The cost of health insurance premiums paid by a business is usually excluded from taxable income on the employee’s W-2. However it should be noted that a 2% or more shareholder of an S corporation is not eligible for this exclusion! However, the 2% shareholder can often deduct the cost of the premiums on his or her personal tax return (form 1040).
So what is a 2% S Corp shareholder?
The IRS refers to a “2% shareholder” as an S corporation shareholder who owns, directly or indirectly, more than 2% of the stock of the corporation on any day during the tax year.
Understanding Indirect ownership – the family attribution rules
The below family members of a shareholder are treated as owning a shareholder’s stock for this purpose:
Example 1 – Stock Sold During Year
Bob sold all of his S Corp stock (15% ownership) in XYZ Corp on January 10, 2014. XYZ Corp is a calendar year S Corporation. Bob’s healthcare premiums were paid by XYZ Corp as he continued to work at the company for the rest of the year. Bob is thus held to be a 2% shareholder in XYZ Corp for 2014 given he owner more than 2% of the company’s stock for at least one day during the calendar year (January 1 through January 9th).
Example 2 – Family Attribution Rules
Peter Piper is an employee of XYZ Corp who’s healthcare is provided to him by the corporation. He does not own any of the S Corp stock however his grandfather Herb Piper owns 60% of XYZ Corp. Under the family attribution rules Peter Piper is now deemed to be a 2% shareholder because of Herb’s ownership.
How to Handle S Corp Healthcare Tax Deductions for Business Owners (or 2% Shareholders)
Reporting to the shareholder
The cost of S Corp healthcare insurance premiums (paid by the S corp) for a 2% shareholder are included on the shareholder’s W2 as taxable income in Box 1. The amount is subject to federal income tax withholding (but that is withholding and not the amount you will owe! Just follow us here). It is not subject to FICA and FUTA taxes if the premiums paid were under a plan for most employees or for a class of employees. The IRS does not define “class of employees” and there is not a requirement that the class not be discriminatory (plain english = you do not have to tip toe around carefully planning this as you do with some other plans).
A plan for our purposes here normally exists if any one of the following applies:
- The plan is in writing or is otherwise made known to employees,
- There is reference to the plan in the employment contract,
- Employees contribute to the plan,
- There is a separate fund for payments apart from the employer’s salary account,
- The employer is required to make the payments.
If any one of the above apply, the benefits are not subject to FICA and FUTA taxes and are not included in Box 3 or Box 5 of the W-2.
How an S Corporation Deducts Healthcare Premiums
The S corp can deduct the cost of healthcare premiums paid for “2% shareholders” on form 1120S. Since the premiums are treated as additional compensation to the shareholders, the deduction should be taken on page 1, Line 7 (Compensation of officers) or Line 8 (Salaries and wages). This reduces net income (or increases the loss) which passes through to the shareholders their K1’s. The deduction passes through proportionately to all owners. With an S Corp you cannot specially allocate the deduction to the person who received the income for the premiums paid on their W2.
How Does the 2% Shareholder Deduct the S Corp Healthcare Premiums?
All, and YES that is 100%, of the cost of health insurance premiums paid by the corporation (and included in the 2% shareholder’s W2) can be taken as an above-the-line deduction on the shareholder’s 1040 personal tax return, subject to two limitations:
- The deduction is not allowed for calendar months in which the 2% shareholder or their spouse is eligible to participate in another employer-subsidized health insurance plan,
- The deduction cannot exceed the taxpayer’s earned income derived from the trade or business that provides the health insurance plan. The easiest way to understand this is to realize that S corp shareholders treat their social security wages from the S corporation as earned income for purposes of this limitation.
Example 3 – How S Corp Shareholders Deduct Healthcare Insurance if Other Coverage is NOT Available:
Tommy is a “2% shareholder” of XYZ Corp. He reviewed his 2013 W2 from XYZ Corp and sees $65,000 in box 1 for taxable income. This included $6,000 of healthcare insurance premiums paid by XYZ Corp for Tommy’s personal health insurance policy. Note Tommy is not married and had no other jobs where he was paid via W2 in the 2013 tax year.
In this scenario Tommy is not subject to any of the limitations we have discussed and he is allowed to take an above the line deduction of $6,000 on his form 1040 personal tax return for 2013.
Example 4 – How S Corp Shareholders Deduct Healthcare Insurance if Other Coverage is Available:
Assume the same facts as in Example 3, except Tommy is now married. His spouse Mary is a W2 employee for another company and was eligible for coverage under her employer’s healthcare insurance plan for the last 4 months of 2013. She declined coverage as Tommy’s plan offered better benefits.
Unfortunately Tommy & Mary may not take a deduction for the premiums paid in the last 4 months of the year. It is irrelevant that Mary declined the coverage offered by her employer. The fact that coverage was available prohibits Tommy and Mary from deducting Tommy’s premiums paid for that period.
Example 5 – How S Corp Shareholders Deduct Healthcare Insurance if There is Limited Social Security Income:
Let’s now assume Tommy is a 2% shareholder of XYX Corp. The company paid $6,000 of health insurance premiums on his behalf in 2013. Tommy was semi-retired in 2013, and only took a salary of $400 per month ($4,800 for the year).
Tommy’s W2 shows $10,800 ($4,800 cash wages + $6,000 health benefits) in box 1 for taxable wages, but only $4,800 (the regular wages) in box 3 for social security wages.
Jerry’s above-the-line deduction is limited to $4,800 (the amount of social security wages from the S corporation). He can deduct the remaining $1,200 on Schedule A of his Form 1040, but it is unfortunately subject to the AGI limitation.
Example 6 – S Corp Shareholder Deduction for Healthcare Insurance with Earned Income Limitation:
Now let’s assume the same circumstances as in Example 6, but Tommy receives $10,000 of business income on his XYZ Corp K1 and an additional $20,000 of wages on a W2 from a different employer.
The limitation is based on earned income derived from the business that provides the health insurance plan. The K1 income from XYZ Corp is now not earned income. The $20,000 of wages from the other W2 are not from the business that provides the health insurance plan. Therefore Tommy is unable to deduct the healthcare insurance premiums paid for him by his S Corp.
Payment of Healthcare Premiums by S Corp
Assuming other qualifications are met premium payments should be a valid deduction if:
- The S corp paid the healthcare premiums in the current tax year, or
- The 2% shareholder paid the premiums and furnishes proof of payment to the S corporation, after which the S corporation reimburses the 2% shareholder for the premium payments in the current tax year. Note must be done in the 2013 tax year to be deductible in 2013.