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Health Insurance for S Corporation Shareholder Employees

An S corporation (S corp) paying a health insurance premium on behalf of a 2% shareholder employee is a common fringe benefit. Most of us understand the economic effect of this arrangement, but what about the tax implications? What rules outline a qualified plan? How do the tax rules impact the S corp and the employee?

Tax treatment

As a general rule, the amount of health insurance paid by an S corp is deducted at the corporate level and is not included in the employee's wages. However, certain rules apply when the benefit is provided to a shareholder employee owning greater than 2% of the S corp's stock.

In this situation, the S corp must adhere to the following requirements to have a qualified plan and remain eligible for a deduction. First, the premium payments must be either paid directly by the S corp or reimbursed to the shareholder employee if the payments are made individually. If the shareholder employee makes the payments, they must submit proof of premium payments to the S corp for proper substantiation. Furthermore, any premium payments must be included as taxable income on the shareholder employee's income tax return. These premium payments are included in wages for withholding purposes on the shareholder employee's W-2, but are not subject to Social Security and Medicare taxes.

Additionally, the shareholder employee is entitled to an "above-the-line" deduction for the full amount of the premiums included on his or her W-2 when computing adjusted gross income on his or her federal Form 1040 (Line 29 on 2007 Form 1040). This deduction is subject to a couple limiting factors. First, the amount of the deduction cannot exceed the taxpayer's earned income. Second, the deduction is not allowed if the taxpayer is eligible to participate in any subsidized health plan provided by either his or her employer or his or her spouse's employer.

Although these special rules apply to a shareholder who owns greater than 2% of the S corp's stock, this could be applicable to other family members that work for the S corp. When calculating the total ownership percentage in an S corp, a shareholder is considered as owning, either directly or indirectly, any stock owned by a spouse, child, grandchild or a parent. There are other related party exceptions with partnerships, trusts and corporations.

Example 1: Corporation A, an S corp, pays $100 of health insurance premiums collectively for all shareholders. Shareholder S owns 60%; Shareholder U (unrelated) owns 39%; and Shareholder D (daughter) owns 1%. Shareholder S's health insurance costs $60. Shareholder U elected no coverage and Shareholder D's health insurance costs $40.

Since Shareholder S owns 60% of the S corp stock, he will be required to report $60 of additional income on his W-2 and subsequent federal Form 1040. Additionally, he will be entitled to a $60 "above-the-line" deduction.

Although Shareholder D only owns 1% of the S corp stock and individually would not be required to report the income, under the related party rules, she is considered as owning a greater than 2% interest in the S corp. Therefore, Shareholder D would be required to report $40 of additional income and is entitled to an equivalent deduction on her income tax return.

Example 2: Corporation B, an S corp, pays $100 of health insurance premiums for Employee L. Employee L is the son of Shareholder M, who owns 100% of S corp B stock. Although Employee L does not own any Corporation B stock, due to the related party rules, he is considered as owning 100%. Consequently, Employee L is required to pick up $100 of additional income and will receive the corresponding deduction on his income tax return.

For more information, please contact Jeff Thomas at 312-980-3219 or your Blackman Kallick representative.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.