Medical coverage is an expensive personal expense for most people. So, for many, a job that provides medical coverage offers an important benefit. For the small business owner there is often a need to obtain personal coverage. It may also be good business practice to offer medical coverage as a fringe benefit to attract and keep good employees. A write-off of all or a portion of the cost of medical coverage is a significant cost-saving feature of providing such coverage.

At the time this book was published, the status of the rules under the Affordable Care Act (“Obamacare”) was in doubt. Proposals to “repeal and replace” the individual and employer mandates, along with other tax rules, were under discussion. This chapter contains the rules for 2017 that apply if no Congressional action is taken, but check the Supplement for any update. If you have employees, familiarize yourself not only with the tax rules on health coverage, but also how health insurance coverage now works. For example, medical conditions have no impact on health insurance today. Your costs depend on the age of workers and where they live. (All you need for a quote are their date of birth and home zip code.) Work with a knowledgeable agent who can advise you on options that won't trigger unintended consequences. Best action: Find a certified PPACA specialist (an agent who has been certified by the National Association of Insurance Underwriters). Someone qualified to sell insurance on the Marketplace (the government exchange) is not necessarily a certified PPACA specialist.

For more information about deducting medical coverage, see IRS Publication 535, Business Expenses, and IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans.

Health Care Mandates

All individuals (other than exempt individuals) are subject to a health care mandate created by the Affordable Care Act (although this could be repealed or at least not enforced for 2017). This requires individuals to have health coverage or pay a tax penalty. Three government agencies are part of the regulatory mix: the IRS, the U.S. Department of Labor, and the U.S. Department of Health and Human Services (HHS).

Self-employed individuals. If you are self-employed and do not have health coverage through a spouse's employer, Medicare, Medicaid, or other insurance program providing minimum essential coverage, you must obtain coverage yourself through a private insurer or through a government Marketplace for individuals (self-employed individuals cannot use the Small Business Health Insurance Options Program, or SHOPs). You must also carry coverage for your dependents. If you cannot afford the coverage, you may qualify for assistance in the form of a tax credit. The premium tax credit applies to those with household income between 100% and 400% of the poverty line (the 2016 poverty line is used for purposes of 2017 credit eligibility). The credit is payable on an advanced basis, so it can be used monthly to lower premium costs.

A self-employed individual who had been an employee but was dislocated by foreign trade and who qualifies for Trade Adjustment Assistance (TAA) may be eligible for the health coverage tax credit. This is a refundable tax credit of 72.5% of premiums for health coverage for the individual and qualifying members of his or her family. However, a self-employed individual who qualifies for both the premium tax credit and health insurance tax credit must choose between them; no double dipping is allowed.

If you opt not to have coverage and do not qualify for an exemption from the individual mandate, you owe a penalty, which is an additional tax reported on your tax return. In 2017, the penalty is $695 per adult and $347.50 per child (up to age 18), up to a family maximum of $2,085 or 2.5% of family income in excess of your filing threshold (e.g., $10,400 if you're single and under age 65), whichever is greater.

The payment cannot be more than the cost of the national average premium for bronze level health plan available through the government Marketplace for you. For 2017, this cap is $272 per month ($23,264 for the year) per individual. The maximum monthly national average premium for a family of 5 or more is capped at $1,360 per month ($16,320 for the year).

The IRS is prevented from aggressively collecting the penalty, but could withhold tax refunds where appropriate. Find more at HealthCare.gov.

Employer mandate. Small employers are not required by federal law to offer health coverage to employees. If they choose to do so, they can act at any time during the year; there is no open enrollment period for buying health coverage by a small employer. Small employers are not barred from dropping coverage to allow employees to obtain coverage (often subsidized by means of the premium tax credit). Small employers can compensate employees to help them pay for individual coverage, or they can reimburse employees for the cost of individually obtained coverage up to set limits (see the discussion on “Qualified Small Employer Health Reimbursement Arrangements” later in this chapter).

The requirement to offer certain health coverage to full-time employees and their dependents or pay a penalty (“play or pay”) applies only to “applicable large employers” (ALEs). The definition of an ALE is a company with more than 50 full-time and/or full-time equivalent employees. Determining whether you meet this threshold is not as simple as doing a body count. This is because part-timers can add up to full-time equivalent employees (FTEs). A combination of employees working 120 hours per month (around 30 hours per week) counts as one employee.

To determine your payroll size, first tally the number of full-time employees (those working 120 hours per month or more). Then figure full-time equivalent employees:

• Step 1: Figure the aggregate number of hours of service (but not more than 120 hours of service for any employee) for all employees who were not employed on average at least 30 hours of service per week for that month (part-timers).
• Step 2: Divide the total hours of service in Step 1 by 120. This is the number of FTEs for the calendar month.

In determining the number of FTEs for each calendar month, fractions are not taken into account.

Off-time counts. In figuring the hours worked, take into account paid leave for vacation, sick days, personal days, and maternity leave for your employees. Do not count unpaid days off.

Seasonal businesses. You don't have to be in retail or agriculture to have a seasonal business. As long as you are seasonal, there's a special rule to follow: If your workforce exceeds 50 FTEs for 120 days or fewer during a calendar year, and the employees in excess of 50 who were employed during that period of no more than 120 days were seasonal workers, you are not a large employer subject to the employer mandate.

Annual determination. The determination of payroll size is made year by year, and is based on payroll for the prior year, called the look-back period. For example, your 2016 payroll is used to determine whether you are subject to the mandate in 2017. You must average the number of employees over the months to find your payroll numbers for the employer mandate. The look-back period is usually the full 12 months.

Controlled businesses. Can you avoid the employer mandate by splitting up your business into multiple companies so that each has no more than 50 FTEs? Unfortunately not. Controlled groups of corporations and unincorporated businesses with a certain level of common ownership are treated as a single business for purposes of the employer mandate. Interestingly, the definitions of controlled groups of corporations and businesses under common control are the same tax-law definition used for qualified retirement plans. In addition, affiliated groups in service organizations (e.g., accounting firms; third-party administrators) are also treated as a single entity when there is some common ownership (it seems to be a 10% threshold).

Penalty. For 2017, the penalty is $2,160 per year for each employee (after subtracting the first 30 employees); the penalty is $3,240 for any full-time employee receiving a premium tax credit (explained under self-employed individuals). The employer penalty is not deductible.

Information reporting. If you provide minimum essential health coverage to employees, whether or not subject to the employer mandate, you are subject to annual reporting requirements explained later in this Chapter.

Deducting Medical Insurance for Employees

According to a study from the Kaiser Family Foundation released in September 2016, 46% of all small businesses with 3 to 9 employees offer this benefit to their employees. But 61% of those with 10 to 24 employees, 80% for firms with 25 to 49 employees, and 91% of companies 50 to 199 employees offer health coverage. This compares to 98% of firms with 200 or more employees. The rates for smaller employers are down slightly from the year before.

If you choose to provide medical insurance, you can deduct the cost of their group hospitalization and medical insurance. Deductible medical coverage also includes premiums for long-term care insurance.

To be deductible, long-term care insurance must:

• Be guaranteed renewable.

• Not provide for a cash surrender value or other money that can be repaid, assigned, pledged, or borrowed.

• Provide that refunds of premiums, other than refunds on the death of the insured or complete surrender or cancellation of the contract, and dividends under the contract may be used to reduce future premiums or increase future benefits.

• Not pay or reimburse expenses incurred for services or items that would be reimbursed under Medicare, except where Medicare is a secondary payer or the contract makes per diem or other periodic payments without regard to expenses.

Medical coverage provided to employees is treated as a tax-free fringe benefit. According to the IRS, medical coverage provided to a domestic partner is taxable to the employee because a domestic partner is not a spouse under state law. However, an employer providing such medical coverage can still deduct it (since the employee is taxed on the cost of coverage for a domestic partner as additional compensation).

The value of long-term care insurance provided through a cafeteria plan or other flexible spending arrangement is not excludable from the employees’ income.

You deduct medical premiums according to your method of accounting. If you use the cash method, you generally deduct premiums in the year you pay them. If you are on the accrual method, you generally deduct premiums in the year you incur the liability for them (whether or not you actually pay the bill at that time). The IRS maintains that premiums covering a period of more than one year cannot be deducted except for the portion of the premium that relates to the current year.

You cannot deduct amounts you set aside or put into reserve funds for self-insuring medical costs (see medical reimbursement plans). However, your actual losses (when you pay for uninsured medical costs) are deductible.

Note: Employers doing $500,000 or more in annual business must provide certain notice to newly hired employees about health coverage. Since you may not know your annual revenue at the time of hiring a new worker, it is advisable to provide the notice to all newly hired employees. Find a sample notice form at www.dol.gov/ebsa/pdf/FLSAwithplans.pdf.

Deducting Health Coverage by Self-Employed Persons and More-Than-2% S Corporation Shareholders

Self-employed persons (sole proprietors, partners, and LLC members), as well as more-than-2% S corporation shareholders, may deduct the cost of health insurance (including long-term care coverage) they receive through their business, but not as a business expense (this rule has not been changed by the Affordable Care Act). A self-employed person who buys coverage in his or her personal name can deduct the premiums above-the-line (assuming there is sufficient income from the business as explained later). However, a more-than-2% S corporation shareholder can only claim an above-the-line deduction for a policy purchased by the corporation, or the corporation reimburses the shareholder for premiums, and includes this amount on the shareholder's Form W-2. If the policy is purchased by the shareholder, premiums must be treated as an itemized medical expense (subject to the adjusted gross income floor). This is so even if state law bars a one-person S corporation from purchasing a policy.

The deduction is taken from gross income on page 1 of Form 1040 (other than for a one-person S corporation whose shareholder personally buys the policy). This means the deduction is allowed even if the self-employed person does not itemize deductions. The policy can be purchased individually (it need not be purchased by the business).

The deduction cannot exceed the net earnings from the business in which the medical insurance plan is established. You cannot aggregate profits from 2 or more businesses to establish the net earnings ceiling required for deducting health insurance premiums. For S corporation shareholders, the deduction cannot be more than wages from the corporation (if this was the business in which the insurance plan was established).

You cannot take the deduction for any month if you were eligible to participate in any employer-subsidized health plan (including your spouse's) at any time during the month. For example, suppose you are a single, self-employed individual and pay for your own health coverage. On July 1, 2017, you begin a job in which your employer provides you with health insurance. You can deduct the applicable percentage of your health insurance from January 1 through June 30, 2017 (the time you did not receive any subsidized health coverage).

You can include “above the line” your Medicare Part B and Part D premiums. You can add your spouse's Medicare premiums if your spouse is covered by Medicare. There has been no IRS guidance on whether COBRA payments by a self-employed person can be deducted as an adjustment to gross income.

In calculating self-employment tax, do not reduce net earnings from self-employment by your allowable medical insurance deduction.

Using Reimbursement Plans

Your business may want to help employees pay their out-of-pocket medical costs. There are various ways to do this.

Tax Credit for Contributions to Employee Health Coverage

There is a credit to encourage small employers to help pay for employee health coverage. The credit is very complicated; it varies with the number of employees, their average full-time wages, the amount of premiums paid, and the average premiums by state for the small group market.

When the credit was created, it had been projected to help 4 million small employers. According to a 2016 GAO report, only 181,000 employers claimed it in 2014 (no more recent statistics are available). Nonetheless, check your eligibility for it.

The tax credit is up to 50% of the employer's contribution to pay for employee health insurance. This credit is limited to small employers; they are defined as having no more than the equivalent of 25 full-time employees (FTEs) with average annual wages in 2017 of less than $52,400. A full credit is available to those with 10 or fewer FTEs with average wages of less than $26,200.

The amount of the credit is based on a percentage of the lesser of: (1) the amount of nonelective contributions paid by an eligible small employer on behalf of employees, or (2) the amount of nonelective contributions the employer would have paid under the arrangement if each such employee were enrolled in a plan that had a premium equal to the average premium for the small group market in the state (or in an area in the state) in which the employer is offering health insurance coverage. The average premium amounts are fixed by the Department of Health and Human Services. These amounts can be found in instructions to Form 8941).

The credit applies only for a maximum of 2 consecutive years, so an employer claiming the credit in 2015 and 2016 cannot claim it in 2017.

The credit also applies only for small employers that purchase health coverage through the Small Business Health Options Program (SHOP) marketplace. SHOPs generally are restricted to employers with up to 50 employees. (There has been talk of eliminating this requirement for 2017; check the Supplement). However, your state may allow you to use it for up to 100 employees. You can buy coverage through a SHOP using your own agent or broker, working with any SHOP-registered agent or broker, or DIY. You can offer a single health care plan or let employees choose their own coverage (“employee choice”).

Some states have their own SHOPs. The majority of states, however, have not set up their own SHOPs, so small employers must use the federal SHOP.

The credit is part of the general business credit. The credit can be used to offset alternative minimum tax liability.

Shifting the Cost of Coverage to Employees

Health insurance is increasingly costly to employers. There are several ways in which business owners can reduce their costs without putting employees out in the cold.

Setting Up Health Savings Accounts (HSAs)

The high cost of health insurance is considered by many small-business owners to be their number-one concern. Now there's a way to cut costs by 40% or more by combining a high-deductible (lower-cost) health policy with a special savings account called a Health Savings Account (HSA). With the liberalization of certain HSA rules, combined with an ever-growing range of investment options, these accounts should gain in popularity. According to the Employee Benefits Research Institute, 20 to 22 million people had a high deductible health plan, the type of coverage that is accompanied by an HSA, by the end of 2015 (no more recent statistics are available).

Archer Medical Savings Accounts (MSAs)

Small employers and self-employed individuals can use MSAs in lieu of Health Savings Accounts to combine low-cost high-deductible health coverage with a savings-type account. The opportunity to set up new MSAs expired at the end of 2007. However, existing MSAs can continue to receive contributions.

COBRA Coverage

Employers who normally employ 20 or more employees and who provide coverage for employees must extend continuation coverage (referred to as COBRA—the initials for the law that created continuation coverage). COBRA entitles employees who are terminated (whether voluntarily or otherwise) to pay for continued coverage of what they received while employed. It also covers families of deceased employees and former spouses of divorced employees. COBRA coverage generally applies for 18 months (36 months in some cases).

Employers can charge for COBRA coverage but only up to the cost of the coverage to the employer plus an administrative fee. This limit on the total cost to the individual for COBRA coverage is 102% of the cost of the insurance. Employers who fail to provide COBRA and/or to provide proper notice of COBRA can be subject to a substantial penalty.

A number of states have their own COBRA rules, referred to as mini-COBRA. Mini-COBRA rules may require coverage from one month to 18 months for firms with as few as 2 employees. Be sure to check any state law requirements on providing continuation health coverage to terminated employees.

Wellness Programs

As a way to reduce health care expenditures, some companies have offered programs designed to encourage good health. These include weight-loss and stop-smoking programs.

A company can pay for wellness programs and deduct the costs as long as the programs adhere to government regulations. Access to a company's program must be nondiscriminatory (i.e., not limited to owners or other key people). Group wellness programs fall into two categories: participatory wellness programs (programs that are not conditioned on a participant's health and do not provide a reward that is based on an individual's satisfying a standard that is related to a health factor) and health-contingent wellness programs (programs that require an individual to satisfy a requirement related to a health factor in order to obtain a reward); each has its own rules.

Incentives, rewards, or other benefits to employees under a wellness program may be taxable or tax free to employees, as listed here:

• A cash benefit is taxable.

• A benefit that is treated as a de minimis fringe benefit, such as a T-shirt, is tax free.

• A gym membership is taxable.

• Benefits akin to medical coverage, such as screening and testing, are tax free.

• Reimbursement of an employee's pretax payment for the wellness program is taxable.

Reporting Health Coverage on W-2s

Employer-paid health coverage continues to be a tax-free fringe benefit (see Chapter 7). However, employers (other than “small employers”) must include the value of this coverage on employees' W-2s. The amount reported is the amount paid by the employer, employee, or a combination of both. Small employers are those who issue fewer than 250 Forms W-2 for the previous calendar year. The IRS could end this small-employer exemption from reporting at any time; check the Supplement for any change.

Reporting Health Coverage on Forms 1095

Do you have to issue an information return to employees detailing their health coverage? It depends on the number of employees and the type of coverage you offer. Here is a brief overview of information returns. Filing requirements and other details are explained in Appendix A.

• Form 1095-A. This form is issued by the government Marketplace to those who purchased coverage through it. An employer does not issue this form.

• Form 1095-B. This form is usually issued by insurance companies providing coverage for employees of non-ALEs (i.e., companies with fewer than 50 employees). However, small employers with self-insured health plans (e.g., health reimbursement arrangements) must provide this form to employees.

• Form 1095-C. This form is issued by ALEs.