Sole proprietors, partners (including LLC members) and two percent shareholders in an S corporation are not treated as “employees” for purposes of certain benefits. Among those benefits is employer provided health insurance coverage. While employer subsidies for health coverage are generally excluded from the income of employees, that is not the case for sole proprietors, partners and two percent S corporation shareholders. Those individuals must include in income the amount of any subsidy and can take a deduction for their health insurance coverage, if at all, on their individual Form 1040 under Section 162(l) of the Internal Revenue Code. A deduction under Section 162(l) is available only if the individual is not eligible for subsidized coverage through the spouse or through another employer.

In a recent chief counsel advice memorandum, the Internal Revenue Service addressed the treatment of Medicare premiums under Section 162(l). A chief counsel advice memorandum is informal guidance issued by the IRS chief counsel to other IRS personnel. Although the advice is released to the public, it cannot be relied upon by other taxpayers. Nevertheless, it does show the IRS’s thinking about different issues.

According to the advice memorandum, all parts of Medicare qualify as insurance, the premiums for which are deductible under Section 162(l). This means that premiums paid for Medicare Parts A, B and D or Medicare Advantage could be deductible under Section 162(l). The advice memorandum also says that the partner and the two percent S shareholder may either pay the premiums directly and be reimbursed by the partnership or S corporation or the premiums could be paid by the partnership or S corporation itself on behalf of the partner or S shareholder. The amounts paid or reimbursed are treated as guaranteed payments to the partner or wages to the S corporation shareholder. The sole proprietor, however, must pay the Medicare premiums directly.

Although the advice memorandum allows a partnership or S corporation to reimburse the partner or shareholder for the premiums, the partnership or S corporation would want to make sure that it is not subject to the Medicare Secondary rules before it does so.  Generally speaking under those rules, employers with at least 20 employees cannot provide incentives for employees to decline group health coverage in favor of Medicare coverage.  Reimbursing an individual’s Medicare premium could be considered an incentive to take Medicare in lieu of the employer’s group health plan.  An employer subject to the Medicare Secondary rules should seek advice from competent counsel before instituting a reimbursement program.

The instructions for the 2010 Form 1040 indicate that Medicare premiums can be used to compute the deduction under Section 162(l). The Form 1040 instructions for earlier years omitted that mention. However, to the extent the statute of limitations is not closed, an individual could amend a return and claim a deduction for those Medicare premiums now.

Individuals paying Medicare premiums and taking deductions under Section 162(l) may wish to review their returns to determine whether they have taken this available deduction.