Health insurance premiums, deductibles, and out-of-pocket expenses skyrocketed in recent years with some families paying over $ 30,000 annually. It’s unfortunate that many traders and investors receive few tax breaks on deducting these costs, whereas many business owners and employees deduct or exclude them from gross income.
Deductibles for Obamacare bronze plans are now almost as high as the health insurance premium itself. Don’t just focus on deducting premiums; consider using a tax-favored health plan to maximize tax savings on deductibles and out-of-pocket spending, too.
In this blog post, I show traders eligible for trader tax status (TTS) how to deduct all health care expenses using the right choice of entity and tax-favored health plan.
Investors, who are not eligible for TTS, don’t have earned income so they may not deduct health insurance premiums above the line from gross income. But investors and other taxpayers may contribute to a health savings account (HSA) for a deduction from gross income. The IRS does not require earned income for an HSA deduction.
As a last resort, investors may attempt to deduct health care costs as medical itemized deductions, below the line, limited to a 10% income threshold and AMT preferences, which may lead to no tax deduction at all.
Tax-Favored Health Plans
In IRS Pub. 969, the IRS covers four types of tax-favored health plans: health savings accounts (HSAs), health reimbursement accounts (HRAs), health flexible spending arrangements (FSAs), and medical savings accounts (Archer MSAs and Medicare Advantage MSAs). The IRS phased out medical savings accounts after 2007. Health FSAs are voluntary salary reduction agreements, and the annual limit is just $2,550 (2016 limit). In this article, I focus on HSAs and HRAs.
I recommend an HSA for both TTS traders and investors with high-deductible heath insurance plans and significant out-of-pocket expenses. All taxpayers may deduct HSA contributions from gross income whether they are a TTS trader, another business, or an investor.
For TTS traders with out-of-pocket costs well more than HSA limits, I recommend an HRA in a C-Corp management company, alongside a trading partnership. The dual entity allows a retirement plan deduction, too.
A married TTS trader who doesn’t want a retirement plan can employ his or her spouse with a stand-alone HRA to cover family health insurance and out of pocket spending.
To deduct health insurance premiums, TTS traders filing single need an S-Corp trading company or C-Corp management company. Sole proprietor traders cannot deduct health insurance premiums unless they are married and hire their spouse with an HRA that includes health insurance premiums.
Health Savings Accounts
An HSA is a tax-exempt trust or custodial account set up with a qualified HSA trustee to pay or reimburse qualified medical expenses. It’s a similar concept to an individual retirement account (IRA). There is an annual HSA tax-deductible contribution limit. Funds withdrawn for anything other than covering qualified medical expenses is considered taxable income and may be subject to an additional 20% tax. File Form 8889 to report the HSA activity as part of your tax return.
The 2017 annual tax-deductible contribution limit for HSAs is $3,400 for single and $6,750 for family coverage. Taxpayers must also have a qualified high-deductible health plan (HDHP) with minimum essential coverage.
You are entitled to build up your HSA and cover out-of-pocket health care expenses when needed, which may be years later. Some traders forgo reimbursing medical expenses to grow their HSA account tax-free, especially if their custodian offers direct access trading. The IRS may force these taxpayers to reimburse medical costs, so save receipts since you established the HSA.
I view an HSA as tax-favored self-insurance to cover high deductibles. It provides tax advantages to all taxpayers including investors and TTS traders organized as a sole proprietor, partner, S-Corp or C-Corp management company. The IRS does not require earned income for an HSA deduction as it does for deducting health insurance premiums. The HSA compliments high-deductible Obamacare plans. When you shop for a health insurance plan, see if it’s HSA compatible, which makes it relatively easy to set up and maintain.
Health Reimbursement Accounts
An HRA is designed for employers to reimburse employees for individual health insurance plans and out-of-pocket costs. It’s a tax-free fringe benefit to the employee, entirely funded by the employer.
Self-employed persons aren’t eligible for HRAs. That means an HRA is appropriate for a C-Corp management company that hires the owner as an employee, or a sole proprietorship that employs the owner’s spouse as an employee. A sole proprietorship cannot hire the owner as an employee.
S-Corps and partnerships treat 2% owners and their spouses as self-employed, not employees, which means that 2% owners of pass-through entities won’t be able to deduct HRA payments from income.
On Dec. 13, 2016, President Obama signed the 21st Century Cures Act, which reauthorized qualified small employer health reimbursement arrangements (QSE-HRA) in companies with fewer than 50 employees, starting Jan. 1, 2017.
Before the Cures Act, Obamacare considered small employers not offering group insurance taboo and subjected them to significant Obamacare penalties if the company used an HRA to reimburse employees for individual insurance coverage. Obamacare wanted to incentivize small employers to offer group health insurance coverage. Obamacare compelled large enterprises with 50 or more employees to offer group plans to employees.
This Obamacare incentive didn’t work out as intended so to help get coverage for small business employees; Congress passed the Cures Act with several requirements. The employer must not offer group insurance to any employee. Employees must have individual insurance meeting minimum essential coverage to exclude HRA benefits from income, and employees cannot double dip (i.e., receive both HRA benefits and Obamacare-exchange subsidies or credits).
Another requirement is QSE-HRA plans have limitations on annual spending: $4,950 for employee-only coverage and $10,000 for family coverage. These limits make sense, as Congress wants to keep a lid on the alternative solution.
It’s different for stand-alone HRA plans with one employee. In this case, there is no limit on HRA spending per year. Most TTS traders qualify for a one-employee HRA since they don’t have outside employees. IRS Pub. 969 states there is no limit on HRAs, and I assume they mean the one-employee or stand-alone HRA.
Selecting a Health Plan
Which entity and tax-favored health plan you select depend on how much you expect to spend per year on health care expenses, not paid by your health insurance carrier. In 2017, the maximum allowable out-of-pocket costs for deductibles, co-payments, and co-insurance is $7,150 for single coverage and $14,300 for families.
The preferred entity solution for most TTS traders is an S-Corp. Hopefully, the HSA is adequate for their needs, since the HRA does not work for a 2% S-Corp shareholder. (2% shareholder or partner means if you own 2% or more of the equity, you are a 2% shareholder.)
If a TTS trader wants an HRA and retirement plan, he or she ought to consider a dual entity solution: a trading partnership and C-Corp management company to arrange HRA and retirement tax benefits. If a TTS trader already has an S-Corp, they can switch it to a C-Corp.
2% S-Corp Shareholder Rule
Per Thomson Reuters Checkpoint tax publisher, “Although no direct authority exists, the authors believe that medical benefit payments to 2% shareholders under a self-insured plan (Section 105 HRA) are deductible by the S corporation and includible in the shareholders’ income under Rev. Rul. 91-26. Since the plan is not insured, the benefits cannot be excluded from income under IRC Sec. 104(a)(3) [ Reg. 1.105-5(b) ].
“Regulation 1.105-5(b)(b) Self-employed individuals. Under section 105(g), a self-employed individual is not treated as an employee for purposes of section 105. Therefore, for example, benefits paid under an accident or health plan as referred to in section 105(e) to or on behalf of an individual who is self-employed in the business with respect to which the plan is established will not be treated as received through accident and health insurance for purposes of sections 104(a)(3) and 105.”
The 2% S-Corp shareholder and 2% partner rules in Section 105 are determined by lineal descendant rules, which means they apply to the taxpayer’s spouse, children, and parents. These attribution rules don’t apply to a sole proprietorship or C-Corp, just to pass-through entities like the S-Corp and partnership. A Schedule C or C-Corp can hire a spouse, but a pass-through entity cannot for purposes of establishing an HRA.
Sole proprietor TTS traders filing a Schedule C are self-employed, and the IRS does not permit the owner to be an employee. Being self-employed, the owner cannot have an HRA. Sole proprietor TTS traders do not have self-employment income from trading, so they cannot deduct health insurance premiums. They wind up with no deduction for these expenses from gross income.
There is a solution for married traders: The sole proprietor employs his or her spouse, who can have a one-employee HRA that covers family health insurance premiums and out-of-pocket spending. The spouse must perform significant and legitimate work for the trading business.
Cash wages to the spouse are subject to payroll taxes, but the HRA benefits are exempt from payroll tax. The Schedule C deducts the HRA payments to the husband or wife, and the spouse excludes those payments from income.
There are some disadvantages. The sole proprietor trader cannot have a retirement plan contribution since he or she does not have self-employment income from trading gains. (One exception: If the trader is a full member of a futures or options exchange trading Section 1256 contracts on that exchange, it is self-employment income under Section 1402i.) The spouse can have a retirement plan contribution on her wage income. The owner is forgoing a retirement plan deduction that can be up to $60,000 per year for a Solo 401(k) plan for a trader age 50 or older. (A retirement plan for the owner is possible with an S-Corp or C-Corp management company.)
There is an IRS red flag from the spouse’s wages and HRA expenses. They could expand the Schedule C loss by $25,000, more or less, which may attract IRS attention, especially if the trader has trading losses reported on other tax forms. In community property states like California, the IRS might view the trading business as jointly owned, which means the spouse cannot have compensation and the HRA.
A non-trader sole proprietor may save self-employment (SE) taxes by including health insurance premiums in the HRA plan. There’s plenty of room with an unlimited one-employee HRA. It makes the health insurance a business deduction rather than an AGI deduction. A business deduction reduces self-employment income (SEI) and SE tax, whereas an AGI deduction does not. SE tax is 15.3% of the base amount of $127,200, and 2.9% unlimited Medicare tax. Sole proprietor traders don’t owe SE tax on trading income, so these SE tax savings do not apply to them.
A 2% partner in a partnership has the same problem as a 2% S-Corp shareholder: HRA benefits are taxable income. TTS traders don’t pay guaranteed payments (compensation) in a partnership because it’s difficult to achieve self-employment income for unlocking a retirement plan contribution as partnerships pass through ordinary losses to the owner’s tax return. TTS traders use an S-Corp to pay officer compensation. (See the chapter on entities in Green’s 2017 Trader Tax Guide.)
A C-Corp may hire the owner or spouse for a one-employee HRA for family coverage.
A C-Corp is a poor choice of entity for a trading company. There is potential double taxation, losses get trapped on the C-Corp level, Section 1256 lower 60/40 tax rates don’t apply on a C-Corp, and there isn’t a $3,000 capital loss allowed against other income. A C-Corp investment company may not deduct Section 212 investment expenses. Some TTS traders use a C-Corp as a management company in conjunction with a trading partnership.
Partnership with C-Corp using an HRA
The ideal solution for a single TTS trader using an HRA, or a married TTS trader using an HRA and retirement plan, is a dual entity structure. A trading partnership and a C-Corp management company with a one-employee HRA plan.
The dual entity solution is right for states and cities that tax S-Corp income like California, Illinois, and New York City.
The partnership pays only a portion of its trading profits to the C-Corp, and the C-Corp pays officer compensation, health insurance premiums, HRA benefits, and retirement plan contributions. With the trading partnership retaining the majority portion of profits, the C-Corp limits double taxation.
It’s a challenge to arrange for the right amount of income in the C-Corp for covering these planned expenses. The C-Corp can be an owner of the partnership and receive a profit allocation plus an administration fee to achieve targeted income. It’s hard to defend higher fees, so the profit allocation is necessary. Keep up formalities between the entities, so the IRS respects the dual entity structure.
If the owner is in a low tax state, consider leaving profits in the C-Corp, which looks better and takes advantage of the 15% federal tax rate on the first $50,000 of C-Corp net income.
The Potential Impact of Tax Reform
Congress may lower C-Corp tax rates for all tax brackets. It also may lower tax rates on business income in pass-through entities, but it’s not clear yet whether trading gains will qualify for business tax rates. I expect that revenue from management fees will be business income, which qualifies for the lower rates.
Tax writers indicated they would safeguard tax benefits for health care expenses and retirement plan contributions. With escalating health care costs, it would be disruptive for Congress to repeal the health care tax exclusions or deductions. Repealing and replacing Obamacare could impact these tax planning strategies.
If you are interested in deducting health insurance premiums and out-of-pocket health care expenditures with an HSA or HRA, contact us for more information.
Postscript June 22, 2017:
Senate Republicans unveiled their health care bill which improves tax-favored health plans, expanding contribution limits and reducing taxes on excess distributions. Section 121 of the bill raises the annual tax-deductible contribution to health savings accounts (HSAs) to the amount of deductible and out-of-pocket limitation. Current HSA limits are $3,400 for single and $6,750 for family coverage (2017 limits), which left a doughnut hole for many taxpayers since deductibles, and out-of-pocket costs average $7,150 for self-only coverage and $14,300 for families. The Senate bill fixes this problem by covering the costs not paid by a health insurance carrier. All taxpayers may contribute to an HSA, and with expanded limits, there is less need for a health reimbursement account (HRA).
Darren Neuschwander, CPA contributed to this blog post.