How to Properly Itemize IRS Medical Deductions

Clients who are self-employed have likely expressed frustration at how complicated the rules are when it comes to itemizing their medical deductions. In his last column of 2020, Julian Block offers guidance that benefits tax planners and individuals alike on this topic.

Dec 18th 2020
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I receive many queries from individuals about how they should handle write-offs for medical expenses when they itemize their deductions on Form 1040’s Schedule A. What particularly vexes itemizers: The rules for medical deductions are so convoluted.

To improve their understanding of the rules, I provide four easily digested explanations.  

First: I explain that they should resign themselves to the cause of their concern, Internal Revenue Code Section 213. It imposes strict limits on deductions for medical expenses.

Second: Section 213 dumps their expenses into two categories. One is for expenditures that are covered by insurance or otherwise reimbursed. The other is for those that aren’t covered, or, put more plainly, are uninsured.

Individuals can’t claim those that are covered. They can claim uninsured expenses.

Third: Only taxpayers who use Schedule A are able to claim uninsured expenses. Taxpayers who use the standard deduction amounts that are available to filers who don’t itemize can’t claim uninsured expenses.

Fourth: Section 213 (a) ordains that itemizers will never be able to deduct 100 percent of their uninsured expenses. It allows them just to the extent that they exceed 7.5 percent of AGI, short for adjusted gross income (line 8 (b) on the 1040 form).

An example: Freelance writer Sadie’s AGI is $100,000. Her uninsured expenses are $10,000. Sadie can’t deduct her first $7,500 of uninsured expenses. Her allowable deduction drops to $2,500.

What becomes of her write-off when her AGI increases to $133,400? It drops to zero.

The rules are more favorable for freelance writers and other self-employed individuals. Suppose Sadie writes a best-seller. What with her book advance and royalties, plus payments for film rights, and going about the lecture circuit, Sadie’s ho-hum AGI soars to well north of one-million dollars.

While she sulks when I explain that a seven-figure AGI eviscerates any Schedule A deduction for medical expenses, she smiles when I mention a special break that’s available to all freelance writers. They don’t have to list their insurance payments on Schedule A, meaning they sidestep the usual nondeductible floor of 7.5 percent.

What’s in it, she wonders, for her? A lot.

She’s able to deduct 100 percent of her payments for medical and dental insurance for herself, her spouse, and dependents and children who at the end of the year are under age 27. Ditto for her premiums for: Medicare Part B and Part D; Medigap policies offered by organizations like AARP; and qualifying long-term care insurance (deductible in an amount that rises with age).

Where Sadie claims the insurance payments on Form 1040. Only people who are their own bosses are allowed to deduct payments on Line 16 of Schedule 1 of the 1040 form—the same way that Sadie claims write-offs for, say, money she moves into tax-deferred retirement plans for self-employed individuals.

Who qualifies for Line 16 deductions? Only those who are self-employed and operate their businesses as sole proprietorships, partnerships, or limited liability companies.

An often-overlooked break: Those qualifying include self-employed persons who start to make hefty payments to their own plans after they lose jobs with companies that provide employer-sponsored insurance plans.

Consistent with this approach, the IRS prohibits Line 16 deductions by newly minted self-employed persons who buy COBRA coverage through their former employers’ groups plans. They must use Schedule A to claim COBRA payments.

Also qualifying are individuals who receive wages from S corporations in which, for example, they own more than two percent of the shares.

What are S corporations? Companies that are taxed much the same way as partnerships are and that pass profits through to their shareholders, who pay taxes at their individual rates.

Other aspects of the special break that affect writers and other freelancers. The break becomes unavailable when self-employed Sadie is covered by her spouse’s employer’s insurance. When Sadie is eligible to participate in a health plan maintained by her employer or her spouse’s employer, she has to include insurance payments on Schedule A.

Similar rules apply when Sadie spends just part of the year—a month or two, say—on staff with a company or organization. No special break for any month during the year in question for which she’s eligible to be covered by an insurance plan provided by an organization that employs Sadie or her spouse. That’s true whether the employment is on a full- or part-time basis.

Another prohibition: Sadie can’t use insurance payments claimed on Line 16 to reduce self-employment income when she fills out Form 1040’s Schedule SE. Sadie has to base her Schedule SE computations strictly on Schedule C, on which she reports receipts and expenses to arrive at a net profit.

How badly do things turn out when Sadie’s premiums are so high and her Schedule C income so low that the insurance costs her more than she made for the year? An adamant IRS insists that she say sayonara to any special write-off for insurance payments that exceed the net (receipts minus expenses) earnings from her business.

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 350 and counting). 

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By SkinnVinny
Dec 22nd 2020 22:13

Nice article. A common issue I see with S-corps is the shareholders not taking sufficient (or any) salary, as SE medical is limited to wages for s-corp shareholders. In the past I've had clients lose out on hefty medical insurance deductions, as they had no wages to claim SE medical deduction, but had to claim it all on Sch. A instead, where it usually died.

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