An IRS Notice released this morning spells out the conditions for S corporation shareholders to get tax-free treatment for their health insurance premiums.
Under Notice 2008-1, the corporation has to either pay the premiums directly or reimburse the shareholder for documented premium payments. The S corporation also must include the payments in Box 1 of the shareholder-employee's W-2 form. The employee must then report the W-2 income, but then deduct the premiums on line 29 of form 1040. The net effect of these maneuvers is the same as if the insurance were never included in income in the first place.
The tax law has had screwy treatment of 2% owner-employees for many years. Until the rules were changed in the late 1990s, such shareholder-employees got no tax break for health insurance costs. Now such shareholders have to pick up the premiums in income, but they get an offsetting deduction. Such premiums are included in Box 1 taxable income, but they don't count as wages for FICA or Medicare tax.
This new Notice is a slight liberalization of the rules. The IRS announced in 2006 that only premiums paid directly by the S corporation qualified for the tax break. The new rule expands the line 29 deduction to premiums paid by the shareholder but reimbursed by the corporation.
IMPORTANT POINT: S corporation shareholders need to make sure that their premiums are included on their 2007 W-2s. Many businesses fail to do so. Practitioners in the past have added the premiums left of the W-2 to the "other income" line, and then deducted it on line 29. Notice 2008-1 says that doesn't work.
If you have such premiums, make sure to let your payroll service know the amount so they can add them to the W-2s in their year-end processing. If you are an S corporation shareholder and you have been paying your own premiums, be sure you turn them in for reimbursement before December 31 so they are included on your W-2.
Yes, it is silly to have to go through the gyrations. Who says the tax law has to make sense? But if you fail to follow these directions, the IRS will say your S corporation health premiums are taxable and non-deductible.
UPDATE, 12/27/2007: MORE ON S CORPORATION HEALTH INSURANCE
UPDATE, 1/2/2007: S CORPORATION HEALTH INSURANCE: READER QUESTIONS
The items included in the Tax Update Blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation.
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