The One Deduction Most S Corporations Get Wrong

The IRS is pretty clear that a greater than 2% shareholder does not have the same benefits available that a regular employee does.

My concern as I read your details is it looks like you’re mixing the two a bit. The benefits will be exempt from Social Security & Medicare, but are not deductible for income tax purposes, but the time you’ve done the proper reporting on your W-2.

But I might be incorrectly reading what you’re doing. My suggestion is to contact your plan administrator and lay out exactly what you are doing. If they say it’s okay, then their name, reputation and E & O insurance is on the line. You should also check in with your CPA to make sure your W-2 is being properly prepared.

Liz, your comment is logical. Unfortunately, tax law doesn’t always follow logic.

My guess (and it’s only a guess) is that we’ve gotten here through a series of rule changes. There was a time a few years ago when we all had our hearts stop for a moment when the IRS said that med insurance had to be in the name of the corp in order to be deductible. That left hundreds of thousands of solopreneurs out in the cold. In fact, the IRS said we had to report the benefit if it was paid by the S Corp on the W-2.

So in effect it became a taxable benefit to the owner, ie no tax benefit.

Then, after a lot of complaints, the deduction came back. But instead of taking it as an S Corp deduction, they’ve done it this circuitous way.

I think they’re tracking how many people actually take the deduction for purposes of stats.

Alexis,

In the case of a distribution, it’s not payroll. So you would pay it out of QuickBooks just like it was a payment to vendor. The account to “charge” for the “expense” is shareholder distribution.

For example, let’s say you have an S Corp with two shareholders - you and Sam. Set up a Shareholder Distribution - Alexis and a Shareholder Distribution - Sam account, each one tagged as an equity account.

Sorry, Alexis, I was (and still am) a bit confused.

You have an employee that you are reimbursing for an expense? So, it’s not related to an S Corporation owner and distribution? What is the expense? Does the employee have any ownership? If so, what percentage?

Also I am the employee and I have 100% ownership. My guess at this point is that I need to take out Federal and State Witholding in Quickbooks but none of the medicare, SS, or federal unemployment.

Should a >2% S-corporation shareholder exclude HRA payments and company paid health insurance premiums from both State Unemployment Taxes and County Personal Proprery Taxes?

I live in Virginia, and the instructions for Virginia unemployment quarterly form VEC-FC-20 (Employer’s Quarterly Tax Report) Line B1 indicates that the Total Wages (before deductions) must equal total on payroll. Instructions also indicate “Wages include cash bonuses, tips, commission, severance pay, etc., and remuneration other than cash paid to individual employees”.

Does the Total Wages (for state unemployment) have to match a certain Total Amount shown on IRS Form 941 (Employer’s Total Federal Tax Return)? If so, IRS Form 941 Line 2 (Wages, Tips, ad other compensation) includes HRA payments and health insurance premiums, but IRS Form 941, Lines 5a (Taxable Social Security Wages) and 5c (Taxable Medicare Wages & Tips) do not include HRA payments or health insurance premiums.

Kathryn,

That should have said that they are not subject to Soc Sec and Medicare. Sorry for the mistake and thanks for catching it.

Japheth says: Should premiums paid or reimbursed on behalf of the shareholder-employee be included somewhere on the quarterly Form 941, or just on the W-2? Thanks!

Oh, good question! I went back and looked at the Form 941. I can’t see where you would include it and I didn’t this past year. (Which worried me, because I thought maybe I should have) As near as I can tell, it’s just reported on the Form W-2. Love to hear if anyone has reported it on the quarterly Form 941.

I just learned about the rules for S corp shareholder medical insurance. My costs have been incorrectly excluded from box 1 of my w2 for the past few years and much of the costs were reported in box 12 as a cafeteria expense for health insurance. We also have a high deductibility health insurance plan and my contribution to a health savings account was also excluded from box 1 and reported in box 12. I plan to have my accountant reissue my w2 for 2010 so that I can properly report these deductions. I guess that my accountant should also file an ammended return for the S corp for 2010. Should I do the same for 2009 and amend my personal return? What about 2008?

My parents and siblings work for a seperate S corp so I compared notes on this subject with them. It looks like they almost got it right. Shareholder medical expense was included in box 1, box 3 it did not matter since they are all over the limit, but it was also included in box 5, resulting in excess medicair taxes. Between my parents and siblings and including both the employee and employer portions this could amount to about 3,000 per year. Is it worth refiling for them or does this increase the chance for an audit? Also, my parents and one of my siblings had the accounting firm for the company also file their personal return, and they correctly took the deduction for medical insurance above the line, but two other siblings have been using turbo tax and missed this deduction. Should they amend their returns or again would this potentially invite an audit?

Thanks

David, I never like to advise whether to prepare an amendment or not. If the return is wrong, then technically it needs to be collected. But their preparer is in the best position as to what the risk of not correcting it (penalties and interest) would be versus correcting it.

Hi James:

Unfortunately, I agree with the benefits company on this one. The rules regarding S Corporations and the >2% owner are pretty clear. The HRA (or MERP) is not allowed.

Likewise, constructive ownership definitions change throughout the Code. In this case, you’re subject to Sec 318, which is really clear that your wife is included as one of the disallowed owners of the S Corp.

If applicable, you may consider hiring your wife as an Independent Contractor so that she has her own Schedule C or even C Corporation. CAUTION: Make sure you have a business purpose for making the change and that she truly is independent, not just a disguised worker.

I have seen what appears to be about a 50/50 interpretation on HRA reimbursement of medical expenses. I understand that it has to hit the “income” line but what is 50/50 is whether payroll taxes are necessary.

Here’s the example, I, like James, own an S-Corp. I realize that I cannot just receive a health reimbursement benefit without declaring it on the W2 line 1, but do I have to apply other Payroll Taxes to this figure?

Thank you for answering, but I’m still a bit confused (by payroll taxes I meant “other” like FICA and FUTA perhaps I used that wrong)…

From the document you referenced:
“These benefits are not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes. The additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder-employee, but would not be included in Boxes 3 and 5 of Form W-2.”

I worked about a month earning for my company but have since gone W2 to a different company. My company has the money to cover some medical bills our family have, so I thought we could distribute the meager amount as a health reimbursement for documented medical expenses (I’ve read that companies can do this for shareholders). Is it correct that I would not have to calculate FICA and FUCA for such a compensation? I’m so fed up with trying to make sense of this stuff that I almost just want to cut a salary check and call it done, and probably get ripped off because I’m not smart enough to understand this nonsense. You are probably the most clearly educated (including our own accountant) I’ve found. So tell me that I am obligated to pay FICA and FUTA on this and I’ll believe it.

wind, I feel your pain:

“The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”

Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense and subject to employment taxes.”

The part that you quoted above applies to non-shareholder employees.

RE:2% S-corp health insurance, if company has loss and shareholder has not taken any salary do we still prepare W-2 and include HI on return in Box 1 & 14, or do we have to give them salary in addition to HI

Same question as Sam and Sarah.. especially because if there are no other wages subject to FICA than the medical deduction would be disallowed on Form 1040 and revert to Sch A. Therefore, if there is no other salary there is no benefit of S/E Medical. (not sure if any income in S-Corp alone in Sarah’s case would allow deduction or not.)