IRS Guidance On Circular Reference in Obamacare Premium Subsidy and Deduction

Some of you may remember this post I wrote last year: Circular Reference In Self-Employed Health Insurance Deduction Under Obamacare Premium Subsidy. It pointed out a circular reference math problem between the premium subsidy under Obamacare and the health care premium deduction for the self-employed.

If you are self-employed, the health care premium is deductible, which lowers your MAGI, which potentially qualifies you for a premium subsidy, which lowers the amount you can deduct because you can’t double dip, which raises your MAGI and reduces your premium subsidy, which increases the amount you can deduct, and on and on.

I wrote last year the math problem can be solved iteratively by a computer but it would be difficult to do on paper forms and worksheets.

The IRS issued guidance on this issue recently in Rev Proc 2014-41. First it acknowledged the circular reference problem:

Thus, the amount of the § 162(l) deduction is based on the amount of the § 36B premium tax credit, and the amount of the credit is based on the amount of the deduction – a circular relationship.

It confirmed iterations are the right way to solve it:

… … If the change in either the § 162(l) deduction or the premium tax credit from Steps 2 and 3 to Steps 4 and 5 is not less than $1, repeat Steps 4 and 5 (using amounts determined in the immediately preceding iteration) until changes in both the § 162(l) deduction and the premium tax credit between iterations are less than $1.

For those who don’t want to do the math over and over, the IRS also gave an alternative method, which basically stops after two iterations. Unfortunately, the alternative method gives you a lower subsidy and a lower deduction. If you want the full credit, don’t be lazy — do the math!

Graphically speaking, the alternative method and the iterative method work like this, using one of the examples given by the IRS:

First you take the whole unsubsidized premium as a deduction. It gives you a tax credit, leaving the rest as your deduction. Taking the smaller deduction gives you a smaller tax credit. The alternative method just stops there.

More iterations will drive up both your deduction and your tax credit. Eventually they converge. In the example given by the IRS, if you don’t do the extra iterations you will leave on the table $381 in tax credit plus $527 in tax deduction.

Iterations are easy to do for a computer. I expect the tax prep programs such as TurboTax, HR Block, and TaxACT will incorporate this when they come out later this year. It will be an interesting test to see who’s on the ball, because not doing it the right way can mean a difference of $500 in how much tax you pay.

Reference: Rev Proc 2014-41, Internal Revenue Service

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Comments

  1. Don Luke says

    Thanks for your follow-up. When I read your post last year, I wondered, “Could we make this harder?” I guess the answer is “Yes.”

    Since the example seems independent of external factors, why won’t the following approach work? Say my medical expenses are $11,720, and using the example, could I take (6849/14000)*$11,720 (i.e. $5,733.59) as my deduction and (7151/14000)*$11,720 (i. e. $5,986.41) as my credit, provided my other tax factors put me in the range where I had to contend with this? This approach seems easier and more straightforward than iterating numerous times. How many more iterations to get convergence? Would my tax saving be $418.57 (11720/14000)*$500)? Even an additional $419 would be worth iterating for!
    (Imagine a new T-shirt for CPA’s “I iterate, Do You?”)

    • Harry Sit says

      The example is very much dependent on one’s exact income, not just a range. Sorry you have to use software that does the right math. Maybe I should build a spreadsheet or web page for this.

  2. JWoodring says

    A spreadsheet for this would be a great tool for those of us who are self-employed and are receiving premium credits!

  3. Worthless Degree says

    Thanks for the post. I echo JWoodring’s sentiment. Hopefully, one of you geniuses can make this Excel spreadsheet or some kind of calculating program. Otherwise, hopefully someone can verify whether Turbotax is doing the calculations correctly when it gets released. Unfortunately, I, with an applied mathematics masters degree from an Ivy League School forgot all his skills that day he graduated.

  4. Ken says

    My thoughts based on the above is that if your income is going to be close to the ceiling for your household size, another words close to the 400% ceiling for any tax credit it may just be better to forgo the credit and be able to take the full amount of your health care payments as an adjustment.
    We are self employed and in 2015 we will drop from a home of 4, me, spouse and two children to just the two of us. That dramatically reduces the income level that qualifies for a tax credit. Ex. Fam of 4, approx. $94k for 2014, Fam of 2, approx. $60k for 2015. Since this ruling only applies to exchange policies due to the double dipping issue, there would be NO add back or iterative calculations if we chose a direct pay health plan and paid the full amount on our own. I wonder if it would work out better even if we just barely qualified for a credit but did not participate in an exchange. We could deduct the full premium paid as a direct adjustment if we avoid the exchange. The flip side is we would loose the 9.5% max of income health insurance premium limit if we did not go through the exchange. At some point it comes down to what is the difference between 9.5% of your income, what you actually pay for premiums and deduct as an adjustment and the final impact it would have on your tax bracket.

    • Harry Sit says

      The whole purpose of worrying about the 400% FPL is to qualify for the premium subsidy tax credit. Your deduction is reduced 1:1 only if you qualify for the credit. Because $1 credit is always better than $1 deduction, I don’t see how forgoing the credit will do any good.

  5. Boggled says

    Self-employed in California. We had to guess our 2014 income in 2012. Then, our premiums were adjusted by Covered California. Now, instead of paying $800 per month, we are paying $300 per month. When we do our 2014 return, what will be our self-employed health insurance premium deduction on Page 1 of the 1040? Am I going to be stuck paying federal and state taxes on an extra $6,000 of income? Should I have paid 100% of our premiums all year and then taken the tax credit later?

    • Harry Sit says

      The tax software (or accountant using software) will tell you what the deduction should be. Depending on your actual income, you may end up paying back the $6,000 in full or in part. Paying 100% up front doesn’t make you better off financially, except the budgeting and surprise factors.

  6. Lee says

    Please help
    (T) & another are each 50% shareholders in s-corp
    There are 2 f/t EEs who get their insurance thru the mrkplace
    One of the shareholders gets ins thru the mktplace for he and his family & the business reimburses
    THe other shareholder does not get his hlth ins thru the mktplace & the business pays his premiums
    For W-2 purposes do these reimb premiums get reflected in box 1 only & then reported on tx rtn as wages and also as above the line deduc?????
    Someone recently told me that the reimb premiums had to be reflected in bxes 1,3 & 5 and are not an above the line deduc
    Any advice would be appreciated

  7. Edmund says

    Harry,

    this issue affects me directly as I am self-employed S-corp owner and take deduction as well as subsidy. Do you know whether or which personal tax software deals with this problem correctly?

    Thanks.

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