If you are unincorporated, or operating as an LLC or a C Corp sole proprietor, these new IRS rules do not affect you. But if you are a locum tenens physician with S Corporation status, you need to read on.

The Internal Revenue Service (IRS) recently issued "Headliner 163," which directly affects sole proprietors operating as S Corporations. IRS Headliners are not new laws or changes to laws. They function as helpful practice tips, and provide insights into the methodology used in examining company policies and filings.

A Primer

This particular Headliner affects the way that a sole proprietor (or greater than 2% S Corp shareholder/partner) deducts health insurance premiums. It clarifies that S Corp sole proprietors cannot purchase health insurance in their own names and claim an above the line deduction for self-employed health insurance premiums. If coverage is purchased in the owner's name versus that of the company, premiums can only be taken as an itemized deduction subject to the limitations based on 7½% of income.

WEIGHING OPTIONS

If you are an S Corp sole proprietor who does not have access to a spousal plan, you have five options to consider. Listed in order of growing tax savings, they are:

1. No coverage
2. Buy personal coverage and claim the amount as an itemized deduction
3. Buy a High Deductible Health Plan (HDHP) and an associated Health Savings Account (HSA)
4. Establish group health insurance coverage through the S Corp with a HSA if the policy qualifies
5. Establish a Health Reimbursement Arrangement (HRA) to reimburse premiums for an HDHP and an HSA to pay for out-of-pocket deductibles.

Of course, the first two have their obvious drawbacks. Option 3 offers tax advantages for out-of-pocket expenses in excess of health insurance premiums—but the premiums must be treated as itemized deductions. The last two are the best strategies for tax savings.

Option 4 has one major obstacle. Only a handful of states—Colorado, Connecticut, Delaware, Florida, Hawaii, Maine, Maryland, Massachusetts, Mississippi, North Carolina, Rhode Island, and Vermont—allow a group health insurance policy to have one member. If you live elsewhere, Option 5 would be your best overall approach for potential tax savings.

The Health Reimbursement Arrangement is set up to reimburse health insurance premiums, as well as long-term and preventative care coverage. Amounts from the HRA are paid by the S Corp, free of income and payroll taxes, and the amounts contributed to the HSA are free of federal and most state income taxes. Total tax savings can be from $1,000 to $4,000, depending on personal expenditures.

HOW TO SET UP AN HRA AND/OR AN HSA

Most insurance companies have a list of administrators that will manage HSAs or HRAs. Do an Internet search to locate prospects, such as 105 Concepts (www.105concepts.com), that offer services not limited by home states of participants.

WILL THE RULE LAST?

The Headliner, published in May, has stirred a lot of interest among S Corp sole proprietors and continues to spark controversy. Until this year, most of the individuals in this category assumed that they were self-employed and entitled to the above the line deduction. The rule may be challenged or revised, but until then, it is a tax planning dilemma to be considered.

Any tax advice contained is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

Reference

Internal Revenue Service, Headliner 163. (2006, May 15). Health insurance covering S Corporation shareholders. Washington, DC: Author.