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Deducting S-corporation Health Insurance Premiums

Notice 2008-1 contains the rules (and examples) for deducting accident and health insurance premiums by a 2% shareholder/employee of an S-corporation. 

"Section 1372(a) provides that, for purposes of applying the income tax provisions of the Code relating to employee fringe benefits, an S corporation shall be treated as a partnership, and any 2-percent shareholder of the S corporation shall be treated as a partner of such partnership."

Definition of a 2 Percent Shareholder:

The following is from IRS Notice 2008-1:

For purposes of § 1372, the term "2-percent shareholder" is any person who owns (or is considered as owning within the meaning of § 318) on any day during the taxable year of the S corporation more than 2 percent of the outstanding stock of such corporation or stock possessing more than 2 percent of the total combined voting power of all stock of such corporation. Section 1372(b).

How an S-corporation Deducts Health Insurance Premiums

An S-corporation deducts the premiums it pays for accident and health insurance to cover a 2% shareholder/employee (and his/her spouse and dependents) as compensation paid to the shareholder/employee.  In other words, the premiums are included in the shareholder/employee's salary.

Notice 2008-1 states that health insurance premiums paid or furnished by an S-corporation on behalf of its 2 percent shareholders in consideration for services rendered "are treated for income tax purposes like partnership guaranteed payments under § 707(c) of the Code. Rev. Rul. 91-26, 1991-1 C.B. 184."

Deduction of Health Insurance Premiums By An S-corporation 2 percent Shareholder/Employee

A 2% shareholder/employee of an S-corporation may be able to take an above-the-line deduction on his/her individual income tax return for the premiums paid by the S-corporation (or reimbursed to the shareholder if the shareholder pays the premiums).

An above-the-line deduction is a deduction that may be claimed even if you don't itemize your deductions.

In other words, you simply claim the deduction on the front of Form 1040 to arrive at adjusted gross income (AGI).

Qualifying for the Above-The-Line Deduction

Whether or not you, as a 2 percent shareholder of an S-corporation, may claim an above-the-line deduction on your personal tax return for health insurance premiums depends on whether you or the S-corporation is considered to have established the health insurance plan.

Whether you or the S-corporation is considered to have established the plan depends on who pays the premiums and how the premiums are reported for income tax purposes rather than whose name the policy is in.

If S-corporation establishes the plan:

If the plan is considered to have been established by the S-corporation, then you may claim an above-the-line deduction for the premiums paid on the front of Form 1040.

If you personally establish the plan:

If the plan is considered to have been established by you, then you cannot take an above the line deduction.

You could, however, take a deduction for the premiums you paid as a medical expense on Schedule A, of Form 1040 if you itemize your deductions.

Medical expenses deducted on Schedule A must exceed 7 1/2 percent of adjusted gross income to get any tax benefit.

Note: When preparing your state return the 7 1/2 percent limitation may not apply. For example, in Arizona you may deduct 100% of your medical expenses if you itemize your deductions. Check the rules for your state.) 

Here's how all this works:

The RULE:

The accident and health insurance plan must be ESTABLISHED by the S-corporation in order for a 2% shareholder/employees to claim an above-the-line deduction for premiums paid.

This rule does NOT mean that the accident and health insurance plan must actually be in the S-corporation's name. It can be in the shareholder/employee's name and still be considered to have been "established" by the S-corporation.

Therefore, an accident and health insurance plan may be set up under either the S-corporation's name or under the name of a 2% shareholder/employee.

The following will clarify this rule:

For an accident and health insurance plan to be considered as being "established" by the S-corporation, which is the requirement for  getting an above-the-line deduction on your Form 1040, any one of the following three scenarios must apply:

  1. The S-corporation obtains an accident and health insurance policy in the S-corporation's name to cover a 2% shareholder/employee (including his/her spouse and dependents):
    • The S-corporation makes all the premium payments.
    • The S-corporation reports the amount of the premiums as wages in the shareholder/employee's Form W-2.
    • The shareholder/employee reports the premiums in his/her gross income on Form 1040.
    • RESULT:
      • The plan is established by the S-corporation.
      • The shareholder/employee may take an above-the-line deduction.
        • You don't have to itemize your deductions to claim this deduction.
  2. The shareholder/employee obtains the accident and health insurance policy in his/her name:
    • The S-corporation makes all the premium payments.
    • The S-corporation reports the amount of the premiums as wages in the 2% shareholder/employee's Form W-2.
    • The shareholder/employee reports the premiums in his/her gross income on Form 1040.
    • RESULT:
      • The plan is established by the S-corporation even though the policy is in the shareholder's name.
      • The shareholder/employee may take an above-the-line deduction.
  3. The 2% shareholder/employee obtains a policy in his/her name to cover himself/herself (including his/her spouse and dependents):
    • The shareholder pays all the premiums
    • The shareholder provides proof of payment of his/her premium payments to the S-corporation.
    • The S-corporation reimburses the shareholder for the premiums he/she paid.
    • The S-corporation reports the amount of the premiums reimbursed to the shareholder/employee as wages in his/her Form W-2.
    • The shareholder/employee reports the reimbursed premiums in his/her gross income on Form 1040.
    • RESULT:
      • The health insurance plan is established by the S-corporation even though it's in the shareholder's name.
      • The shareholder/employee may take an above-the-line deduction.

When You May Not Claim an Above-The-Line Deduction for Health Insurance Premiums

1) Plan not established by S-corporation.

If the health insurance plan is NOT considered established by the S-corporation, you cannot take an above-the-line deduction for health insurance premiums. 

Example:

2) Earned income from trade or business limitation.

The deduction for S-corporation health insurance premiums is not allowed to the extent that the amount of the deduction exceeds the earned income derived by the taxpayer from the trade or business with respect to which the plan providing the medical care coverage is established.

3) You're eligible to participate in a plan by your employer (if you work for another company) or your spouse's employer.

The deduction is not allowed for amounts during a month in which the taxpayer is eligible to participate in any subsidized health plan maintained by an employer of the taxpayer or of the spouse of the taxpayer. Section 162(l)(2)(B).

Amended Returns

Taxpayers who did not claim the health insurance deduction on a prior year's return may file an amended return on Form 1040X.

It must be filed timely (3 years from the due date of the original return, plus extensions, or 2 years from the date the tax was paid, whichever is later).

You need to write the following at the top of the amended return:

Notice 2008-1 contains the rules (and examples) for deducting accident and health insurance premiums by a 2% shareholder/employee of an S-corporation. 

Next:

S-corporations: How to Reduce Your FICA Taxes if You Own an S-corporation

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