The IRS recently issued
Notice 2008-1, which provides rules under which certain employees may deduct the
insurance premiums their employers pay. To be eligible, an employee must be a 2
percent shareholder in the employer’s corporation, and the employer must be classified
as an “S corporation”—meaning shareholders must pay income tax on their share
of income derived from the corporation regardless of whether they take money
out of the corporate account.
The rules, now in
effect, apply to deductions for accident and health insurance premiums the
employer pays or reimburses for when the payment or reimbursement is included
in the employee-shareholder’s gross income.
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Background
Internal Revenue Code
Section 1372(a) states that an S corporation must be treated like a partnership
in regard to fringe benefit taxation. Essentially that means that a 2 percent
shareholder—someone who owns more than 2 percent of the corporation’s
outstanding stock during a taxable year—will be treated as a partner in the
corporation.
When a corporation pays
premiums on behalf of a 2 percent shareholder, the corporation may deduct the cost
of the fringe benefit. The premium payment is included in the employee’s wages
for tax withholding purposes, and the employee must include the premiums in his
or her gross income.
An employee-shareholder
isn’t an “employee” for purposes of the Internal Revenue Code provision
governing contributions for premium payments. As such, any contributions or
reimbursements that the S corporation makes to the employee’s premiums must be included
in his or her gross income.
Qualifying for a
Deduction
If all of the following
requirements are met, 2 percent employee-shareholders may take a deduction:
• The
employee-shareholder’s earned income must be greater than the amount of the
premiums covering him or her.
• The
employee-shareholder cannot be eligible to participate in a subsidized health
plan that the S corporation maintains or that his or her spouse’s employer
maintains.
• The
employee-shareholder must report any premium payments or reimbursements made by
the S corporation as gross income on his or her individual tax return.
• The S corporation must
be the one to “establish” the plan providing healthcare coverage for the
employee shareholder. It establishes the plan by making a payment or
reimbursement on the employee-shareholder’s behalf for premium payments for the
current tax year.
• The S corporation must
report the premium payments or reimbursements as the employee-shareholder’s wages
on the W-2 for the taxable year in which the payments or reimbursements have
been made.
Practical Implications
The IRS notice also
illustrates when employee-shareholders may or may not be entitled to claim a
deduction. For example:
• An
employee-shareholder who participates in a medical plan that the S corporation
did not establish and for which the corporation does not make any premium
payments or reimbursements will not be entitled to a deduction.
• Conversely, if the
shareholder obtains a policy in his or her name, and the S corporation makes
all of the premium payments and reports those premium payments as wages on the
employee-shareholder’s W-2, the IRS will consider the plan established, and the
employee will be entitled to the deduction.
• If the S corporation
does not make premium payments but reimburses the employee-shareholder for
payments he or she makes to a plan that he or she has obtained, the
employee-shareholder will be entitled to a deduction, provided the S
corporation reported the reimbursements as wages.