Health Insurance for S-Corp Owners: The 2-Percent Shareholder Rules

Health insurance is one of the trickiest employee benefits for S-corp owners because the tax code treats them like partners for fringe benefits even though they are employees for wages. Small errors, like paying premiums from the business account without reporting them on the W-2, are common and easy to fix if caught early. Here is how the rules generally work.

Who is a "2-percent shareholder"

A 2-percent shareholder is anyone who owns, directly or by attribution, more than 2 percent of the outstanding stock or more than 2 percent of the total voting power. The attribution rules count stock owned by certain family members, so a spouse, child, or parent of an owner can be treated as owning the same shares. In most closely held S-corps, all working owners are 2-percent shareholders, and some family members employed by the company are as well.

The general treatment

For a 2-percent shareholder, health insurance premiums the company pays or reimburses are treated like wages for income tax purposes:

The company deducts the premiums as a compensation expense, when properly reported.
The premiums are included in the shareholder's W-2, Box 1 wages, subject to federal income tax withholding.
The premiums are generally not subject to Social Security and Medicare tax if paid under a qualifying accident and health plan (so they are not in Boxes 3 and 5).
The shareholder deducts the premiums as the self-employed health insurance deduction on Schedule 1 of Form 1040, subject to eligibility conditions.

The net effect can be that the shareholder does not pay income tax on the premium after the personal deduction, though it also cannot be used to reduce payroll taxes as it can for regular employees. Also, because the deduction is taken on the personal return and not as a business expense, some limits on the personal deduction apply, such as the amount cannot exceed earned income from the S-corp.

Requirements to claim the personal deduction

The IRS has said the plan must be established by the S-corp for the deduction to work. There are two ways to do this: the company pays the premium directly to the insurer, or the shareholder pays and the company reimburses the shareholder. Either way, the amount must be included in W-2 wages. If the company does not include it in wages, the shareholder generally cannot claim the deduction. The other qualifications include not being eligible to participate in a subsidized employer plan through the shareholder's or the spouse's employer for the same months. See self-employed health insurance deduction for the general rule.

Practical steps

Confirm the insurance policy or plan is in the S-corp's name, or in the shareholder's name with the company reimbursing.
Tell the payroll provider the amounts to include as taxable wages for the 2-percent shareholder, and mark them properly (many systems have a "S-corp 2 percent shareholder health insurance" setting).
Verify the W-2 at year end. Box 1 should include the premiums. Boxes 3 and 5 should generally not, except where the company pays other than through a plan.
Report the deduction on the personal return (Schedule 1, or the applicable line) with the right amount.
Keep records of premium invoices, proof of payment, and the reimbursement policy.

Premium tax credit and marketplace plans

Owners who buy coverage through a government marketplace and rely on premium tax credits have extra interactions: the self-employed health insurance deduction and the credit can affect each other in ways that require iteration in the calculation. Consider professional help when you use both.

Health savings accounts

S-corp shareholders of more than 2 percent are treated as self-employed for HSA purposes. Company contributions to an HSA for these owners generally must also be included in W-2 wages (not subject to FICA in the same way), and the owner takes the HSA deduction on the personal return. See HSA for business owners.

Other fringe benefits

The 2-percent shareholder rule affects more than health insurance. Benefits treated similarly include group-term life insurance, accident and health plan benefits, meals furnished for the convenience of the employer (in some cases), and certain other fringe benefits. Owner-employees also cannot use cafeteria plans, so pre-tax premium payments through a Section 125 plan are not available to them. Those benefits may be available to other employees, which raises nondiscrimination issues in some plans. Ask your adviser before offering broad benefits.

Reimbursement arrangements and ICHRAs

Some small companies offer individual coverage HRAs or other reimbursement arrangements to employees. The rules for 2-percent shareholders under those arrangements are technical, and owner participation can raise questions. Get advice before including owners.

Health insurance and wages

Including premiums in W-2 wages can also help the wage side of compensation: they count as wages for the purpose of some calculations, though they are not the same as cash salary for reasonable compensation. Ask your adviser how the numbers are treated in your case, including the QBI deduction and retirement plan compensation.

Common mistakes

The company pays premiums, but nothing is reported on the W-2. The shareholder's personal deduction can be lost.
The shareholder pays premiums personally and takes no deduction. Missing a benefit.
The wrong boxes are used. Premiums included in Box 3 or 5 may be reported as subject to FICA when they need not be.
Paying a spouse's premiums with no plan or policy.
Ignoring the earned-income limit on the deduction.
Not coordinating with other employer coverage the owner or spouse could join.
Deducting premiums as a business expense on the 1120-S while also taking the personal deduction, resulting in a double benefit.
Adding premiums for the wrong months.

What to bring to your adviser

Gather policy documents, monthly premium statements, W-2 drafts, and the payroll provider's fringe benefit setup. The reconciliation is short if the records are neat. Because rules can change and there are state-specific wrinkles, confirm your treatment each year. For more on the payroll side, see S-corp payroll for owner-employees.

AE Tax Advisors can review your coverage setup and W-2 reporting, and a discovery call is an easy way to begin.