Medicare, Medigap, and Long-Term Care Premiums: How deductible are they?

In response to my rumination about the strategy for surviving in Year 1 of Bumhood, when Social Security imposes an earnings limitation that amounts to real poverty, readers have speculated that structuring my business as a sole proprietorship rather than as an S-corporation would allow  me to deduct Medicare, Medigap, and long-term care premiums dollar-for-dollar against business income, rather than having to jump the 7.5% hurdle set up for people who itemize. Frugal Scholar made the interesting discovery that “employees of an S corp can take the self-employment health insurance deduction.”

It’s an interesting concept; I just sent off an e-mail to Tax Lawyer inquiring about it.

Somehow, though, I doubt Uncle Sam will let me run Medicare premiums through a corporation. Social Security automatically withholds Medicare Part B from your Social Security check—you don’t get a choice about it. It might be possible to work some sort of scam with the Medigap premiums, but even there…questionable.

The point of incorporating CE Desk as an S-corp, in my case, is to allow me to stay in business during this endless first year of penury, during which the government penalizes me if I earn more than $14,160 because I’m under age 66. I earn about $240 more than that teaching six sections of freshman comp. Without a way to shelter my editing and blogging income, I would have to close both of those enterprises down. As we know, when you quit working at a freelance enterprise, your clients go away permanently, so that when you want to revive your little business, you have to start over from scratch. I’m getting too darned old to start over from scratch! Plus FaM is starting to earn a small but steady income…I don’t want to get rid of that, either.

Channeling the income from the S-corp means that if I earn, let’s say, $5,000, through freelance enterprises, the money belongs to the corporation, not to me. I am an employee of the corporation. My “job” is to direct the corporation. The corporation has to pay me an amount deemed “reasonable” by the IRS. It’s not paying me for my day-to-day editing and writing work; it pays me to be a corporate director. So, on a $5,000 income it pays me a little over $500. That is salaried income.

The S-corp does not shelter the salary you pay yourself from self-employment tax. What it does is convert some (but not all) of your freelance income into a “dividend,” on which none of the social welfare taxes are due. From my pittance, it has to withhold FICA and Medicare, and it has to pay FUTAand the employer’s share of FICA on the amount it pays me. The rest of the money—the part that remains after my “salary” is paid—can either remain in the corporation to be used to cover operating expenses (or just to sit there) or can be disbursed to the corporation’s owner(s) as “dividends.”

Because Social Security views dividends as return on investment, not as salaried income, this part of my freelance revenues doesn’t count toward the $14,160 earnings limit.

While it is true that you don’t pay self-employment tax on the dividend part of your drawdown from the corporation, it also is true that you don’t get credit toward Social Security for that part of your annual earnings. Thus if you did this for a very long time—say, starting fresh out of law school or medical school—you would greatly reduce the amount of your Social Security entitlement when the time comes to retire. If you engaged this strategy, you would have to be certain that you were going to earn and save a great deal of money during your career…otherwise, in your old age you’d end up just as penurious as an aging college English lecturer.

According to Elderlaw, qualified long-term care insurance premiums and Medigap premiums are regarded as medical expenses and are deductible if they exceed 7.5% of your gross income:

Premiums for “qualified” long-term care policies will be treated as a medical expense and will be deductible to the extent that they, along with other unreimbursed medical expenses (including “Medigap” insurance premiums), exceed 7.5 percent of the insured’s adjusted gross income. If you are self-employed, the rules are a little different. You can take the amount of the premium as a deduction as long as you made a net profit–your medical expenses do not have to exceed 7.5 percent of your income.

Medigap will cost me about $1,200 in 2010; long-term care is about $960, for a total of $2,160. Medicare Part B will cost me $1,326 this year.

According to IRS Publication 502, Part B premiums are also treated as medical expenses:

Medicare B is a supplemental medical insurance. Premiums you pay for Medicare B are a medical expense. If you applied for it at age 65 or after you became disabled, you can include in medical expenses the monthly premiums you paid.

Thus the total amount, before I buy any eyeglasses, contact lenses, or prescriptions, that will qualify as medical expenses will be $1,326 + $1,200 + $960 = $2286. And I’m not even adding Medicare Part D into that. The total, with Part D, probably will come to around $2,400.

If I stand down off one class this fall, my total earned income will be $1257(12) + $2,400(5) + $500 + $500(12) = $33,584. That’s Social Security + teaching + freelance income + drawdown from 403(b). Multiply that by 7.5% and you get $2,518. So…one pair of Costco glasses puts me over the 7.5% qualifying threshold—that’s before I visit a doctor, before I buy a prescription drug, before I buy a couple boxes of contact lenses, before I pay for a shingles shot. And the 7.5% is on adjusted gross income, which you can be sure will be less than $33,584.

I don’t earn enough from freelancing to live on (far, far from it!), and so there’s no question of my working the business so that I write off medical costs and everything else against my taxes. If a miracle happened and FaM’s traffic went up about tenfold, I’d have to reconsider that. But unless the government can be persuaded to regard my teaching income as “self-employed” (which Tax Lawyer says it will not do), in my case the S-corporation is probably better than a sole proprietorship, because it allows me to keep the pittance I do earn through freelance editing and blogging from biting into my Social Security earnings.

Next year, when I’m 66 and can work until I drop without being punished for the privilege, will be another matter. But I’ll cross that bridge when I come to it.