot take the health insurance deduction because the business has no earned income! If you are trading as a sole proprietor, you will miss out on this valuable deduction. But there are solutions available to you.
How Traders Can Take the Self-Employed Health Insurance Deduction
To get around the business income limitation, you would need to form an entity to trade through. A trader can establish a partnership, Limited Liability Corporation (LLC), or an S Corporation and open up the self-employed health insurance deduction. Just keep in mind that this deduction is NOT a business expense. Health insurance premiums are not deducted directly on the businesses tax return. They are still going to be deducted on Line 29 of your personal Form 1040.
How an S Corporation Deducts Health Insurance Premiums
If your trading business is organized as an S Corporation, your deduction is limited to the amount of wages you are paid by your corporation. The insurance costs are added to your wages and are deducted as such by the S Corporation. You only have to pay income taxes on this amount, as the cost of the insurance is not subject to Medicare and Social Security taxes. Let’s look at an example:
Trader X has established an S Corporation and has a $100,000 trading profit for the year. Trader X has $15,000 in health insurance premiums and pays a $15,000 salary to himself/herself. There are no federal, Medicare, or Social Security taxes withheld from this salary. The S Corporation takes a $15,000 deduction for the wages paid out, making the net profit $85,000. Trader X has $15,000 in W-2 wages to report on his/her taxes but takes the $15,000 self-employed health insurance deduction on Line 29 of the Federal 1040. The net effect is the S Corporation gets the $15,000 deduction and Trader X only pays taxes on the net profits of $85,000. No self-employment taxes are due on the trading gains from the S Corporation because of the classification of the trading gains as unearned income.
How a Partnership and LLC Deduct Health Insurance Premiums
If your trading business is set up as an LLC or a partnership, the health insurance premiums are treated as a guaranteed payment. There is no need to pay out a W-2 salary. The business lists the payment on Schedule K-1 it provides to the IRS and you will report this as income from the trading business on your personal return. You are then responsible for income and self-employment taxes on this amount.
You can still take the self-employed health insurance deduction, which will effectively wipe out the extra income tax you have to pay. But the deduction does not reduce the self-employment taxes due on your personal return.
The Bottom Line
The deduction for self-employed health insurance premiums is a valuable tax break for traders. There are some hoops to jump through to keep it off of your Schedule A and fully deductible, but saving thousands of dollars in taxes each and every year make it well worth the extra work. Click here for a list of other tax deductions available to traders.
[Editor’s note: Get ready for Tax Day with more articles by Steve Ribble here. If you have any last minute tax questions, leave them for Ribble below.]
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