Fringe Benefit Rules for Shareholder-Employees of S Corporations

Whether in Bangor, Maine or elsewhere in the United State, shareholder-employees of S corporations continue to be subject to some special income tax rules. The term shareholder-employee refers to individuals who own 2% or more of the stock of an S corporation on any day of a tax year, as well as certain other individuals related to those shareholders. Under the family stock attribution rules, a person is considered to own the stock owned by that person’s spouse, children, grandchildren, and parents.

While there is some uncertainty regarding which fringe benefits are subject to these special income tax rules, they appear to apply to adoption assistance programs, cafeteria plans, employee achievement awards, group-term life insurance coverage up to $50,000, health and accident insurance plans, health savings accounts, meals and lodging furnished for the convenience of the employer, medical reimbursement plans and disability plans, moving expense reimbursements, and transportation fringe benefits. Fringe benefits not covered by the 2% shareholder rules (which include educational assistance programs, pension plans, and work-related fringe benefits) are deductible by the corporation, up to the limits specified by the relevant Code section, and are excluded from the shareholder-employee’s income.

Since shareholder-employees are not generally considered employees for fringe benefit purposes, they cannot exclude the cost of the covered fringe benefits from gross income. These fringe benefits must be reported as additional compensation on their W-2s. However, shareholder-employees may be able to claim the self-employed health insurance deduction on health and accident premiums paid on their behalf. The deduction is not available for calendar months in which a shareholder-employee or spouse is eligible to participate in another employer-subsidized health insurance plan. Furthermore, the deduction is limited to the shareholder-employee’s earned income, which equals the social security wages the shareholder receives from the S corporation. Any portion that exceeds the earned income limitation is deductible as an itemized deduction, subject to the AGI floor for itemized medical deductions.

Last year we noted that, under the Public Health Service Act, employers that directly pay for or reimburse all or a portion of their employees’ health insurance premiums on a tax-free basis under policies that were purchased in the individual market may be subject to a penalty of up to $100 per day per applicable employee. While this provision continues to apply for employees in general, in February 2015 the IRS delayed the implementation of these Section 4980D penalties for shareholder-employees until 2016. The guidance further stated that the IRS and the Department of Labor are contemplating the publication of additional guidance on the application of the market reforms to shareholder-employees. After 2015 though, cautious S corporations should not directly pay premiums for an individual health insurance policy on behalf of any employee or shareholder-employee, or reimburse the individual for those premiums. Instead, the individual’s salary for both FIT and FICA purposes can be increased to cover the cost of premiums. However, the individual must be able to choose how to spend the increased compensation; there can be no restrictions placed on the additional salary. We will keep you updated as new developments arise.