When running a business as an S Corporation, compliance with tax regulations can be both intricate and essential, especially when it involves health insurance for shareholders. One of the most overlooked aspects is how to handle health insurance benefits for shareholders who own more than 2% of the company. This article breaks down why it’s crucial for S Corporation owners to understand these rules and what steps they need to take to ensure compliance.

Understanding the Basics: What’s the Rule?

The IRS has specific rules for S Corporation shareholders who own more than 2% of the company’s stock (referred to as “2% shareholders”). If an S Corporation provides health insurance to these shareholders, the cost of the premiums must be included as wages on their W-2 form. This requirement ensures that the health insurance benefits are treated consistently under the tax code and that both the S Corporation and the shareholders comply with employment and income tax rules.

Why Does the IRS Care?

The distinction stems from the unique treatment of S Corporations under the tax code. S Corporations are pass-through entities, meaning that profits and losses pass through to shareholders’ individual tax returns. Because of this, the IRS wants to prevent shareholders from receiving untaxed compensation through health insurance benefits. By including the value of the health insurance in the shareholder’s W-2, the IRS ensures that the benefit is subject to income tax withholding and that the shareholder receives a corresponding tax deduction for self-employed health insurance on their personal return.

Steps to Report Health Insurance for 2% Shareholders

1. Add Premiums to Wages: The S Corporation must add the cost of the health insurance premiums paid on behalf of the 2% shareholder to their gross wages on their W-2 form in Box 1 (Wages, Tips, Other Compensation). However, these amounts should NOT be included in Boxes 3 or 5 (Social Security and Medicare wages). The corresponding amount should then be reported in Box 14 (other).

2. Deduct the Premiums on the Shareholder’s Individual Return: The 2% shareholder can then claim a deduction for the health insurance premiums on their individual tax return (Form 1040) as self-employed health insurance, which reduces their adjusted gross income (AGI).

3. Report in the Corporate Books: Ensure that the premiums paid by the corporation are clearly documented as shareholder health insurance in the company’s records. This documentation is crucial in the event of an IRS audit.

Benefits of Complying: Avoiding Penalties and Maximizing Deductions

Properly including health insurance premiums in W-2 wages ensures that the S Corporation and its shareholders avoid common pitfalls, such as:

• IRS Penalties: Misreporting health insurance benefits can result in additional taxes and penalties for both the corporation and the shareholder.
• Lost Deductions: When handled correctly, the 2% shareholder can deduct the cost of health insurance premiums as a self-employed health insurance deduction, reducing their personal tax liability.
• Audit Risk: The IRS has increased scrutiny on shareholder-employee compensation and benefits, making accurate reporting more important than ever.

Make note that if you have a PEO service that covers your health insurance plan, please reach out to them as some of them do not qualify.  Therefore, you do not add the information to your W-2, and you do not receive the self-employed health insurance deduction.  As a reminder, shareholders are not allowed to participate in the Sec. 125 plan either.

The Bottom Line

For S Corporation owners, correctly handling health insurance for 2% shareholders is not just about compliance—it’s about maximizing tax efficiency and ensuring that the corporation and its shareholders are in good standing with the IRS. By understanding the regulations and taking the necessary steps, S Corporation shareholders can benefit from health insurance coverage while staying on the right side of tax law.

Before you hit submit on those W-2 forms in January, keep these rules in mind.  It will help you navigate the complexities of shareholder compensation and ensure that everyone benefits from the right reporting and deductions.  If you need assistance or have any questions regarding the shareholder health insurance reporting requirements, please reach out to Terri Brechter, CPA at 713-350-2475 or tbretcher@abipcpa.com.