Small Business Taxes & ManagementTM--Copyright 2008, A/N Group, Inc.
Background
Special rules apply to fringe benefits for any S corporation shareholder who owns more than 2% of the outstanding stock of the corporation. Basically, the corporation can't take a deduction for certain fringe benefits. The law doesn't enumerate the particular fringe benefits, but the House Committee Report on the original act specifies four benefits:
The same rules apply to partnerships and, in fact, that's where the rule came from. Sole proprietors cannot deduct on Schedule C their health insurance, either.
All is not lost, however. Self-employed individuals can deduct their health insurance premiums toward their adjusted gross income on their Form 1040. Partners in a partnership are considered to be self-employed. The IRS has held that S corporation shareholders can also deduct health insurance premiums on their Form 1040, but only if the amount is included as wages on their W-2.
While the rules sound unduly complex, taking a shortcut is likely to result in the loss of a deduction for the health insurance premiums. With premiums for a family plan easily running $12,000 a year, consider the cost if the deduction were denied for three years.
Handling the Premiums
Accident and health insurance premiums paid or furnished by an S corporation on behalf of its 2% shareholders in consideration for services rendered are treated for income tax purposes like partnership guaranteed payments under Sec. 707(c). An S corporation is entitled to deduct the cost of such employee fringe benefits under Sec. 162(a) if the requirements of the section are satisfied. The premium payments are included in wages for income tax withholding purposes on the shareholder-employee's W-2, but are generally not wages subject to Social Security and Medicare taxes. The shareholder must include the amount of the insurance premiums in gross income because he or she is not considered an employee for purposes of Sec. 106.
Here's how it works in general. Madison Inc. pays health insurance premiums for Fred (its sole shareholder) and two other unrelated employees. Madison deducts the premiums for the other employees under employee benefits, but deducts Fred's premiums under officer's compensation. It includes the amount on Fred's W-2, subject to income tax withholding, but not FICA. At this point, the premiums are a wash. Madison's deducting them (so Fred's share of Madison's income is reduced), but Fred's picking them up as wage income on his personal return. But Fred deducts the premiums on his 1040. The result should be pretty close to what would have happened if Madison could have simply deducted them on its return and not included them in Fred's income.
IRS Notice 2008-1
The IRS recently released Notice 2008-1 clarifying the rules. The Notice and the examples make it clear that some variations on the example above are acceptable, but there are limits. To be eligible for the deduction, there must be a plan providing medical care coverage for the 2% shareholder-employer established by the S corporation. A plan providing medical care coverage for the 2% shareholder is established by the S corporation if:
If the accident and health insurance premiums are not paid or reimbursed by the S corporation and included in the 2% shareholder-employee's gross income, a plan providing medical care coverage for the 2% shareholder-employee is not established by the S corporation and the 2% shareholder is not allowed the deduction. In addition, the S corporation must report the premiums paid or reimbursed as wages on the shareholder-employee's W-2 in the same year and the shareholder must report the premiums paid or reimbursed as income on his or her 1040.
The IRS has developed four examples that illustrate the rules. The examples assume that each shareholder is a 2% shareholder-employee whose earned income from the S corporation exceeds the amount of the premiums. Furthermore, none of the shareholders in the examples are eligible to participate in any subsidized health plan maintained by an employer of the shareholder or the shareholder's spouse.
Example 1: For 2008, Fred obtains an accident and health insurance policy in his name and makes the premium payments on the policy. The S corporation makes no payments or reimbursements with respect to the premiums. In this case a plan providing medical care for Fred is not established by the corporation and Fred is not entitled to the deduction under Sec. 162.
Example 2: For 2008, the S corporation obtains an accident and health insurance plan in the name of the S corporation. The plan provides coverage for Sue, her spouse and dependents. The S corporation makes all the premium payments to the insurance company. The corporation reports the amount of the premiums as wages on Sue's W-2 for 2008 and Sue reports that amount as gross income on Form 1040 for 2008. Here a plan providing medical care for Sue has been established by the S corporation and Sue is allowed the deduction under Sec. 162 for 2008.
Example 3: For 2008, Ken obtains an accident and health insurance policy in his name. The S corporation makes all the premium payments. The S corporation reports the amount of the premiums as wages on Ken's W-2 for 2008 and Ken reports that amount as gross income on his 1040. Here a plan providing medical care for Ken has been established by the S corporation and Ken is allowed the deduction under Sec. 162.
Example 4: For 2008, Dale obtains an accident and health insurance policy in his name. Dale makes the premium payments to the insurance company and furnishes proof of the premium payment to the S corporation. The S corporation reimburses Dale for the premium payments. the S corporation reports the amount of the premium reimbursements as wages on Dale's W-2 and Dale reports that amount as gross income on his 1040 for 2008. A plan providing medical care for Dale has been established by the S corporation and Dale is allowed the deduction under Sec. 162.
Amended Returns
Taxpayers who did not claim deductions for fringe benefits described in Notice 2008-1 may file timely amended tax returns to claim the deduction under Sec. 162 if the requirements of the notice are satisfied. The statement "Filed Pursuant to Notice 2008-1" should be written on the top of any amended return.
The IRS does not consider payments of accident and health insurance premiums by an S corporation on behalf of 2% shareholder employees to be distributions for purposes of the single class of stock requirement of Sec. 1361(b)(1)(D).
Other Points
There are some other points to keep in mind. These are some frequently encountered questions regarding the deduction for health insurance premiums for self-employed taxpayers, 2% S corporation shareholders and partners.
You can deduct 100% of the health insurance premiums on your 1040. But no deduction is allowed in excess of your earned income (see Sec. 401(c)) derived from the trade or business providing the health insurance coverage. Earned income here generally means your wages from the S corporation. You can't add the wages from different businesses. Only the earned income from the business providing the plan counts.
A 2% shareholder is any person who owns more than 2% of the stock of the S corporation or is deemed to own the stock by the attribution rules. For example, Fred owns 20% of Madison Inc. His wife, Sue has no stock in her name, but, because of the attribution rules, she's deemed to own the same 20% Fred does.
The deduction is not allowed if you are eligible to participate in a subsidized health plan maintained by you or your spouse's employer. The determination of eligibility is made on a month-by-month basis. For example, Fred is a 50% shareholder-employee of Madison Inc. for all of 2008 and Madison paid health insurance premiums for him and his wife, Sue, for the entire year. Sue, worked for Chatham Inc. during the first 4 months of 2008 (after which she was unemployed) where she was allowed to, but did not participate in a subsidized plan. Fred can deduct the health insurance premiums for only the last 8 months of the year.
Copyright 2008 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
--Last Update 01/03/08