S Corporation Fringe Benefits
A 2% shareholder is any person who owns more than 2% of the corporation’s outstanding stock on any day during the S corporation’s tax year, considering both direct and constructive ownership.
The related-party stock attribution rules also apply to the S corporation. Under these rules, your spouse, parents, children and grandchildren are considered to own the same stock as you. Furthermore, if you employ them in your S corporation, their fringe benefits are subject to the same rules.
Let’s take a closer look at some of the most common favorable fringe benefits.
1. Health Insurance
In order for a 2% shareholder in an S Corporation to receive a full deduction for health insurance premiums paid on behalf of the employee, the employee’s spouse, or their dependents, the following steps must be followed:
- The S corporation must pay the insurance premiums, either directly or through reimbursement to the shareholder.
- The S corporation must include the health insurance as wages not subject to FICA on the shareholder’s W-2.
- The cost of the health insurance premiums are deducted on the shareholder’s individual return, using the self-employed health insurance deduction on page 1 of their Form 1040.
Warning No. 1 – Greater than 2% shareholders cannot participate in a Section 125 Plan. The shareholder’s participation will destroy the S corporation’s tax-favored Section 125 cafeteria plan. If the 2% shareholder participates in the Section 125 plan, not only is the plan disqualified, but the benefits will be taxable to themselves and all employee participants.
Warning No. 2 – According to the IRS, earned income of a more-than-2% shareholder in an S corporation under which an insurance plan is established is the shareholder’s Medicare wages (Box 5 of Form W-2) from that corporation. Since health insurance premiums are not included in Medicare wages, this definition of earned income effectively requires a 2% shareholder have cash wages subject to FICA taxes that equal or exceed the premiums in order for the 2% shareholder to receive the full health insurance deduction on his or her individual return.
Warning No. 3 – Beware of Employees. The S corporation can pay for or reimburse the 2% shareholders’ individually-owned insurance but the S corporation may not pay for or directly reimburse the non-managerial employees for such policies.
An S corporation which directly pays for or reimburses employees for employee-arranged health insurance premiums (as opposed to paying premiums for company-arranged group coverage) faces stringent Affordable Care Act penalties.
2. Health Reimbursement Arrangements (HRAs)
A shareholder-employee who owns more than 2% of the shares can’t gain an extra benefit from a Section 105 plan or other HRA.
If the S corporation reimburses the more than 2% shareholder-employee using a health reimbursement plan or account, it simply creates more taxable income to the shareholder. Likewise, if health insurance costs are included in the reimbursement, the shareholder treats the health insurance costs included in his or her W-2 as discussed in No.1 above.
For medical reimbursements other than health insurance, the S corporation reports the income as wages on the W-2, the shareholder itemizes those deductions as a medical expense on Schedule A of Form 1040 (federal income tax form used to report an individual’s gross income).
3. Health Savings Accounts (HSAs)
The S corporation treats contributions to the more than 2 percent shareholder-employee’s health savings account (HSA) as W-2 income; however it is exempt from Social Security and Medicare, and the shareholder-employee deducts the HSA on his or her Form 1040.
4. Disability Insurance
The S corporation treats the premiums paid for an income replacement disability policy on a more than 2% shareholder-employee as wages for withholding tax purposes that are exempt from FICA and federal unemployment taxes.
Under this requirement, the more than 2% shareholder-employee has constructively paid the disability premiums personally because of the W-2 treatment, and that means he or she collects the disability income tax-free.
Fringe benefits that are not as beneficial to the S corporation shareholder:
- While some fringe benefits give your S corporation a tax deduction for the compensation, the benefit is compensation on the shareholder’s W-2. Effectively, this gives the shareholder zero tax benefit from the fringe benefit.
- These benefits increase the corporation’s share of the FICA taxes on the compensation it has to add to the 2% shareholder’s W-2.
- The benefit increases the 2% shareholder’s personal FICA taxes because of the compensation added to the W-2.
These non-beneficial fringe benefits subject to FICA taxes include:
1. Group Term Life Insurance
Shareholder-employees cannot deduct the group term life insurance on their personal return. To see whether it is a good or bad the idea to cover a more than 2% shareholder-employee with group term life insurance, you need to compare the cost savings (if any) of the group insurance with the additional FICA taxes paid by both the corporation and the shareholder.
2. Qualified Moving Expense Reimbursements
For tax years beginning January 1, 2018 and before January 1, 2026 tax reform eliminates the fringe benefits and tax deductions for moving expenses. This applies to both employees and shareholder-employees who own more than 2 percent.
3. Meals and Lodging
Meals and/or lodging that are provided to a more than 2% shareholder-employee for the company’s convenience (for example, because the shareholder-employee must be on the company premises for overnight duty) are treated as wages subject to FICA and are not deductible on the shareholders’ personal tax return.
However, this benefit is tax exempt if paid to a non-managerial employee, or one that is a shareholder who owns less than 2% of the shares.
4. Qualified Employee Achievement Program
The 2% shareholder may not deduct the value of the achievement award on his or her personal income tax return.
5. Qualified Adoption Assistance
If the 2% shareholder is paid the adoption assistance fringe benefit and it’s included on the shareholder’s Form W-2, the shareholder can claim the adoption credit allowed by the tax code on his or her personal income tax return.
For more information on how to report these and other fringe benefits on your federal and state payroll reports and Form W-2, please contact your KTLLP advisor.