This post is my continuing effort to translate an IRS regulation from legalese into English. The source document is here: 26 CFR 601.105: Examination of returns and claims for refund, credit, or abatement;
The IRS has figured out that the interplay between the ACA premium tax CREDIT and the self-employed health insurance DEDUCTION is “circular” –the amount of each is influenced by changes in the amount of the other. IRS says that taxpayers can use any approach they choose to figure this out, but IRS suggests two possible approaches. The first is called the “Iterative Calculation”
Specified premiums are premiums for a specified qualified health plan or plans for which the taxpayer may otherwise claim a deduction under § 162(l). A specified qualified health plan is a qualified health plan, as defined in §1.36B-1(c), covering the taxpayer, the taxpayer’s spouse, or a dependent of the taxpayer (enrolled family member) for a month that is a coverage month within the meaning of § 1.36B-3(c) for the enrolled family member
The SPECIFIED PREMIUM amount is the actual total premiums charged for health insurance coverage from a qualified health plan. For our purposes we will assume a single taxpayer, buying insurance via an exchange, and that if the taxpayer paid the full cost of the premium, it would cost $8000 for a year of coverage.
(2) A taxpayer’s § 162(l) deduction may not exceed the lesser of:
(A) The taxpayer’s earned income (within the meaning of § 401(c)) derived by the taxpayer from the trade or business with respect to which the health insurance is established; and
(B) The sum of (1) the specified premiums not paid through advance credit payments, and (2) the limitation on additional tax determined under § 1.36B-4T(a)(3)(iii).
There might be some limits on the $8000 SPECIFIED PREMIUM amount.
So start by figuring out total earned income derived from self employment (SE INCOME)– this will ordinarily be the amount reflected on Schedule C. If that is less than $8000, then the taxpayer’s TENTATIVE DEDUCTION is limited to the SE INCOME figure. (This situation could come up if you are claiming a large number of business expenses, or if you had a particularly bad year. )
Then, if you received an ADVANCE PREMIUM CREDIT via the exchange, look at the total you actually paid out-of-pocket for your qualified heath plan, and add to that the maximum possible clawback based on your income level. So if total income after other deductions is less 400% of the Federal Poverty line, use the Additional Tax Limit table to figure out the maximum clawback for for excess tax credits you might have received, and add that to the premium total.
Let’s say income from self-employment was $42,000, which puts your income between the 300% and 400% percent mark of the federal poverty line, which in turn limits maximum clawback for single taxpayer to $1250. That means that even if it turns out that the credit you received was too high, you may not be able to claim the $8000 SPECIFIED PREMIUM amount simply because the total of your actual out-of-pocket insurance costs plus he maximum clawback will still be less than $8000.
Let’s assume that you received $5000 in advance premium tax credits, and actually paid $3000 in premiums; we’ll also assume that you you are using the $1250 clawback limitation number from the chart – your TENTATIVE DEDUCTION would then be $4250 (the $3000 you actually paid plus the $1250 maximum deduction.)
Just for purposes of comparison, we’ll also assume that you have a friend who has the same income and insurance premium level as you; and your friend bought insurance from the exchange, but the friend chose to defer receiving any advance premium tax credits and paid the full amount for insurance. Since FRIEND did not receive “advance credit payment”, the specified premiums were $8000, and there is no potential clawback because no money was paid out. So FRIEND’s TENTATIVE DEDUCTION is $8000 — the dollars FRIEND actually paid for insurance coverage.
Step 1: Determine adjusted gross income, modified adjusted gross income,
and household income by taking a § 162(l) deduction for the amount of specified
premiums after applying the limit in section 5.03;
You’ll need to figure out the rest of your taxes first– so total up all of your income and all possible above-the-line deductions (on the first page of the 1040), and use the TENTATIVE DEDUCTION figure to come up with a TENTATIVE MAGI. (Don’t forget to add back any numbers for untaxed income specified in Figuring your household income (Part One).
We’ll continue to assume that the figure for MAGI is $42,000. We’ll also assume that the total amount of money actually spent on premiums was $3000 and you chose to use the $1250 limitation number from the chart (based on guessing that your income is between 300-400% of the FPL) — so you used $4250 as the TENTATIVE DEDUCTION.
(2) Step 2: Compute the premium tax credit using the adjusted gross income, modified adjusted gross income, and household income determined in Step 1;
You are going to figure out a TENTATIVE CREDIT, based on an assumption that you can take the maximum allowable DEDUCTION. To figure your tax credit amount you are also going to need other information — you will need to know the Federal Poverty Line, the “benchmark” premium rate for your state, the total cost of premiums for the policy you selected, etc. Some of this information might be available on forms sent to you by your state’s exchange. We’ll assume for now that you can find the information needed to a calculate this amount. We’ll assume for purposes of an example that the tax credit allowed is $3500.
But let’s look at FRIEND. Remember — we assumed that you both earned $42K. But for the preliminary calculation, you are deducting $4250 from that amount and FRIEND can deduct $8000. So now your MAGI is $37,750 and your FRIEND’s MAGI is $34,000. (For purposes of this calculation we are assuming that neither you or FRIEND have any other deductions or add backs to change the MAGI, or any other sources of income other than self-employment)
(3) Step 3: Determine the § 162(l) deduction by subtracting the Step 2 premium
tax credit amount from the specified premiums and then applying the limit in section
OK, we are now going to subtract $3500 – your actual tax credit – from the $8000 actual premium, and also applying the clawback limit. In other words, now that you know that your tax credit should have been $3500 instead of the $5000 you took, you know that you actually should have paid $4,500 for health insurance. But because of the clawback limits, the total you can be expected t pay is $4250, so you are going to continue to use that figure as your ADJUSTED TENTATIVE DEDUCTION.
On the other hand, let’s say that after doing the math, FRIEND is entitled to a $3860 credit. Why a higher credit than you? Because FRIEND actually paid full cost for her insurance, which gives her a bigger deduction, reducing her MAGI to something lower than yours. So with the anticipated tax credit, FRIEND’s insurance cost will be reduced to $4200: the $8000 FRIEND paid for insurance, minus the $3800 credit FRIEND is going to get when she files her tax return.
Step 4: Compute the premium tax credit using the adjusted gross income, modified adjusted gross income and household income determined by taking into account the § 162(l) deduction in Step 3;
If your ADJUSTED TENTATIVE DEDUCTION is different from the original TENTATIVE DEDUCTION, you are going to runt the calculation again. Since your $4250 hasn’ t changed, there is no more math for you to do.
But your FRIEND needs to reduce her DEDUCTION from $8000 to $4200, which will cause her MAGI to go up to $37,800 — $50 more than yours. So FRIEND needs to recalculate her tax credit based on the new MAGI. Let’s say that now the calculation says she is owed a tax credit of $3495. (It’s now less than you, because her MAGI was $50 higher than yours– I’m getting my new tax credits by applying a 9.5% multiplier to the income differential, based on the assumption that is the percentage used to calculate credits at that income level. See Computing the Premium Assistance Credit Amount.)
Step 5: Repeat Step 3 by substituting the Step 4 premium tax credit for the Step 2 premium tax credit.
Your friend now has to do the same thing again, but now with the assumption that her DEDUCTION will be $4505 based on the reduced CREDIT she calculated in Step 4. Now her MAGI is $37,495 – $255 less than yours — and I’m guessing that her CREDIT will come to $3524. Her income went down, so credit has gone up again. (This is kind of like one of those old Three Stooges routines where when one drawer is shut, another one pops open.)
Step 6: If changes in both the § 162(l) deduction and the premium tax credit
from Steps 2 and 3 to Steps 4 and 5 are less than $1, use the section 162(l) deduction
and premium tax credit amounts for the specified premiums determined in Steps 4 and
5. 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.
Your friend needs to calculate once more, now with the assumption that her tax CREDIT is $3524, reducing her DEDUCTION to $4476, and producing a MAGI figure of $37,524 — now $226 less than yours, bumping her credit up to $21 more than yours — and meaning that she is going to have to do the math once more, this time assuming a CREDIT of $3521. Basically, following the IRS Iteration Calculation, your friend will have to repeat this exercise, with figures seesawing back and forth, until the numbers come out to something less than a dollar.
I don’t think that its rocket science to figure out that your friend will get to that point when her CREDIT number comes out to something within $10 of yours – so let’s assume she’s gone through several more cycles and ends up with a MAGI of $37,740 and a tax credit of $3500.95 – which is less than a dollar, so a stopping point for her.
The taxpayer may claim a premium tax credit and § 162(l) deduction for the specified premiums equal to the amounts determined under Step 6. If a taxpayer is unable to complete Step 6 because changes between iterations always exceed $1, the
taxpayer should not use the iterative calculation method, but may use the alternative calculation method in section 5.03 or another method that produces amounts that satisfy applicable tax law.
Even IRS isn’t sure that their math sequence will work.
But let’s go back to they hypothetical you and your friend. In the end, in my hypothetical, the friend did get within that $1 limit – so lets say that she ends up taking a DEDUCTION of $4499 and a CREDIT of $3501 (rounded up from the $3500.95 that is acceptable to IRS).
Your FRIEND gets a refund on her taxes of $3501. She paid $8000 for insurance, so her net cost for health insurance came to $4499.
You owe IRS $1250 — they can’t get more from you because your income is still under the 40% FPL level and there is a limit on the clawback — and you paid $3000 in insurance — bringing your net cost for health insurance to $4,250 – so you saved $249 on insurance compared to your friend by opting for advance payments.
It won’t seem that way in April because your FRIEND will be dancing happily with her big fat IRS refund check and you’ll be stuck casting about for the $1250 you owe IRS … but in this case those clawback limits mean you come out ahead.
I”d point out that there will be no such happy ending if your final MAGI exceeds the 400% FPL mark — if you have another friend who estimated the same lower income figure as you did (with a +$5000 tax credit), but ends up with $60,000 in self-employment income instead — then there is no cap on the clawback, and that other friend will owe IRS $5000. But that friend will also be able to deduct that amount ($3000 out of pocket plus $5000 tax clawback), reducing the friend’s MAGI to $52,000 — still too much to qualify for a tax credit, but you can see how confusing this might be for a person who earns, say, $53,000. Subtracting the full $8000 premium would yield a $45,000 MAGI, which does qualify for a credit, but by my math I’m guessing the credit is $2811 – the $1250 clawback provision leaves the friend’s deduction at $4250 — and subtracting $4250 from $53,000 results in an income too high to qualify for subsidies or any sort of clawback limitation.