Medical Expenses Should be Deductible by All - Then Tax Issues Won’t Cause Reform to Fall

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By Gerald S. Deutsch, Esq.
Glen Head, NY

The medical program in our country needs fixing, if for no other reason than that a large number of unemployed people have lost - or when their “COBRA” runs out - will lose medical insurance for themselves and their families.

There seems to be opposition to almost every aspect of proposals advanced, some of them worthy of further discussion. But one proposal - to tax medical benefits afforded employees to help finance a new program - drew outrage.
But let's look at this for a moment. If benefits are taxable, won't they be deductible as medical expenses? Yes, but: (1) only if the taxpayer itemizes deductions; (2) for regular tax purposes, only to the extent that these expenses exceed 7 1/2% of adjusted gross income (AGI); (3) for alternative minimum tax (AMT) purposes, only to the extent they exceed 10% of AGI.

This problem was solved for self-employed persons, partners and 2% or more stockholders in S corporations who are taxed on medical benefits afforded them by their entities. Section 162(l) allows such amounts to be deducted as “self employed health insurance” on page one of the 1040 before arriving at AGI. Thus, the standard deduction may also be claimed.

This puts self employed persons, partners and 2% S corporation shareholders in the same position as employees who are not taxed on their benefits. Partners and 2% S shareholders are taxed, but they get a deduction equal to the amount of the income. (And their partnership or S corporation - like a C corporation - gets a deduction.)

But the rules are so complex and they create distinctions without differences. Consider a fairly recent IRS Notice - Notice 2008-1, 2008-2 I.R.B. 251, issued in December of 2007, which discusses §162(l) and shows in its examples why some distinctions make little sense.

In Example 3, a shareholder obtains an accident and health insurance policy in his own name. The S corporation makes all the premium payments to the insurance company. The S corporation reports the amount of the premiums as wages on the shareholder's Form W-2, and the shareholder reports that amount as gross income on Form 1040. A plan providing medical care for the shareholder has been established by the S corporation and the shareholder is allowed the deduction under §162(l). But in Example 1, a shareholder obtains an accident and health insurance policy on his own and he makes the premium payments on the policy. The S corporation makes no payments or reimbursements with respect to the premiums. A plan providing medical care for the shareholder is not established by the S corporation. The shareholder is not entitled to the deduction under §162(l). This shareholder must be subject to the restrictions of §213.

(But note that according to CCA 200524001, a self-employed individual/sole proprietor may deduct medical care insurance costs for himself and his family from earned income of his trade or business when a health insurance policy purchased by the sole proprietor is issued in his individual name and not in name of sole proprietor's trade or business.”)

So if the law is changed to tax corporate employees, then partners and 2% S corporation shareholders will be in a better position - which is almost unheard of! Unless, of course, §162(l) is to be repealed. A step backwards and surely against small business.

That leaves only those who pay for their own insurance subject to the harsher rules of §213 and the restrictions in being able to deduct medical expenses as noted above. Why? Aren't these the people we want to help encourage to purchase medical insurance? Aren't these the people who generally claim the standard deduction?

So why not allow all medical expenses that are (i) paid for by the taxpayer or (ii) are considered taxable income to the taxpayer to be allowed as a deduction in full in determining AGI? Why not allow all taxpayers to be treated the same way? Again, why not encourage those not covered by employers' insurance to obtain their own insurance coverage?

For more information, in the Tax Management Portfolios, see Maule, 503 T.M., Deductions: Overview and Conceptual Aspects, and Kenty, 389 T.M., Medical Plans -- COBRA, HIPAA, HRAs, HSAs and Disability,and in Tax Practice Series, see ¶2840, Medical Expenses.