Written by TaxSpeaker
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Most professionals know the rules regarding health insurance paid for 2% S corporation shareholders. The old IRS Notice 2008-1 tells us to add health insurance paid for 2% shareholders in an S corporation to their W-2, Box 1 (only) assuming it is non-discriminatory.
The first issue we ran into this year in our Taxspeaker Q&A series was the question about what to do with spouses and family members of 2% shareholders. The attribution rules from IRC Section 318 and the related Regulations at 1.318-1 state very clearly that “An individual is considered to own the stock owned, directly or indirectly, by or for his spouse (other than a spouse who is legally separated from the individual under a decree of divorce or separate maintenance), and by or for his children, grandchildren, and parents.”
What this means is that the spouse, children, grandchildren and parents are also treated as owning 2% of the stock, without regard to whether they are a dependent or not. This means two things; first, that health insurance paid for these folks should also be added to their W-2, box 1 and deducted by the S corp as wages; and second, that since they are treated as owning 2% of the stock they also qualify for the self-employed health insurance deduction.
The problem we encountered this year is directly related to the above summary. Because the additional health insurance is not usually subject to FICA or Medicare, many taxpayers and preparers are mistakenly just taking the self-employed health insurance deduction on the 1040 without adding the amount to the W-2 or complying with the requirements to qualify for the SE health deduction.
For an S corporation shareholder to qualify for the SE health insurance deduction on the 1040, the S corporation must either pay the premiums directly, or reimburse the shareholder for the premiums by year end. The S corporation then artificially adds the premium to W-2, Box 1 wages and deducts the amounts as wages, not insurance. The shareholder than receives an artificially increased W-2, which is offset by the reduced S corporation income, but the shareholder then also qualifies for the SE health insurance deduction, so that by the end there is 1 addback of income, 2 deductions of the same amount and 1 net deduction. Many professionals wonder why we go through all of this, and mistakenly just have the shareholder pay the insurance personally and then incorrectly take the SE health deduction, but the reasons for these calculations go back to an earlier era when the SE health insurance deduction was less than the current 100%.
Here is an example:
Let’s say Sue’s corporation has $100,000 of income before her own officer wages of $50,000. If Sue pays $10,000 of health insurance for herself through the S corp, the S corp will show a net profit of $40,000 (after adding in her health insurance to her W-2), and will qualify her for an $8,000 QBI deduction. Sue will receive a $60,000 W-2, $40,000 of K-1 income, a $10,000 SE health deduction and an $8,000 QBI deduction and pay tax on $82,000. Be careful not to reduce QBI a 2nd time by the SE health deduction which already reduced QBI by $10,000 with the W-2 addback at the S corp level.
Now let’s say Sue decided not to go through with this ridiculous exercise and paid her health insurance personally, and incorrectly went ahead and took the same $10,000 SE health insurance deduction. She will receive a $50,000 W-2, $50,000 of K-1 income, and an incorrect $10,000 QBI deduction, and an incorrect $10,000 SE health insurance deduction, paying tax on $80,000. By not following the correct treatment, Sue has understated her income by $2,000.
The same example applies to her spouse, kids, grandkids and parents that work in the S corporation!