Businesses operating as S corporations have many of the same benefits of pass-through taxation as partnerships or LLCs taxed as partnerships. In addition, however, S corporations have always had unique issues with respect to health insurance premiums paid to (or on behalf of) their shareholders who own more than 2% ownership interest. With the Affordable Care Act (ACA), even more issues have arisen with respect to health insurance, and S corporations are especially affected by these new rules.
Health and accident insurance premiums paid on behalf of a greater than 2-percent S corporation shareholder-employee are deductible by the S corporation and reportable as wages on the shareholder-employee’s Form W-2, subject to income tax withholding. However, these additional wages are not subject to Social Security, or Medicare (FICA), or Unemployment (FUTA) taxes if the payments of premiums are made to or on behalf of an employee under a plan or system that makes provision for all or a class of employees (or employees and their dependents). Therefore, the additional compensation is included in the shareholder-employee’s Box 1 (Wages) of Form W-2, Wage and Tax Statement, but is not included in Boxes 3 and 5 of Form W-2.
Under Section 162(l), a 2-percent shareholder-employee is eligible for an above-the-line deduction in arriving at Adjusted Gross Income (AGI) for amounts paid during the year for medical care premiums if the medical care coverage was established by the S corporation and the shareholder met the other self-employed medical insurance deduction requirements. If, however, the shareholder or the shareholder’s spouse was eligible to participate in any subsidized health care plan, then the shareholder is not entitled to the above-the-line deduction.
IRS NOTICE 2008-1
The insurance laws in some states do not allow a corporation to purchase group health insurance when the corporation only has one employee. Therefore, if the shareholder was the sole corporate employee, the shareholder had to purchase his health insurance in his own name. To keep playing field fair, the IRS issued Notice 2008-1, which ruled that under certain situations the shareholder would be allowed an above-the-line deduction even if the health insurance policy was purchased in the name of the shareholder.
The notice provided four examples, including three examples in which the shareholder purchased the health insurance and one in which the S corporation purchased the health insurance. Notice 2008-1 states that if the shareholder purchased the health insurance in his own name and paid for it with his own funds, the shareholder would not be allowed the above-the-line deduction. On the other hand, if the shareholder purchased the health insurance in his own name but the S corporation either directly paid for the health insurance or reimbursed the shareholder for the health insurance and also included the premium payment in the shareholder’s W-2, the shareholder would be allowed an above-the-line deduction.
IMPACT OF AFFORDABLE CARE ACT ("ACA")
The Affordable Care Act (ACA) did not change the above rules regarding the federal tax treatment of health and accident premiums paid for a 2% shareholder. However, for tax years after 2013, ACA imposes penalties on the S corporation if the S corporation offers a health plan that fails to comply with certain market reform provisions, which may include plans under which the S corporation reimburses employees for the cost of individual health insurance premiums. The excise tax "penalty" is potentially astronomical: $100 per day, per employee, per violation.
Among the ACA market reform provisions is a requirement that a group health plan must not impose annual limits on essential health benefits. In Notice 2013-54, the IRS indicated that a health plan under which an employer reimburses employees for the cost of individual health insurance premiums (sometimes referred to as “employer payment plan”) will generally be treated as failing this requirement because the employer payment plan is treated as imposing a "limit" up to the cost of the individual policy premium.
The excise tax for failure to satisfy the ACA market reforms generally will not be imposed on an S corporation in the following two situations:
The S corporation provides medical benefits under a health plan that satisfies the ACA market reform requirements (for example, a group health plan that does not provide for reimbursement of individual policy premiums), OR
No more than one active employee participates in the "employer payment plan" under which the S corporation reimburses the cost of individual policy premiums.
The ACA market reform provisions do not apply to plans that cover fewer than two participants who are active employees [IRC § 9831(a)(2)].
TRANSITION RELIEF PROVIDED BY IRS NOTICE 2015-17
On February 18, 2015, the IRS issued Notice 2015-17, which provides transition relief for S corporations that sponsor "employer payment plans" covering 2-percent shareholders. The notice provides that, unless and until additional guidance provides otherwise, S corporations and shareholders may continue to rely on Notice 2008-1 with regard to the tax treatment of 2-percent shareholder-employee and their healthcare arrangements for all federal income and employment tax purposes.
The Department of Labor and the IRS are contemplating publication of additional guidance on the application of the market reforms to a 2-percent shareholder-employee healthcare arrangement. Until such guidance is issued, the excise tax under IRC § 4980D will not be asserted for any failure to satisfy the market reforms by a 2-percent shareholder-employee healthcare arrangement. In addition, unless and until additional guidance provides otherwise, an S corporation with a 2-percent shareholder-employee healthcare arrangement will not be required to file IRS Form 8928 (regarding failures to satisfy requirements for group health plans under Chapter 100 of the Internal Revenue Code, including the market reforms) solely as a result of having a 2-percent shareholder-employee healthcare arrangement.