Two-Percent S Corp Shareholders by Attribution May Deduct Health Insurance Costs

(Parker Tax Publishing April 2019)

The IRS Office of Chief Counsel advised that an individual who is a 2-percent shareholder of an S corporation under the attribution rules in Code Sec. 318 is entitled to deduct amounts paid by the S corporation under a group health plan for all employees that are included in the individual's gross income, if the individual otherwise meets the requirements of Code Sec. 162(l). The Chief Counsel's Office noted that, in order for 2-percent shareholder-employees to deduct the amount of accident and health insurance premiums, the S corporation must report the premiums paid or reimbursed as wages on the shareholder-employee's Form W-2 and the shareholder-employee must report the premiums as gross income on his or her Form 1040. CCA 201912001.

In CCM 201912001, the Chief Counsel's Office was asked whether an individual who is a 2-percent shareholder of an S corporation pursuant to the attribution of ownership rules under Code Sec. 318 is entitled to the deduction under Code Sec. 162(l) for amounts that are paid by the S corporation under a group health plan for all employees and included in the individual's gross income, if the individual otherwise meets the requirements of Code Sec. 162(l).

Under Code Sec. 1372(a), an S corporation is treated as a partnership and a 2-percent shareholder is treater as a partner for purposes of the income tax provisions of the Code relating to employee fringe benefits. A 2-percent shareholder is defined in Code Sec. 1372(b) as any person who owns (or is considered as owning within the meaning of Code Sec. 318) on any day during the S corporation's tax year more than 2 percent of the outstanding stock of the S corporation, or stock possessing more than 2 percent of the total combined voting power of all of the S corporation's stock. Code Sec. 318(a)(1) provides that an individual is considered as owning the stock owned, directly or indirectly, by or for (1) his or her spouse (other than a spouse who is legally separated from the individual under a divorce decree or separate maintenance agreement), and (2) his or her children, grandchildren, and parents.

In Rev. Rul. 91-26, the IRS ruled that accident and 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 Code Sec. 707(c). An S corporation can deduct the cost of such employee fringe benefits under Code Sec. 162(a) if the requirements of that provision are satisfied (taking into account the rules of Code Sec. 263). The premiums are included in wages for income tax withholding purposes on the shareholder-employee's Form W-2, but are not wages subject to social security and Medicare taxes if the requirements for exclusion under Code Sec. 3121(a)(2)(B) are satisfied. The 2-percent shareholder must include the amount of the premiums in gross income under Code Sec. 61(a).

Code Sec. 106 provides an exclusion from the gross income of an employee for employer-provided coverage under an accident and health plan. Under. Reg. Sec. 1.106-1, a 2-percent shareholder is not an employee for purposes of Code Sec. 106. Accordingly, as noted in Notice 2008-1, the premiums are not excludible from the 2-percent shareholder-employee's gross income under Code Sec. 106.

Under Code Sec. 162(l)(1)(A), an individual who is an employee within the meaning of Code Sec. 401(c)(1) can take a deduction in computing adjusted gross income for amounts paid during the tax year for insurance that constitutes medical care for the taxpayer, his or her spouse, and dependents. Code Sec. 162(l)(2)(A) provides that the deduction is not allowed to the extent that it exceeds the earned income (defined in Code Sec. 401(c)(2)) derived by the taxpayer from the trade or business with respect to which the plan providing the medical care coverage is established. Code Sec. 162(l)(2)(B) provides that the deduction is also not allowed for amounts paid during a month in which the taxpayer is eligible to participate in any subsidized health plan maintained by an employer of the taxpayer or his or her spouse.

Rev. Rul. 91-26 states that a 2-percent shareholder-employee in an S corporation who otherwise meets the requirements of Code Sec. 162(l) is eligible for the deduction under Code Sec. 162(l) if the plan providing medical care coverage for the 2-percent shareholder-employee is established by the S corporation. Such a plan is established by the S corporation if (1) the S corporation makes the premium payments for the insurance policy in the current tax year, or (2) the 2-percent shareholder-employee pays the premiums, furnishes proof of payment to the S corporation, and the S corporation reimburses the 2-percent shareholder-employee in the current tax year. If the premiums are not paid or reimbursed by the S corporation and included in the 2-percent shareholder-employee's gross income, the plan is not established by the S corporation and the 2-percent shareholder-employee is not allowed the deduction under Code Sec. 162(l).

Compliance Tip: In order for the 2-percent shareholder-employee to deduct the amount of the premiums, the S corporation must report the premiums paid or reimbursed as wages on the 2-percent shareholder-employee's Form W-2 in that same year. In addition, the shareholder must report the premium payments or reimbursements from the S corporation as gross income on his or her Form 1040.

The Office of Chief Counsel advised that, under the rules described above, an individual who is a 2-percent shareholder of an S corporation pursuant to the attribution of ownership rules under Code Sec. 318 is entitled to the deduction under Code Sec. 162(l) for amounts that are paid by the S corporation under a group health plan for all employees and included in the individual's gross income, if the individual otherwise meets the requirements of Code Sec. 162(l).

For a discussion of the tax treatment of accident and health insurance premiums paid by S corporations, see Parker Tax ¶33,540.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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