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Deducting S corporation Health Insurance Premiums
Notice 2008-1
Notice 2008-1 contains the rules (and examples) for deducting accident and health insurance premiums by a more-than-2% shareholder/employee of an S corporation. Section 1372(a) provides that, for purposes of applying the income tax provisions of the Code relating to employee fringe benefits, an S corporation shall be treated as a partnership, and any 2-percent shareholder of the S corporation shall be treated as a partner of such partnership.
Definition of a 2% Shareholder
The following is from IRS Notice 2008-1:
For purposes of § 1372, the term "2-percent shareholder" is any person who owns (or is considered as owning within the meaning of § 318) on any day during the taxable year of the S corporation more than 2 percent of the outstanding stock of such corporation or stock possessing more than 2 percent of the total combined voting power of all stock of such corporation.
How an S corporation Deducts Health Insurance Premiums
An S corporation deducts the premiums it pays for accident and health insurance to cover a 2% shareholder/employee (and his spouse and dependents) as compensation paid to the shareholder/employee. In other words, the premiums are included in the shareholder/employee's salary and reported on the individual's W-2 form.
Notice 2008-1 states that health insurance premiums paid or furnished by an S corporation on behalf of its 2 percent shareholders in consideration for services rendered "are treated for income tax purposes like partnership guaranteed payments under § 707(c) of the Code. Rev. Rul. 91-26, 1991-1 C.B. 184."
Health Insurance Premium Deduction Rules
The rules that apply to S corporations also apply to:
- Partnerships and
- Multi-member LLCs (but not to a single-member LLC)
Plan Must be Established By the Business:
If you're a more-than-2% shareholder/employee in an S corporation, a partner in a partnership, or a member in a multi-member LLC, you may only deduct health insurance premiums directly on Form 1040, line 29, Self-employed health insurance deduction, IF the health insurance plan is considered to have been established by the business and not by you personally.
In determining if the business estabished the plan, whose name the policy is in is not taken into account (it could be in the more-than-2% shareholder/employee's name or in the business's name).
The following two elements are considered in determining who established the plan:
- Who actually pays the premiums, and
- How the premiums are reported for income tax purposes by both you and the business
For the plan to be considered established by the business, the business must pay the premiums and include the premiums in the more-than-2% S corporation shareholder/employee's gross wages on Form W-2. If the more-than-2% S corporation shareholder/employee puts the policy in his own name, personally pays the premiums without getting reimbursed from the business, the plan is not considered to have been established by the business and the.
Any One of Three Scenarios Must Be Satisfied
For an accident and health insurance plan to be considered established by the business, any one of the following three scenarios must apply:
Scenario 1:
The business obtains an accident and health insurance policy in the business's name to cover its more-than 2% shareholder/employees (in the case of an S corporation), partners (in the case of a partnership), and members (in the case of a multi-member LLC). The plan also covers their spouses and dependents:
- The business makes all the premium payments.
- The business reports the amount of the premiums as:
- Part of gross wages on Form W-2, in the case of a more-than-2% shareholder/employee of an S corporation.
- Guaranteed income in each partner's Schedule K-1, in the case of a partnership..
- Guaranteed income in each LLC member's Schedule K-1, in the case of an LLC.
- The default tax treatment of a multi-member LLC is that of a partnership if no election is made to treat the LLC as an S corporation or C corporation.
- If an election was made on Form 2553 to treat the LLC as an S corporation, then the LLC members would be treated as employees of the business instead of partners (the default tax treatment) and the premiums would be reported in each member's W-2 as part of their gross wages.
Scenario 1 Result:
- In this scenario, the plan is established by the S corporation.
- Each 2% shareholder/employee, partner, and LLC member may take the deduction on Form 1040, line 29.
- If you were a more-than-2% shareholder/employee of an S corporation, the health insurance premiums paid on your behalf would be included in your gross wages on your W-2.
- If you were a partner in a partnership or member of a multi-member LLC, the premiums would be included in your Schedule K-1 as guaranteed income.
Scenario 2:
A more-than-2% shareholder/employee, partner, or member of a multi-member LLC obtains an accident and health insurance policy in his own name:
- The business makes all the premium payments.
- The business reports the amount of the premiums as:
- Part of gross wages on Form W-2, in the case of a more-than-2% shareholder/employee of an S corporation.
- Guaranteed income in each partner's Schedule K-1, in the case of a partnership.
- Guaranteed income in each LLC member's Schedule K-1, in the case of an LLC.
- A multi-member LLC is treated as a partnership, which is the default tax treatment if no election was made to treat the LLC as an S corp. or C corp.
- If an election was made to treat the LLC as an S corporation, then the members would be treated as employees of the business and the premiums would be reported in each member's W-2 as part of their gross wages.
Scenario 2 Result:
- In this scenario, the plan is established by the business even though the policy is not in the business's name.
- The premiums paid by the business may be deducted on Form 1040, line 29.
Scenario 3:
A more-than-2% shareholder/employee, partner, or member of a multi-member LLC obtains a policy in his name to cover himself his spouse and two children.
- The shareholder/employee, partner, or LLC member pays all the premiums
- Proof of payment is provided to the business
- The business reimburses the 2% shareholder/employee, partner, or LLC member for the premiums paid.
- The business includes the amount of the premiums reimbursed to the 2% shareholder/employee in his W-2 gross wages.
- The business reports the amount of the premiums reimbursed to the partner or LLC member as guaranteed income on Schedule K-1
Scenario 3 Result:
- In this case, the health insurance plan is considered established by the business even though the plan is not in the business's name because the business reimbursed the premiums to the 2% shareholder/employee, partner, or LLC member,
- The 2% shareholder/employee, partner, and LLC member may deduct the premiums paid on Form 1040, line 29.
- The more-than-2% shareholder/employee, partner, and LLC member report the reimbursed premiums in their gross income on Form 1040 as explained in Scenario 1.
When a 2% S corporation Shareholder, Partner, or LLC Member May Not Claim the Deduction on Form 1040, Line 29:
Here's a situation where health insurance premiums may not be deducted directly on Form 1040, line 29:
- A more-than-2% shareholder/employee, partner, or member of a multi-member LLC pays the premiums for a health insurance policy.
- The business does not make any premium payments and does not reimburse the premium payments made by the 2% shareholder/employee, partner, or LLC member
In this case, the plan was not established by the business because the business did not pay any of the premiums nor did the business reimburse the premiums to the 2% shareholder/employee, partner, or LLC member.
The premiums may not be deducted on Form 1040. Instead, the deduction may only be claimed on Schedule A as an itemized deduction as a medical expen
Caution!
Do not include amounts for any month you were eligible to participate in an employer-sponsored health plan (Section 162(l)(2)(B)) or amounts paid from retirement plan distributions that were nontaxable because you were a retired public safety officer.
You cannot claim the health insurance premium deduction if you file Form 1040A or Form 1040EZ.
Earned Income From Trade or Business Limitation
The deduction for health insurance premiums is not allowed to the extent that the amount of the deduction exceeds the earned income derived by the taxpayer from the trade or business with respect to which the plan providing the medical care coverage is established.
Amended Returns
Taxpayers who did not claim the health insurance deduction on a prior year's return may file an amended return on Form 1040X. It must be filed timely (3 years from the due date of the original return, plus extensions, or 2 years from the date the tax was paid, whichever is later).
You need to write the following at the top of the amended return:
- Filed Pursuant to Notice 2008-1
Notice 2008-1 contains the rules (and examples) for deducting accident and health insurance premiums by a 2% shareholder/employee of an S corporation.