What Are the Benefits (and Drawbacks) of S Corporation Medical Insurance?

Choosing an S corporation as your business structure comes with several tax advantages, including the opportunity to lower the shareholders' self-employment taxes. However, many S corp shareholders are surprised by the treatment of employer-provided health insurance premiums.

This article covers how S-corp owners receive employer-sponsored health insurance and the tax treatment of those benefits for the company and the shareholder.

Photo by Hush Naidoo Jade Photography on Unsplash

Health Insurance Employee Benefit for an S Corporation

Many business owners assume that the business can provide health insurance to employees, including owners, tax-free. While this is true for C corporations, it isn't the case for S corps.

S corporations can provide health insurance as tax-free employee fringe benefits to non-owner employees. The company deducts the premiums as a business expense and employees don't have to include the cost of coverage in their taxable wages.

However, if the company provides medical care coverage for shareholders who own 2 percent or more of the company's stock, the premiums are considered taxable income to the shareholder.

How Does the IRS Determine 2% Shareholders?

According to the IRS, a 2 percent shareholder is someone who owns, directly or indirectly, more than 2 percent of the outstanding stock of the S corporation or more than 2 percent of the total combined voting power of all stock on any day of the tax year.

S corporation shareholders can't get around this rule by employing their spouse and getting coverage through the spouse's participation in the company-sponsored health plan. For these purposes, the IRS considers spouses and other family members to be S-corp owners, even if they don't own any stock. This includes:

·         Spouses

·         Children

·         Grandchildren

·         Parents

Treating Medical Insurance Premiums as Wages

The good news is that the company and the shareholder can still receive tax benefits for these health insurance premiums.

Tax treatment by the company

The company can deduct the premium payments for 2 percent shareholders on its Form 1120S income tax return.

Because the premiums are considered additional wages to the shareholder, the deduction appears under Compensation of Officers on page 1. It reduces the net income (or increases the net loss) that passes through to shareholders on their Schedule K-1.

Tax treatment by the 2% shareholder

The health insurance premiums are included in Box 1 of the shareholder's W-2. This means the amount is subject to income tax. However, shareholders don't have to pay Social Security, Medicare, or unemployment (FUTA) taxes on the premiums as long as the plan provides coverage for all employees or a class of employees.

Shareholders can deduct 100% of the premiums paid by the company as a self-employed health insurance deduction. This is an above-the-line deduction on the shareholder's individual tax return, Form 1040, so they don't have to itemize to benefit.

However, there are two limitations to keep in mind:

1.       The deduction isn't allowed for any calendar months in which the shareholder of their spouse is eligible to participate in another employer-sponsored health insurance plan.

2.       The deduction can't be greater than the taxpayer's "earned income"—i.e., their Social Security wages from the company.

S corp owners can also use this method to deduct premiums for accident, dental, vision, and long-term care insurance coverage.

Reporting Health Plan Premiums to Shareholders

As mentioned above, the business can claim a tax deduction for premiums paid for 2% S corporation shareholders. One caveat is that the deduction passes through proportionately to all shareholders—you can't specifically allocate the premiums to those who received the income on Form W-2.

So what happens when some shareholders receive health insurance benefits, and some don't?

Recently, we helped a client in this situation.

Health Insurance for S Corp Shareholders: An Example

Say you start a business with four shareholders, each of whom owns 25% of the business. Each owner's salary is equal, but only two need medical benefits through the company while the other two are covered by a spouse's plan from another employer.

To complicate matters further, say one of the shareholders who needs coverage is single and requires coverage only for themselves, while the other needs coverage for their spouse and dependent children.

The dilemma here is how to fairly allocate those premiums since the business is covering 100% of the cost of medical care coverage for those two shareholders. Understandably, the owners who didn't need health benefits felt they were being underpaid.

To balance out their compensation, we "trued up" their payroll each quarter for income tax purposes. As a result, on their end-of-year Form W-2s, each shareholder will have equal compensation in Box 1.

Medical insurance premiums aren't a tax-free fringe benefit for S corporation shareholders as they are for other employees. However, shareholders can still access tax-advantaged health benefits through the company.

If you need help determining how to allocate premiums or additional compensation, schedule a call with Slate. We can help you comply with IRS rules and keep your shareholders happy.