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IF IT'S NOT ON THE W-2, S CORP SHAREHOLDERS CAN'T DEDUCT HEALTH INSURANCE
December 13, 2007
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
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Comments
I am not sure this makes sense.
1. By doing the above, would we increase payroll taxes for the shareholder-employee?
2. What is the benefit of doing this? Doesn't the shareholder-employee deduct insurance payments on line 25 and 29 already, with income passed through on line 17? What difference does it make to have the inclome on line 7?
Posted by: Marty | January 1, 2008 2:59 PM
Which box of the W-2 should the insurance premium be identified?
Posted by: CHERYL IERARDI | January 14, 2008 4:22 PM
Cheryl, it needs to be part of box 1 wages, but not Box 3 or 5 wages. You may also identify it in Box 14, but you aren't required to.
Posted by: Joe Kristan | January 14, 2008 4:40 PM
Great info on this new information! I do have a couple questions - 1. what if there are other employess of the S corp, but the 100% owner is the only employee offered, and covered by, health insurance? Do these rules remain the same? Or are the premuims now subject to FICA and Medicare, but still passed through and deductible above the line on the 1040?
2. What about prior years - 2006 and earlier - if insurance was passed through as draws, and taken as an above the line deduction, would an amended 1120s AND amended W-2's be filed to reclassify those payments? (And amended 1040, with a net effect of zero, since w-2 wages would increase by the amount of decreased S corp income....)
Thanks!
K
Posted by: Karen | January 18, 2008 11:05 PM