How S-corporation owners can deduct health insurance expenses

Author: J&R Accounting Group LLC. |

Blog by J&R Accounting Group LLC

Choosing an S-corporation to form your business comes with a number of impressive tax advantages. You don’t pay corporate income tax, and your Social Security and Medicare tax bills are lower—instead, profits are allocated to shareholders and taxed at that level.

Things get more complicated when it comes to health insurance, though. While S-corporation employees can claim employee health insurance as a tax-free benefit, shareholders who own more than 2 percent of the company stock cannot. For these individuals, the path to tax-advantaged health insurance is more complicated.

Health Insurance Not a Tax-Free Fringe Benefit for S Corporation Shareholders

S-corporations can provide health insurance as a tax-free fringe benefit to its non-owner employees. In this case, the business offers a group health insurance policy to employees and deducts the cost as a business expense, paying no tax on the insurance premiums.

Ordinarily, when you form a corporation to own and operate your business, you’ll work as its employee. If you form a regular “C” corporation, your corporation can provide you with health insurance as an employee fringe benefit and deduct the cost as a business expense. And you don’t have to pay any tax on the amount of the insurance premiums because they qualify as a tax-free employee fringe benefit.

However, when you elect S corporation tax status for your corporation, special tax rules come into play. Under these rules, anyone who works for an S corporation and owns 2% or more of its stock, must include in his or her wages the cost of certain employee fringe benefits provided by the corporation, including health insurance. This means income taxes must be paid on the amount of the premiums. Social Security and Medicare taxes have to be paid as well unless the procedure described below is followed.

Moreover, you can’t get around this rule by employing your spouse and providing him or her with company health insurance that covers you and rest of your family. Your spouse and other family members are considered S corporation shareholders for these purposes, even if they don’t actually have any stock in their names. They are treated as if they own all the stock that you own.

Personal Deduction for Health Insurance Premiums

 

S-corp owners may not have the same access to tax-free health insurance as non-owner employees, but they can still ensure their premiums are tax-advantaged. Specifically, S-corp owners can take a personal income tax deduction on the health insurance premiums paid by the business.

For S-corp owners to qualify for the deduction, their health insurance policy must be established by the business and not by the S-corp owner personally.

To determine whether the policy is established by the business, the IRS considers:

  • Who pays the premiums for the policy, and
  • How the premiums are reported for income tax purposes by both the business and the S-corp owner.

 

The fact that you’re not entitled to claim employee health insurance as a tax-free fringe benefit when you have an S corporation is not good. But things aren’t all bad for S corporation shareholders. You may still be able to take a personal income tax deduction for the health insurance premiums paid by your corporation.

Self-employed people are allowed to deduct health insurance premiums (including dental and long-term care coverage) for themselves, their spouses, and their dependents. When you’re an S corporation owner with more than 2% of the company stock, you’re treated the same as a self-employed person when it comes to deducting health insurance premiums.

This is not a business deduction. It is a special personal deduction you take on the first page of your Form 1040 as self-employed health insurance. If you have Medicare coverage, you may deduct your Medicare premiums as part of this deduction—this includes all Medicare parts (not just Part B). Your insurance can also cover your children up to age 27 (26 or younger as of the end of a tax year), whether or not they are your dependents.

Your deduction is limited to the amount of wages you are paid each year by your S corporation. You get the deduction whether you purchase your health insurance policy as an individual or have your S corporation obtain it. However, your S corporation must pay the premiums for you to get the deduction. Thus, if your purchase your policy yourself, you must have your S corporation reimburse you for the cost. If you choose the reimbursement option, be sure to submit your receipts to the corporation along with an expense report.

The amount of the premiums must be included in your employee wages on your annual Form W-2, and you must include the amount as wages on your Form 1040. Your S corporation deducts the amount as employee compensation on its own return.

You must pay income tax on the health insurance premium payments made by your S corporation. However, such payments are not subject to Social Security and Medicare taxes if (1) you’re the only employee of your S corporation, or (2) your corporation has other non-owner employees and provides them with health insurance. However, these taxes must be paid on the payments if your S corporation has non-owner employees but does not provide them with health insurance.

Treating Medical Insurance Premiums as Wages

Health and accident insurance premiums paid on behalf of a greater than 2-percent S corporation shareholder-employee are deductible by the S corporation and reportable as wages on the shareholder-employee’s Form W-2, subject to income tax withholding. (A 2-percent shareholder is someone who owns more than 2 percent of the outstanding stock of the corporation or stock possessing more than 2 percent of the total combined voting power of all stock of the corporation.)

However, these additional wages are not subject to Social Security, or Medicare (FICA), or Unemployment (FUTA) taxes if the payments of premiums are made to or on behalf of an employee under a plan or system that makes provision for all or a class of employees (or employees and their dependents). Therefore, the additional compensation is included in the shareholder-employee’s Box 1 (Wages) of Form W-2, Wage and Tax Statement, but is not included in Boxes 3 and 5 of Form W-2.

A 2-percent shareholder-employee is eligible for an above-the-line deduction in arriving at Adjusted Gross Income (AGI) for amounts paid during the year for medical care premiums if the medical care coverage was established by the S corporation and the shareholder met the other self-employed medical insurance deduction requirements. If, however, the shareholder or the shareholder’s spouse was eligible to participate in any subsidized health care plan, then the shareholder is not entitled to the above-the-line deduction.  IRC § 162(l).

IRS Notice 2008-1 states that if the shareholder purchased the health insurance in his own name and paid for it with his own funds, the shareholder would not be allowed an above-the-line deduction. On the other hand, if the corporation obtains and pays for health insurance in its name, covers the shareholder under the policy, and reports the premiums as W-2 wages to the shareholder, then the shareholder is allowed an above-the-line deduction.  Similarly, if the shareholder purchased the health insurance in his own name but the S corporation either directly paid for the health insurance or reimbursed the shareholder for the health insurance and also included the premium payment in the shareholder’s W-2, the shareholder would be allowed an above-the-line deduction.

The bottom line is that in order for a shareholder to claim an above-the-line deduction, the health insurance premiums must ultimately be paid by the S corporation and must be reported as taxable compensation in the shareholder’s W-2.

 



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