U.S. federal tax law differentiates the tax accounting methods for employee health benefits from the treatment of self-employed individuals. Operators of small businesses organized as S corporations under state law are considered to the self-employed for income tax reporting but are typically also employees of the S corporation.
Employer paid health benefits are most commonly classified as: a) qualified health insurance, b) supplemental insurance, c) cafeteria plan, d) Flexible Spending Account (FSA), e) Health Savings Account (HSA) or f) Health Reimbursement Arrangement (HRA).
The reporting of health benefits for shareholder/employees of S corporations has historically been one of the most misunderstood and misapplied topics in employee benefits tax reporting by tax preparers. While the implementation of the Affordable Care Act did not change these methods of tax reporting, it did bring additional confusion to the field. This confusion and errant tax reporting appears to continue today. This blog posts attempts to present the topic a simply as possible but includes adequate legal citations to substantiate each of the points presented.
IRS introduces the concept of “2% shareholder” to differentiate between an owner/employee vs a common law non-owner employee who happens to own a small amount of the company perhaps through some type of employee stock ownership incentive plan. The result of this distinction is that shareholders with less than 2% ownership are treated as common law non-owner employees while those with 2% or more ownership are treated as self-employed individuals.
The proper way for S-corporations to report health benefits to more than 2% shareholders is:
- Deduct health insurance premiums paid or reimbursed by the S-Corp on the Form 1120 business tax return and then report these same payments as taxable W2 income to the shareholder.
- These amounts are not subject to Social Security and Medicare taxes as described in Internal Revenue Code section 3121.
- The individual taxpayer is then entitled to a deduction of this amount on Line 29 of the Form 1040).
- If an S corporation pays or reimburses any health expenses other than health insurance, this arrangement should be done as ordinary taxable wages not as part of any employee benefit plan that that involves other employees.
- Do not include shareholder/employees in cafeteria plans, Health Reimbursement Arrangements or Flexible Spending Arrangements. This prohibition is detailed in 26 CFR 1.125-1 and IRS Notice 2002-45.