My concern is with the definition of earned income for this purpose. All the examples in Notice 2008-1 assume the S corp shareholder has earned income from the S corp, which is defined in section 401(c)(2) as self-employment income. But S corps don't generate self employment income. Do the wages count as earned income for this purpose? (So as long as the wages exceed the premiums the shareholder can get the line 29 deduction?) The Notice doesn't say so.
What if the S corp has a loss? if the wages exceed the premiums and both the wages and the premiums create a loss, does the shareholder still get the line 29 deduction?
Fortunately, the tax law gets us around the problem that the reader raises. Sec. 162(l)(5) says that you substitute "wages" for "earned income" for purposes of the health insurance deduction:
5) Treatment of certain S corporation shareholders
This subsection shall apply in the case of any individual treated as a partner under section 1372
(a), except that—
(A) for purposes of this subsection, such individual’s wages (as defined in section 3121) from the S corporation shall be treated as such individual’s earned income (within the meaning of section 401(c)(1)).
That means that an S corporation loss doesn't reduce "earned income" for purposes of computing the shareholder's deduction for health insurance included on his W-2, because S corporation K-1 losses aren't part of W-2 wages.
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