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Generally speaking, any expenses an employer incurs related to health insurance for employees and their “tax dependents” as defined under federal tax law are 100% tax-deductible as ordinary business expenses under both California and federal income tax law.
However, as explained below, the tax consequences under California and federal tax law are different for expenses incurred in connection with providing health insurance to employees’ registered domestic partners or same-sex spouses and their dependents, if they are not tax dependents of the employee under federal tax law. A domestic partner or same-sex spouse (and his or her children) typically does not qualify for tax-dependent treatment.
Beyond this general rule, things get a bit more complicated. Below we offer detailed information on the tax implications of offering a group plan for your business. Before we get started, it’s important to understand a few key distinctions. When discussing taxability of health insurance, there are a few main issues:
- For employers, main issues include:
- Whether an employer’s health coverage premium contributions are tax-deductible as a business expense.
- Whether an employer’s reimbursements for the costs of coverage and care are tax-deductible as a business expense.
- For employees, main issues include:
- Whether an employer’s premium contributions are taxed as income.
- Whether an employer’s medical reimbursements are taxed as income.
- Whether an employee’s share of premium is paid with pre-tax or after-tax income.
Also, the taxability of health insurance can be affected by how you set up the health plan. For example, with just a little paperwork on the employer’s part, a worker can contribute to the cost of health insurance on a pre-tax basis, lowering the amount of the worker’s taxable income and increasing the worker’s take-home pay. In addition, because taxable income is reduced, related employer-paid payroll taxes are also reduced. We’ll explain this in more detail below.
|How do business owners calculate tax savings from group health coverage?|
If you find yourself getting confused, just remember that most tax-related questions boil down to one or more of the main issues listed above. These are the main questions employers and employees find themselves asking. We will answer them below.
Obviously, tax issues can get complicated, so you should consult with your accountant or attorney about your specific circumstances.
What Does It Mean to Be Self-Employed?
Keep in mind that the answers to these issues may differ depending on the legal structure of the business. Some employers are considered self-employed and are subject to special rules. Generally speaking, owners of C corporations and LLCs classified as corporations for tax purposes are not considered to be self-employed. These business owners are considered to be employees of the business.
On the other hand, the following types of employers are considered to be self-employed for purposes of health care benefits:
- Owner of a sole proprietorship,
- Partner in a partnership,
- Member of an LLC classified as a partnership for tax purposes, and
- Shareholder of 2 percent or more of the stock of an S corporation.
As we continue to discuss rules below, keep in mind that employers who are not self-employed are considered to be workers, so any rules that apply to workers apply to the employer as well. If the employer is self-employed, a special rule may apply.
Tax-Deductibility of Employer’s Premium Contributions
A common concern for employers is whether their contributions toward health coverage premiums are deductible as business expenses. In general:
- Employer premium contributions for employees and their opposite-sex spouses and tax dependents are 100% deductible as business expenses under federal and state tax law. This is true regardless of business type-sole proprietorship, partnership, LLC, corporation, etc. Employers may also deduct premium contributions paid on behalf of registered domestic partners, same-sex spouses and their dependents for California state tax purposes only. These rules also apply to owners of C corporations and LLCs classified as corporations for tax purposes. These business owners are considered to be employees of the business for purposes of the tax treatment of premium contributions.
- If an employer is self-employed, contributions for him or herself and his or her opposite-sex spouse and tax dependents are 100% deductible as a business expense on the business owner’s tax return. Self-employed individuals may also claim this deduction for health insurance costs paid for their registered domestic partner or same-sex spouse and their dependents under California law.
- Employers should be aware that the Patient Protection and Affordable Care Act offers small businesses healthcare tax credits to help offset the cost of insurance. These tax credits have been available since the 2010 tax year. To qualify for a tax credit of up to 35% now and 50% in 2014 through health exchanges, small business owners must pay at least half of employees’ healthcare premiums and have 25 or fewer full-time equivalent employees who earn an average of $50,000 or less per year.
To see whether you qualify for the tax credit and to find out how it is calculated, visit “Small Business Tax Credit” in the tool box.
Tax-Deductibility of Employer’s Medical Reimbursements
Reimbursements provided by employers for medical expenses and health care coverage of employees are treated similarly to employer-provided premium contributions, as long as some rules are followed. The employer must have a “plan” in writing that stipulates the employer will provide health coverage by reimbursing its employees for all or part of medical expenses or the cost of coverage purchased directly by the employees. Employers should obtain documentation of the medical services before reimbursing the employee.
As long as the requirements are satisfied, employers may deduct as business expenses any reimbursements provided for their employees and their opposite-sex spouses and tax dependents under federal and state tax law. Employers may also deduct reimbursements paid on behalf of employees’ registered domestic partners, same-sex spouses and their dependents under California state tax law.
Employers who are self-employed may also deduct the cost of their own and their tax dependents’ healthcare expenses, but as personal expenses rather than business expenses.
Taxability of Value of Health Plan to Employee
Another issue employers face is whether the value of the health plan—basically, the amount of the premium costs—is taxable to the recipient. Keep in mind that the recipient could be an employee or a self-employed business owner. The general rule is as follows:
- Employees are not taxed on the value of their health coverage. The value of employer-provided health coverage for the employee and their opposite-sex spouse or tax dependents is not taxable income to the employee under federal and state tax law. The coverage is tax-exempt to the employee whether it is provided under a group or individual insurance policy.
- An employee who is provided coverage for a same-sex spouse, domestic partner or their dependents is subject to federal tax on the value of the coverage provided by the employer for the non-tax dependents, less the amount (if any) paid by the employee for the coverage. Such amounts also are considered wages for purposes of federal payroll taxes. On the other hand, California allows an exclusion from gross income for employer-provided health coverage for registered domestic partners, same-sex spouses and their dependents.
- Business owners who are considered to be self-employed are taxed on the value of their health coverage. As we explained above, the following types of employers are considered to be “self-employed”: owners of sole proprietorships, partnerships, LLCs classified as a partnership for tax purposes, and 2 percent shareholders in an S corporation. These business owners will be taxed on the value of their health coverage, but receive an offsetting deduction on their tax returns.
Taxability of Reimbursements to Employees
If an employee pays the premiums on personally owned health insurance or incurs medical costs and is reimbursed by the employer, the reimbursement generally is excluded from the employee’s gross income and not taxed under both federal and state tax law. This includes premiums for tax dependents and opposite-sex spouses. However, there are some circumstances in which the reimbursement is taxable income, including the following:
- If an employer simply pays the employee an extra amount and does not specify in writing that the amount must be used to pay the health coverage premium, it will be taxable to the employee as income.
- If the employer is self-employed, any reimbursements for their own or their dependents’ health care costs are taxable income to the self-employed employer.
It may be difficult to provide reimbursements for individual coverage while complying with California’s small group law (AB1672) and tax law. To further explore these issues, contact a tax professional.
California law, but not federal tax law, also allows an exclusion from gross income for employer reimbursements for same-sex spouses, registered domestic partners and their dependents.
Taxability of Employees’ Premium Contributions
Generally speaking, an employee contribution toward health coverage is deducted from wages on an after-tax basis unless the employer establishes a special arrangement under Section 125 of the federal tax code. Without a Section 125 plan in place, taxes are imposed on employees’ pay before they pay their share of the premium.
Section 125 plans include:
- Before-tax “premium only” plans. Plans that allow employees to pay the premium for themselves and their tax dependents with before-tax dollars. Employees may also use pre-tax dollars to pay premiums for non-tax dependents as long as the value of the coverage is taken into account for purposes of calculating the employee’s taxable income.
- Flexible spending account plans. Reimbursement plans that, in essence, allow employees to pay for certain eligible out-of-pocket medical expenses with before-tax dollars.
- Cafeteria or flexible benefit plans. Plans that give the employee a choice of taxable pay or nontaxable benefits.
In various ways, these plans allow you and the employee to save on taxes. If employees contribute to the premium with before-tax pay, they will reduce their federal income tax, state income tax, Social Security tax, and other payroll taxes. You will also save employer taxes (FICA and FUTA) on the amount of employees’ before-tax contributions.
Under the Affordable Care Act, for FSAs under a cafeteria plan, annual contributions will be limited to $2,500 beginning in 2013; the limit is indexed to the Consumer Price Index for following years. There is currently no federal limit and employers set the annual cap.
Another note: The FSA definition of qualified medical expenses is the same as those allowed under itemized tax deduction. This change, effective January 1, 2011, no longer allows coverage of over-the-counter items unless directed by a physician.