Corporations owned by less than 100 non-corporate shareholders can elect to be treated as a Subchapter S Corporation (“S Corp”) for tax purposes. We’ve previously talked about reasonable compensation for business owners (see our November 16, 2011 blog article). We’ll now focus on an important change in reporting that many businesses are not handling correctly!
Health insurance premiums paid by an S Corp for more than 2% shareholders must be treated as wages to that owner. In other words, the only way an S Corp can deduct the amount paid for shareholder health insurance is to include it as part of the shareholder’s salary; the owner’s health insurance can no longer be called an insurance expense or employee benefit expense on the 1120S federal tax return.
The net income effect for the corporation is the same, but shareholder-employee’s W-2 wages will increase by the amount of the health insurance premiums paid by the S Corp. Thankfully, no Social Security and Medicare tax is withheld for wages attributed to the insurance premium. The shareholder-employee may be eligible to deduct the medical insurance premiums from their Adjusted Gross Income (“AGI”) on their 1040 income tax return.
It gets more confusing. Some states have insurance laws that don’t allow a one-employee corporation to purchase health insurance for the owner. Then the shareholder has no choice but to buy health insurance in their own name instead of through the corporation. IRS Notice 2008-1 says that in order for a shareholder to be eligible to deduct the medical premium from their AGI on their 1040, the corporation must either a) pay the health insurance provider directly, or b) reimburse the shareholder and be able to prove reimbursement. If the shareholder purchases the health insurance in their own name and pays for it personally, that shareholder would not be allowed a deduction from AGI.
Just to make it even more convoluted, if the shareholder or their spouse is eligible to participate in any other subsidized health care plan, then they cannot take a deduction from AGI on their 1040 for the medical insurance paid by the S Corp. The only chance the owner might then get to deduct those premiums is as an itemized deduction – and then only for the amount that, combined with their other aggregate medical expenses, exceed 7.5% of AGI. The odds are if a shareholder cannot deduct the medical from AGI, they will mostly likely have to pay personal income tax on this benefit.
We have already seen too many S Corps that are not following these IRS laws on medical insurance for closely-held businesses. Gary Kaplan has years of experience with the IRS and S Corp owners. He will be happy to help you with your questions, and make sure you get it right.