IRS Offers Opportunity for 2% Shareholders of S Corp.

By Angela Kegerreis, CPA, Houston, TX


The IRS recently issued Notice 2008-1, offering an opportunity for 2% shareholders of an S corporation to receive a deduction for health insurance premiums under Sec. 162(l). A 2% shareholder is defined as a person who owns directly or constructively under Sec. 318 on any day of the S corporation’s tax year more than 2% of the corporation’s outstanding stock or more than 2% of the combined voting power of all the corporation’s stock (Sec. 1372(b)).

Sec. 162(l)(1)(A) states that when computing adjusted gross income, an employee is allowed to take a deduction for medical insurance paid by the S corporation on behalf of the employee, the employee’s spouse, and dependents. The deduction would not be allowed if the employee was eligible to participate in a subsidized plan provided by an employer of the taxpayer or the taxpayer’s spouse. Previously, a 2% shareholder was not considered an employee under Sec. 106; therefore, the shareholder was not eligible to exclude insurance premiums paid by an employer from income by way of a deduction afforded to other employees.  

When dealing with fringe benefits, an S corporation is treated as a partnership under Sec. 1372(a), which means the 2% shareholder is treated as a partner. In general, when a partner receives payment of insurance premiums as compensation for services, that income is treated as a guaranteed payment under Sec. 707(c). The S corporation is allowed a deduction for the premium payments if the rules of Sec. 162(a) are satisfied. The payments are required to be reported as income by the employee under Sec. 61(a).

Under Notice 2008-1, a 2% shareholder is allowed an above-the-line deduction on Form 1040, U.S. Individual Income Tax Return, for accident and health insurance premiums paid under a plan that is “established by the S corporation.” This poses the question: What are the requirements for a plan to qualify as being “established by the S corporation”? A plan can satisfy this requirement in two ways: The S corporation makes the payments on behalf of the qualifying 2% shareholder, or the shareholder makes the payments and is then reimbursed by the S corporation.

In order for the 2% shareholder to deduct the premiums on his or her individual return, the S corporation must include the premium payments in the employee’s Form W-2 for the tax year in which it is paid, and the shareholder must report those wages as income on Form 1040. In addition, the employee’s earned income from the S corporation must exceed the cost of the premiums under the policy for the shareholder-employee and spouse or dependents, if applicable.

The deduction is also available for prior tax years. If a qualifying taxpayer would have been allowed a deduction in a previous tax year using the new rules, an amended return may be timely filed to claim the deduction with a statement “Filed Pursuant to Notice 2008-1” written on the top of the amended return.

An S corporation is allowed to have only one class of stock (Sec. 1361(b)(1)(D)). Generally, a corporation is treated as having only one class of stock if all outstanding shares of  the corporation’s stock confer identical rights to distribution and liquidation proceeds (Regs. Sec. 1.1361-1(l)(1)). Notice 2008-1 states that accident and health insurance payments made on behalf of 2% shareholders will not be considered distributions with respect to the S corporation single class of stock requirement.





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