A Healthy Deduction for 2% Shareholders

Article excerpt

In Notice 2008-1, the IRS has offered an opportunity for 2% shareholders of an S corporation to receive a deduction for health insurance premiums under IRC [section] 162(1). A 2% shareholder is defined in section 1372(b) as a person who owns directly or constructively under section 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. Previously, a 2% shareholder could not deduct such payments and had to recognize them in income.

Section 162(1)(1)(A) allows an employee to take a deduction for medical insurance paid by the S corporation on behalf of the employee, the employee's spouse, and dependents. Previously, a 2% shareholder was not considered an employee; therefore, the shareholder was not eligible to deduct the insurance premiums paid by the S corporation. When dealing with fringe benefits, an S corporation is treated as a partnership, which means the 2% shareholder is treated as a partner. In general, when a partner receives payment of insurance premiums as compensation, that income is treated as a guaranteed payment under section 707(c) and must be reported as income by the shareholder under section 6 l(a).

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AN ESTABLISHED PLAN

Under Notice 2008-1, a 2% shareholder is allowed an above-the-line deduction 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.

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. …