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Section 199A Self-Employed Health Insurance

Section 199A Self-Employed Health Insurance

 

By Jason Watson ()

Posted February 10, 2019

 

When comparing business activities on a Schedule C versus an S Corp election, one of the gripes is the reduction of the Section 199A qualified business income deduction in an S corporation because the payment of reasonable shareholder salary reduces net business income. As we have shown in Chapter 8 of our book, the reduction of Section 199A benefits is still eclipse by the savings of self-employment taxes in an S corporation. However, the final regulations for Section 199A have a little quirk which bolsters the benefits of an S corp election over garden variety LLCs reported on Schedule C. How? One of the answers is the Section 199A Self-Employed Health Insurance reduction in net qualified business income (QBI).

 

Let’s run through it, shall we?

 

Section 199A Calculation Recap

The basic Section 199A pass-through deduction is 20% of net qualified business income, which is huge. If you make $200,000, the deduction is $40,000 times your marginal tax rate of 24% which equals $9,600 in your pocket. The is direct cash in your pocket. Extra cheese on your whopper!

 

But you knew all this since you’re smart and you’ve been snooping around the internets in your PJs sipping cold coffee. Perhaps what you didn’t know is this $200,000 cannot be viewed in isolation when it comes to self-employment taxes, self-employed health insurance and retirement plan contributions. Moving on…

 

Section 199A Final Regulations

The final regulations 1.199A for the Section 199A deduction clarified all kinds of things and the handling of the deductible portion of self-employment tax, self-employed health insurance and retirement plans for small business owners is one of them. Here is the code from 1.199A-3(b)(1)(vi)

 

(vi) Other deductions. Generally, deductions attributable to a trade or business are taken into account for purposes of computing QBI to the extent that the requirements of section 199A and this section are otherwise satisfied. For purposes of section 199A only, deductions such as the deductible portion of the tax on self- employment income under section 164(f), the self-employed health insurance deduction under section 162(l), and the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis to the gross income received from the trade or business.

 

Section 199A Final Regulations

Here is the key phrase- “For purposes of section 199A only, deductions … are considered attributable to a trade or business” and therefore reduce the qualified net business income for the calculation of the Section 199A. In other words, you would not have these expenses if you otherwise did not have a small business. Sure, you pay Social Security and Medicare taxes, pay health insurance premiums and contribute to a 401k plan with your W-2 job, but those “expenses” are attributed to your employment; same concept here.

 

What does all this mean? Before we get into that, the last sentence is crazy lawyer talk- “to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis to the gross income received from the trade or business.” We’ll speculate on what this tidbit means since guidance specific to this phrase is not available or at least cannot found in our research databases (Thomson Reuters and Bloomberg).

 

Section 199A Schedule C Calculation

The best way to show this is to jump right into a table-

 

  Scenario 1 Scenario 2
Net Business Income on Schedule C 100,000 100,000
less Deductible Portion of SE Tax 7,065 7,065
less Self-Employed Health Insurance (SEHI)   12,000
less 401k Plan / SEP IRA Contribution   37,087
Net Business Income for Section 199A Calc 92,935 43,848
Section 199A Qualified Business Income Deduction 18,587 8,770

 

What are we showing here? We are showing that the qualified business income must be reduced by the amount of deductible self-employment taxes, self-employed health insurance premiums and 401k / SEP IRA contributions. What jumps right out at you is the massive change in the Section 199A deduction between the two scenarios. We speak with people on a near-hourly basis who want to maximize the Section 199A deduction; Yes, we do too! But… let’s not lose track of the overall income tax savings!

 

See below-

 

Delta in Section 199A Deduction 9,817
Delta in SEHI / 401k Deductions 49,087
Tax Savings @22% in Scenario 2 8,639

 

What are we showing here? The $9,817 above represents the difference in Section 199A deduction calculation between Scenario 1 and 2 in the previous table. The $49,087 is the sum of the self-employed health insurance premiums and the 401k / SEP IRA contribution (this example is a 401k since a SEP IRA could not reach $37,087 with $100,000 in biz income).

 

If you subtract $9,817 from $49,087 you get $39,270, even in Canada. Multiply this by 22% (assumed marginal tax rate) and you get $8,639. This is the difference, cash in your pocket difference, by deducting SEHI and 401k after the reduction in Section 199A benefits. So, Yes, you short-changed yourself on a strict Section 199A deduction, but your overall tax world is dramatically improved with these deductions.

 

Section 199A Side by Side Comparisons

The following table is crazy long, but it illustrates the difference in overall tax savings by electing your LLC to be taxed as an S corporation. Here are the assumptions-

 

  No S S Corp
Biz Income 100,000 100,000
Salary / Officer Comp 35,000 35,000
SEHI, HSA, etc 12,000 12,000
Employer 401k / SEP IRA 37,087 8,750

 

Here we go…

 

ln   No S S Corp
1 Net Business Income Before Wages, etc. 100,000 100,000
2 less W-2 Wages, includes SEHI 0 35,000
3 less Self-Employment Tax / Employer Payroll Taxes 7,065 1,760
4 less Self-Employed Health Insurance (SEHI) 12,000 0
5 less Employer 401k / SEP IRA 37,087 8,750
6 Section 199A Qualified Business Income 55,848 54,491
       
  Adjustments to Adjusted Gross Income / Net Business Income    
7 less Social Security Tax 5,726 0
8 less Medicare Tax 1,339 0
9 less SEHI, 401k 49,087 31,000
       
10 Other Taxable Income 0 0
       
11 Adjusted Gross Income 43,848 58,491
12 Itemized / Std Deductions 24,000 24,000
13 Taxable Income Before Section 199A 19,848 34,491
       
14 Section 199A Net Biz Income 11,170 10,898
15 Section 199A W-2 Wage Limit 0 17,500
16 Section 199A Taxable Income Limit 3,970 6,898
       
17 Section 199A Benefit (lower of ln 14, 15, 16) 3,970 6,898
18 Marginal Income Tax Rate 12% 12%
19 Income Tax Benefit from Section 199A -476 -828
20 plus Self-Employment Tax 14,130 0
21 plus Tax on Line 12 Delta (above) 0 1,757
22 plus Payroll Tax (Employee and Employer) 0 3,519
23 Net Tax After Section 199A Benefit 13,653 4,448
       
24 S Corp Benefit SE Tax Reduction Only   10,611
25 S Corp Benefit Section 199A Only   -1,406
26 Net S Corp Benefit $   9,205

 

Wow! That’s a lot to take in. The big takeaway is line 6. Note how the net business income for use in calculating the Section 199A deduction is nearly identical between a non-S Corp and an S Corp. The reason is that such a large chunk is being walloped off because of self-employed health insurance and 401k / SEP IRA contributions relative to the $100,000 net business income.

 

Also keep in mind that self-employed health insurance premiums are a component of officer compensation (also known as reasonable shareholder salary), but it does not increase Social Security and Medicare taxes. Approximately $1,836 of the $9,205 above is attributed to the $12,000 in health insurance premiums.

 

Recall that we take the lower of lines 14 and 16, and line 15 only factors in when you exceed the 24% marginal tax bracket as a household. Therefore, while your Section 199A deduction benefit (line 19) is lower in S Corp land, the overall tax savings is much higher (due to the reduced self-employment tax).

 

Let’s look at $200,000 in net business income.

 

ln   No S S Corp
1 Net Business Income Before Wages, etc. 200,000 200,000
2 less W-2 Wages, includes SEHI 0 70,000
3 less Self-Employment Tax / Employer Payroll Taxes 10,918 4,437
4 less Self-Employed Health Insurance (SEHI) 12,000 0
5 less Employer 401k / SEP IRA 37,087 17,500
6 Section 199A Qualified Business Income 151,995 108,063
       
  Adjustments to Adjusted Gross Income / Net Biz Income    
7 less Social Security Tax 8,240 0
8 less Medicare Tax 2,678 0
9 less SEHI, 401k 49,087 31,000
       
10 Other Taxable Income 0 0
       
11 Adjusted Gross Income 139,995 147,063
12 Itemized / Std Deductions 24,000 24,000
13 Taxable Income Before Section 199A 115,995 123,063
       
14 Section 199A Net Biz Income 30,399 21,613
15 Section 199A W-2 Wage Limit 0 35,000
16 Section 199A Taxable Income Limit 23,199 24,613
       
17 Section 199A Benefit (lower of ln 14, 15, 16) 23,199 21,613
18 Marginal Income Tax Rate 22% 22%
19 Income Tax Benefit from Section 199A -5,104 -4,755
20 plus Self-Employment Tax 21,836 0
21 plus Tax on Line 12 Delta (above) 0 1,555
22 plus Payroll Tax (Employee and Employer) 0 8,874
23 Net Tax After Section 199A Benefit 16,732 5,674
       
24 S Corp Benefit SE Tax Reduction Only   12,962
25 S Corp Benefit Section 199A Only   -1,904
26 Net S Corp Benefit $   11,058

 

Again, a lot to take in. Let’s chat about your unique situation!

 

Section 199A Proration

Remember that crazy sentence from before- “to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis to the gross income received from the trade or business.” We take this to mean that if you had income that was not considered qualified business income such as interest and dividends earned within the business, then the reduction in QBI due to the deductible portion of self-employment tax, self-employed health insurance premiums and retirement plan contributions would be pro-rated using the portion of QBI as a fraction of gross business income.

 

As of this writing, we cannot find any authoritative guidance to expand on this, support this, or otherwise clear up some crummy code.

 

Here is our summary of the major issues recently updated by the final regulations, rental property safe harbor (Notice 2019-7) and how all this crud affects S corporations-

 

 

 

Jason Watson is the Managing Partner of the Watson CPA Group, a business consultation and tax preparation firm, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online.

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