IRS Modifies Rule for Deducting Health Insurance Premiums by S

IRS Modifies Rule for Deducting

Health Insurance Premiums

by S Corporation

2-Percent Shareholders

2321 N. Loop Drive, Ste 200  Ames, Iowa 50010 www.calt.iastate.edu

December 17, 2007

- by Roger McEowen

Overview

IRS has issued as a Notice a proposed revenue

ruling drafted by the American Institute of

Certified Public Accountants (AICPAs) that

allows a 2-percent S corporation shareholder-

employee to take an above-the-line deduction

for accident and health insurance premiums paid

(or reimbursed) by the S corporation (and

included in the shareholder’s gross income) on a

policy in the shareholder’s name rather than in

the name of the corporation.

The Notice

clarifies an issue that arose in 2006 when IRS

stated that an S corporation 2-percent

shareholder could not deduct medical insurance

premiums except as premiums paid by a self-

employed person, and then only if the policy

was in the corporation’s name.

Now, IRS says

that if the corporation pays the premium directly

to the insurance company, or pays the

shareholder the amount of the premium as a

reimbursement, then the shareholder can deduct

the premium as a self-employed person.

The

IRS’ change of position has implications for

practitioners in terms of filling-out IRS Form W-

2 and filing amended returns for open years to

reflect the new rule.

S Corporations and Fringe Benefits

I.R.C. §1372 treats an S corporation as a

partnership when determining how to tax

employee fringe benefits.

Under that provision,

any 2-percent shareholder of the S corporation is

treated as a partner.

In general, accident and

health insurance premiums paid by an S

corporation to its 2-percent shareholders are

treated as partnership guaranteed payments

under I.R.C. §707(c)

if the premiums are paid

for services rendered as a partner and to the

extent the premiums are determined without

regard to partnership income.

Thus, the

premium amount is not deductible by the

corporation, and the 2-percent shareholder must

include the premium amounts in gross income

(in most situations). The premiums are not

excludable under I.R.C. §106 (the exclusion for

employer-provided coverage, because a 2-

percent shareholder is not considered an

employee for purposes of I.R.C. §106.

However, I.R.C. §162(l) does allow employees,

as defined in I.R.C. §401(c)(1), to take a

deduction for medical care insurance premiums

if some requirements are met.

Also, I.R.C.

§162(l) permits a self-employed person, a

partner, and an S corporation

shareholder/employee to claim a deduction for

100 percent of the health insurance premiums

for the taxpayer, spouse and dependents, limited

by the income from the business that has the

plan (thus, the business must have a health

insurance plan).

The health insurance premiums for a 2-percent

shareholder/employee must be included in the

shareholder’s W-2 as income in Box 1.

The

amount is not subject to FICA as long as the

plan is an employee plan as opposed to an owner

plan.

Notice 2008-1

In 2006, IRS issued a Headliner

denying the

deduction for a 2-percent shareholder when the

policy is in the shareholder’s name and the

shareholder pays the premium.

But, the Notice

clarifies that a shareholder is entitled to the 100

percent deduction if the S corporation is paying

the premiums directly or if the S corporation is

reimbursing the 2-percent shareholder. That is

the case if the corporation establishes a plan

providing medical care coverage.

In addition,

the S corporation must report the premiums paid

or reimbursed as wages on the 2-percent

shareholder’s Form W-2 for the year, and the

shareholder must report the premium payments

or reimbursements as gross income. The Notice

sets forth four examples that cover the various

types of arrangements that are possible:

Example 1: For 2008, a

shareholder obtains an accident and

health insurance policy in the

shareholder’s name and pays the

premiums on the policy. The S

corporation makes no premium

payments. The S corporation does

not establish a plan providing

medical care for the shareholder.

The Notice states that the

shareholder is not entitled to a

deduction under I.R.C. §162(l). The

S corporation failed to “establish” a

plan.

Example 2: For 2008, the S

corporation obtains an accident and

health insurance plan in the S

corporation’s name. The plan

provides coverage for a shareholder

as well as the shareholder’s spouse

and dependents. The corporation

pays the premiums to the insurance

company. The corporation reports

the premium amounts as wages on

the shareholder’s Form W-2 for

2008 and the shareholder reports

that amount as gross income on

Form 1040 for 2008. The Notice

states that the shareholder can take a

deduction under I.R.C. §162(l) for

2008.

Example 3: For 2008, a

shareholder obtains an accident and

health insurance policy in the

shareholder’s name. The S

corporation makes all of the

premium payments to the insurance

company and reports the amount of

the premiums as wages on the

shareholder’s Form W-2 for 2008.

The shareholder reports that amount

as gross income on Form 1040 for

2008. The Notice states that the

shareholder can take a deduction

under I.R.C. §162(l) for 2008.

Example 4: For 2008, a

shareholder obtains an accident and

health insurance policy in the

shareholder’s name, and pays the

premiums directly to the insurance

company. The S corporation

reimburses the shareholder for the

amount of the payments. The S

corporation reports the amount of

the premium as wages on the

shareholder’s Form W-2, and the

shareholder reports a like amount as

gross income on Form 1040 for

2008. The Notice states that the

shareholder can take a deduction

under I.R.C. §162(l) for 2008.

Impact of the Notice

The Notice expands the deduction that can be

taken on line 29 of Form 1040 to premiums paid

by a 2-percent shareholder that are reimbursed

by an S corporation. S corporation shareholders

will need to make sure that any premium

amounts are included on the 2007 Form W-2.

That is one item that is now worth checking. In

the past, tax practitioners have typically added

the premium amounts to the “other income” line

on Form 1040, and then deducted it on line 29.

That won’t work any longer.

It is also important to notify payroll departments

of the amount of any accident and health

insurance premiums so that the amount can be

added to the W-2s during year-end processing.

For S corporation shareholders that have been

paying their own premiums, the premium

amounts should be turned in for reimbursement

before December 31, 2007, so that the amounts

are included on the shareholder’s Form W-2.

The Notice is a liberalization of past rules, and

taxpayers can file amended returns for open tax

years to claim the deduction under I.R.C.

§162(l) if the requirements of the Notice are

satisfied for those particular years.

But, failure

to follow the Notice could result in the

premiums being taxable and non-deductible.

IRS Notice 2008-1, 2008-2, IRB 1. The AICPA’s

proposed revenue ruling was drafted by Sydney

Traum and approved by the AICPA’s Tax Executive

Committee, the California Society of CPAs, the

Florida Institute of CPAs and the American

Association of Attorney-CPAs prior to its submission

to IRS on December 27, 2006.

IRS Headliner, Vol. 163 (May 15, 2006).

Notice 2008-1, 2008-2, IRB 1.

I.R.C. §1372(a).

I.R.C. §1372(a)(2). A “2-percent shareholder” is

defined as any person who owns (or is considered as

owning within the meaning of I.R.C. §318) on any

day during the S corporation’s tax year, more than 2

percent of the outstanding stock of the corporation, or

stock possessing more than 2 percent of the total

combined voting power of all of the corporate stock.

See also Rev. Rul. 91-26, 1991-1 C.B. 184.

As guaranteed payments, the premiums are

deductible by the partnership under I.R.C. §162

(subject to the capitalization rules of I.R.C. §263) and

includable in the recipient-partner’s gross income

under I.R.C. §61.

Under prior law, 2-percent shareholders did not

receive any tax break for health insurance costs.

Under current law, 2-percent shareholders must

include the premium amount in income (but the

amount does not count as wages for FICA or

Medicare tax), but can take an offsetting deduction.

There are other restrictions such as not being

eligible to participate in a subsidized plan by an

employer of the spouse’s employer.

Rev. Rul. 91-26, 1991-1 C.B. 184.

IRS Announcement 92-16, 1992-5 I.R.B. 53.

IRS Notice 2008-1, 2008-2, IRB 1.

IRS Headliner, Vol. 163 (May 15, 2006).

The Headliner is silent regarding reimbursement of

the premiums by the S corporation.

For a plan to be considered “established by the S

corporation,” the S corporation must make the

premium payments in the current tax year, or the

shareholder may make the premium payments and

furnish proof of payment to the S corporation, which

then must reimburse the shareholder in the current

tax year. The Notice does not require that the S

corporation actually adopt a written plan.

The Notice assumes, for purposes of the Examples,

that each shareholder is a 2-percent shareholder with

earned income from the S corporation in excess of

the amount of the premiums for the accident and

health insurance policies covering the shareholder,

spouse and dependents, and that none of the

shareholders are eligible to participate in any

subsidized health plan maintained by an employer of

the shareholder or the shareholder’s spouse.

The statement, “Filed Pursuant to Notice 2008-1”

should be written on the top of the amended return.

IRS also stated in the Notice that they do not

consider payments of accident and health insurance

premiums by an S corporation on behalf of 2-percent

shareholder-employees to be distributions for

purposes of the single class of stock requirement of

I.R.C. §1361(b)(1)(D).