Current federal tax law allows self-employed individuals to deduct the entire amount they spend on health insurance for themselves and their spouses and dependents. This treatment is similar to the tax exclusion for employer contributions to the health plans of wage earners, with one noteworthy exception: employer contributions are exempt from payroll taxes (e.g., Medicare and Social Security taxes), but health insurance expenditures by the self-employed are not deemed a deductible business expense and thus are subject to the self-employment payroll tax. Several bills in the 111 th Congress would enable self-employed taxpayers to exclude those expenditures from the income base for the tax. This report examines the current tax treatment of these expenditures, the legislative history of the deduction, its effectiveness as a policy tool for improving access to health care for the self-employed, proposals in the 111 th Congress to alter the deduction, and the implications of the leading health care reform proposals in Congress for health insurance coverage among the self-employed. Current Law

Under Section 162(l) of the Internal Revenue Code (IRC), self-employed individuals are allowed to deduct the entire amount of their spending on health insurance for themselves and their immediate family members. Use of the deduction is subject to several limitations. First, the deduction may not exceed a self-employed taxpayer's net earned income from the trade or business in which the health plan was purchased, less the deductions for 50% of the self-employment tax and contributions to certain pension plans (e.g., Keogh plans or simplified employee pension plans for the self-employed). Second, the deduction may not be claimed for any month when a self-employed individual is eligible to participate in a health plan offered by an employer or a spouse's employer. Third, the expenditures used to compute the deduction may not also be included in the medical expenses eligible for the itemized deduction under IRC Section 213—though health insurance expenditures that cannot be deducted under IRC Section 162(l) may be included in these medical expenses. Finally, health insurance spending by self-employed individuals is not deemed an ordinary and necessary business expense, which means those expenditures must be added to the income base for the self-employment tax of 15.3%. On the other hand, the expenditures eligible for the deduction are subject to the self-employment tax, whereas employer contributions to employee health plans are exempt from payroll taxes. Legislation in the 111th Congress That Could Affect Health Insurance Coverage for the Self-Employed

Numerous bills to create new tax subsidies for the purchase of health insurance have been introduced in the 111 th Congress. At least five bills in the current Congress would modify the deduction to equalize the tax treatment of health insurance purchased by the self-employed and the tax treatment of health benefits obtained by wage earners through their employers. But the same provision in H.R. 533 , H.R. 1470 , H.R. 1763 , H.R. 3067 , and S. 725 would exempt these expenditures from the self-employment tax by allowing the self-employed to treat them as a deductible business expense. More specifically, it would make the following notable changes in the current health care system:
require all individuals to have health insurance or pay a penalty, create a health insurance exchange where individuals and smaller companies can purchase health insurance, provide subsidies for the purchase of health insurance for individuals and families with incomes at or below 400% of the federal poverty level, require employers to provide health insurance to all employees or pay into a health insurance exchange trust fund, offer exceptions to the employer mandate to certain small firms and provide a tax credit to small employers that do provide coverage, impose new regulations on health plans participating in the health insurance exchange and in the small-group health insurance market aimed at improving access to affordable health insurance, and expand Medicaid coverage to eligible households with incomes up to 133% of the federal poverty level. Policy Issues Related to the Deduction

The tax deduction for health insurance expenditures by the self-employed has several advantages. It is relatively simple for the IRS to administer and for self-employed individuals to claim. The deduction also establishes a substantial degree of parity between the tax treatment of health insurance purchased by the self-employed and the taxation of health benefits employees receive from their employers.
Federal tax law allows self-employed individuals to deduct from their gross income the entire amount they spend on health insurance for themselves and their spouses and dependents.
This report explains how these expenditures are treated under the federal tax code, reviews the legislative history of the deduction, assesses its effectiveness as a policy tool for expanding access to health care for the self-employed, describes proposals in the 111th Congress to modify the deduction, and discusses the implications of leading health care reform proposals in Congress for health insurance coverage among the self-employed.
Under Section 162(l) of the Internal Revenue Code (IRC), qualified self-employed individuals may deduct the entire amount of their payments for health insurance for themselves and immediate family members. Use of the deduction is governed by several rules. First, it may not exceed an eligible taxpayer's net earned income from the trade or business in which the health plan was established, less the deductions for 50% of the self-employment tax and contributions to certain pension plans. Second, the deduction may not be claimed for any period when a qualified individual is eligible to participate in a health plan offered by an employer or by a spouse's employer. Third, the expenditures used to claim the deduction cannot be included in the medical expenses eligible for the itemized deduction under IRC Section 213. Finally, health insurance expenditures by self-employed individuals are subject to the self-employment tax.
The tax deduction for health insurance expenditures by the self-employed has advantages and disadvantages. On the one hand, it is relatively easy for the IRS to administer and for self-employed taxpayers to claim, and the deduction comes close to establishing parity between the tax treatment of health insurance for the self-employed and the taxation of employer contributions to employee health plans. On the other hand, the deduction delivers the largest tax benefit for the same insurance policy to those who arguably need it the least: self-employed individuals in the highest tax bracket. It also is uncapped, thus encouraging the purchase of generous plans.
Several bills in the 111th Congress (H.R. 533, H.R. 1470, H.R. 1763, H.R. 3067, and S. 275) would eliminate the final remaining obstacle to achieving equal tax treatment for the health insurance purchased by the self-employed and the health benefits employees receive through their employers. The obstacle lies in the difference between the income base for the payroll taxes paid by wage earners and the self-employment taxes paid by the self-employed: health insurance expenditures by the self-employed are subject to the self-employment tax, whereas employer contributions to employee health plans are not subject to the payroll tax. Each bill would allow the self-employed to deduct these expenditures as an ordinary and necessary business expense, thereby removing them from the income base for the self-employment tax.
Some of the health care reform legislation being considered in the House and Senate could affect health insurance coverage for the self-employed. Though it remains unclear whether either chamber will pass such a bill in the current Congress—and if so, what tax provisions it might contain—enough is known about the key issues in the congressional debate to sketch their implications for the self-employed. Proposals that would expand private health insurance coverage or simultaneously expand public and private coverage options (e.g., H.R. 3200) could lead to greater coverage among the self-employed through income-based tax subsidies for the purchase of insurance and an individual mandate.