Small Business Taxes & ManagementTM--Copyright 2010, A/N Group, Inc.
While it seems like deducting health insurance premiums for a shareholder/employee of an S corporation should be a simple matter, only the tax law can make something that should be simple, complicated. The problem goes back many years, and arose soon after S corporations became part of tax law. They were viewed as similar to partnerships, and there was a prohibition on deducting certain fringe benefits of partners. Thus, a deduction was denied an S corporation for certain fringe benefits, most importantly health insurance, paid on behalf of S corporation shareholders. Well, not all shareholders. Only those owning more than a 2% interest, since a 2% shareholder is not considered an employee. (See below for a caution.)
That was a major issue some 20 years ago when Congress changed the law to allow self-employed individuals to deduct a portion of their health insurance against adjusted gross income (i.e., not as an itemized deduction) on their Form 1040. (Allowing the deduction on the front of the 1040 is a benefit for a number of reasons.) Self-employed individuals are those filing a Schedule C and partners in a partnership. And, if the original theory disallowing a deduction for health insurance applied to S corporation shareholders, that theory should also apply to now allow a deduction to S shareholders.
But even that couldn't be done without some complexity. Originally only 50% of the premiums were deductible. That gradually rose to the current 100%. And, unfortunately, S corporation shareholders were caught in issues they must still deal with.
The law imposes a number of requirements on the S corporation and shareholder before the health insurance premiums are completely deductible. In many cases the requirements are straightforward and easily met. But there are a few fine points that can result in a trap. And, considering the current cost of health insurance, the lost deduction can be significant.
Approach. Technically, the health insurance of a 2% shareholder isn't deductible by the corporation unless it's included in the shareholder-employee's income. The approach is to include the income on the shareholder's W-2. That makes it deductible by the corporation. At this point it's a wash--the corporation gets a deduction and the shareholder has income (of course, the deduction is "passed through" to the shareholder). In the final step the shareholder deducts the premiums on his Form 1040, making the insurance premiums deductible.
2-percent shareholder. First, the rule only applies to shareholders owning more than 2% of the S corporation's stock. That includes any person who owns, or is considered as owning within the meaning of Section 318, on any day during the tax year of the S corporation more than 2% of the outstanding stock of the corporation, or stock possessing more than 2% of the total combined voting power of all stock.
Section 318 contains "attribution rules". We won't get into the details, but, basically, you will be considered as owning stock owned directly or indirectly, by or for your spouse (other than one from whom you are legally separated or divorced) and your children, grandchildren and parents. For example, you own 50% of Madison Inc. Your son will be considered to own those same shares. Thus, if you hire your son to work in the business and the corporation pays his health insurance, the same rules regarding health insurance applies to him as well as you. (The rules also apply to trusts, estates, partnerships and corporations owning an interest or in which you own an interest.)
Earned income and subsidized plan available. You cannot take a deduction for amounts during a month in which you are eligible to participate in any subsidized health plan maintained by an employer or your spouse's employer. The rules apply separately to regular health insurance and long-term care insurance.
For example, your S corporation pays the health insurance for you and your spouse. You spouse works full-time for an employer who will provide health coverage where your spouse must contribute 25% of the cost. You're covered through your S corporation because the plan allows you to see certain specific doctors. Because your spouse is eligible to be covered by a subsidized plan, you cannot deduct the health insurance premiums provided by the S corporation.
The other requirement is that the deduction on your 1040 cannot exceed your earned income from the trade or business with respect to which the plan providing medical coverage is established. Basically, you can't deduct insurance premiums if they exceed your salary from the business. For example, for 2010 Madison Inc. paid you only $9,000 in salary. The medical insurance premiums it paid totaled $12,000. The excess $3,000 would not be deductible on your 1040.
Such a situation could occur if the business is having a difficult year, is in a start-up mode, etc. There are a number of considerations here. You may be able to increase your salary enough to secure a full deduction. But it may not matter much. If the business is doing that poorly, chances are you're in a low bracket and the deduction may be worth little or nothing. Work through the numbers with your accountant, but keep in mind that planning ahead is important here.
Corporation or shareholder's plan? The plan providing medical care coverage for the 2% shareholder must be established by the S corporation. The plan providing for coverage 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 shareholder is not established by the S corporation and the shareholder is not allowed the deduction.
In order for the shareholder to deduct the amount of the premiums, the S corporation must report the premiums paid or reimbursed as wages on the shareholder-employee's Form W-2 in that same year. In addition, the shareholder must report the premium payments or reimbursements from the S corporation as gross income on his or her Form 1040.
Distributions to shareholders. One of the requirements for an S corporation is that there be only one class of stock. Distributions to shareholders not in proportion their stock holdings can create a second class of stock. In Notice 2008-1 the IRS announced that it 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).
IRS Notice 2008-1 (IRB 2008-2) provided four examples that illustrate the rules. In the examples below, Madison Inc. is an S corporation and Fred and Sue are 2% shareholder-employees.
Example 1--In 2010 Fred, a shareholder in Madison Inc., obtains an accident and health insurance policy in his name and makes the premium payments on the policy. Madison makes no payments or reimbursements with respect to the premiums. In this case a plan providing medical care for Fred has not been established by the S corporation and Fred is not entitled to the deduction under Sec. 162(l).
Example 2--In 2010 Madison obtains a health insurance plan in the name of Madison. The plan provides coverage for Fred, his spouse, and dependents. Madison makes all the premium payments to the insurance company. Madison reports the amount of the premiums as wages on Fred's Form W-2 for 2010 and Fred reports that amount as gross income on Form 1040 for 2010. In this case a plan for providing medical care for Fred has been established by Madison and Fred is allowed the deduction under Sec. 162(l).
Example 3--For 2010, Sue obtains a health insurance policy in her name. Madison makes all the premium payments to the insurance company. Madison reports the amount of the premiums as wages on Sue's Form W-2 and Sue reports that amount as gross income on Form 1040. In this case a plan providing medical care for Sue has been established by Madison and Sue is allowed the deduction under Sec. 162(l).
Example 4--For 2010, Sue obtains a health insurance policy in her name. She makes the premium payments to the insurance company and furnishes proof of premium payment to Madison. Madison then reimburses Sue for the premium payments. Madison reports the amount of the premiums as wages on Sue's Form W-2 and Sue reports that amount as gross income on Form 1040. In this case a plan providing medical care for Sue has been established by Madison and Sue is allowed the deduction under Sec. 162(l).
Here are some additional points to keep in mind.
Long-term care insurance is considered to be similar to health insurance. The same rules discussed above apply to the premiums for those policies.
While we've called the coverage health insurance, the actual term used is accident and health insurance.
Deducting the premiums on the front of your 1040 has the advantage of reducing your adjusted gross income. That can allow you to avoid the income phaseouts applicable to many credits, deductions, etc.
Most taxpayers lose deductions because the facts don't fit the law. That is, the law has specific requirements and your situation doesn't meet those. This is one time when you can change the facts to fit the law. You do that by just making sure you meet the requirements. For example, don't forget the rule applies to children employed in the business. Generally, that should be easy here.
Copyright 2010 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. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 04/04/10