Taxation of Health Plan Benefits for Partners and S Corporation Shareholders

Perhaps the most often confused area of small business employee benefits is health plans for partners or S corporation shareholders. I’ve personally discussed the topic dozens of times with clients, students, and other professionals. I’ve written several articles on the topic. Yet, still, am not able to remember all the relevant details without resorting to notes.

The confusion starts with the word “employee.” A partner is not an employee of the partnership under Rev. Rul. 69-184. For S corporations, Section 1372 directs that a more-than-2% S corporation shareholder must be treated as a partner for fringe benefit purposes. So some S corporation employees (for other purposes) may not be considered employees for the purpose of taxing health benefits. The employer-paid coverage exclusion of Section 106 is for employees. It does not apply to partners.

Partners and S corporation shareholders use a two-part tax mechanism. The business pays and deducts the premium as compensation, the owner reports it as income, and the owner then recovers the income tax through the above-the-line deduction of Section 162(l) expense deduction on their personal tax return. The net result usually lands close to the employee exclusion, but the path is different, and the path is where practitioners lose the deduction.

Uninsured health benefits are different. The second step deduction on the individual tax return does not apply.

The S corporation procedure

1. Confirm the ownership percentage. The threshold is more than 2% of outstanding stock or more than 2% of total combined voting power, measured on any day during the tax year. Exactly 2.00% does not trigger the rules.
2. Stock owned by a spouse, children, grandchildren, and parents is attributed to the shareholder for purposes of considering the tax treatment of health benefits. A spouse who owns no stock but works for the corporation is still a more-than-2% shareholder by attribution, and cannot be covered as a rank-and-file employee.
3. Establish the written plan documents under the corporation. The corporation either pays the insurer directly or reimburses the shareholder for premiums paid personally, with documentation. Notice 2008-1 governs. A policy the shareholder bought and paid for with no corporate involvement and no corporate reporting produces no Section 162(l) deduction.
4. Report the premiums in Box 1 of the shareholder’s Form W-2. Do not include them in Boxes 3 and 5. Announcement 92-16 and Section 3121(a)(2)(B) exempt the amounts from FICA and FUTA when the coverage is provided under a plan for employees or a class of employees.
5. Claim the deduction on the individual return using Form 7206, carried to Schedule 1. The cap is the shareholder’s W-2 wages from that corporation, not the K-1 result. A pass-through loss does not reduce the deduction.
6. Test the subsidized-plan limitation month by month. No deduction is allowed for any month the shareholder or spouse was eligible to participate in a subsidized plan maintained by either one’s employer. Medical, dental, and long-term care coverage are tested separately, so a spouse’s employer plan that covers medical but not long-term care does not defeat the long-term care premium.

The partnership procedure

The mechanics for partnerships differ only at the start of the tax accounting process, and end the same as an S corporation. The partnership pays or reimburses the premium and reports it as a guaranteed payment under Section 707(c) on the partner’s Schedule K-1. Rev. Rul. 91-26 is the authority. The partner includes the guaranteed payment in income and then claims Section 162(l), capped by net earnings from self-employment from that partnership.

Note that Section 162(l)(4) bars the deduction from reducing net earnings from self-employment, so the partner still pays SECA on the full amount. That is a real cost the S corporation shareholder avoids, since W-2 wages are not self-employment income and the premium is excluded from Boxes 3 and 5 besides. It is one of the few places where the S election produces a defensible, quantifiable difference rather than a rule-of-thumb one.

Uninsured health benefits

Section 105 normally permits tax-free reimbursement of medical expenses through an employer plan whether or not insurance is involved. A self-insured medical reimbursement plan, sometimes marketed as a “105 plan” or an HRA, pays deductibles, copays, dental work, vision care, and other out-of-pocket costs directly.

Section 1372 does not distinguish between insured and uninsured benefits. It reaches employee fringe benefits generally, so a more-than-2% shareholder and a partner are shut out of Section 105(b) exactly as they are shut out of Section 106. That much is familiar.

Section 162(l) covers amounts paid for insurance constituting medical care, including dental and qualified long-term care insurance. It does not cover reimbursement of uninsured expenses. The two situations therefore diverge:

1. The corporation pays a $9,000 family premium for a more-than-2% shareholder. It goes in Box 1, and Section 162(l) returns the income tax. The owner is close to whole.
2. The corporation reimburses that same shareholder $4,000 for a deductible and two crowns. It goes in Box 1, and nothing returns it. The owner has converted a nondeductible personal expense into taxable wages and gained nothing, except the possibility of a Schedule A medical deduction above the 7.5% AGI floor, which most owners never clear.

The second transaction is worse than doing nothing. A distribution would have been tax-free to the extent of basis. This is the most common owner-benefit error I encounter, and it is usually introduced by a well-meaning bookkeeper who watched the premium treatment work and generalized it.

Ambiguity regarding FICA

Announcement 92-16 and Section 3121(a)(2)(B) exempt premium amounts from FICA when provided under a plan for employees or a class of employees. Section 3121(a)(2)(B) is worded broadly enough to reach payments for medical or hospitalization expenses generally, which on its face covers uninsured reimbursements. Notice 2008-1, however, addresses premiums. Uninsured reimbursements to a 2% shareholder might not be FICA-exempt, and I would not build one on the assumption that they are subject to FICA either. Since the arrangement has no upside for the shareholder in the first place, the cleanest answer is to keep uninsured reimbursements for owners out of the corporate health plan entirely.

The impact of the ACA

A standalone self-insured medical reimbursement plan is a group health plan. It violates the annual dollar limit prohibition of PHSA Section 2711 and the preventive services requirement of Section 2713 unless it fits an exception. Notice 2013-54 said so plainly, and the penalty under Section 4980D is $100 per day per affected individual. The workable exceptions are these:

1. A plan with fewer than two participants who are current employees, under Section 9831(a)(2). This is the solo-owner escape valve, and it is useless for an S corporation owner, who is taxable on the benefit regardless.
2. A QSEHRA under Section 9831(d), available to employers under 50 full-time equivalents.
3. An individual coverage HRA under the 2019 regulations, integrated with individual market coverage.
4. An excepted benefit HRA, which is limited in amount and cannot reimburse major medical premiums.
5. Excepted benefits generally, including limited-scope dental and vision.

Owners are excluded from the first four as participants. The compliance structures and the owner-eligibility rules do not overlap, which is why an arrangement can be fully ACA-compliant and still produce nothing for the person who paid to set it up.

Cafeteria Plans, HSAs, QSEHRA and ICHRA Plans

Owners in both categories are excluded from Section 125 cafeteria plans, which means no pre-tax salary reduction for premiums, no health flexible spending account, and no salary-reduction HSA contributions. Owners are also excluded from QSEHRA and ICHRA participation on a tax-favored basis.

The HSA deserves a separate note, because it is the one place where a parallel rescue exists. A corporation may contribute to a more-than-2% shareholder’s HSA, report the contribution in Box 1, and leave the shareholder to claim the above-the-line deduction under Section 223. That structure mirrors the premium treatment. Nothing comparable exists for uninsured medical reimbursements, and practitioners who reason by analogy from the HSA to the HRA reach the wrong answer.

The sole proprietor’s familiar maneuver of hiring a spouse and reimbursing family medical costs through a Section 105 plan collapses in the S corporation because of attribution. Practitioners who carry that idea over from a Schedule C engagement create a Section 4980D exposure rather than a deduction.

Uninsured benefits work in a C corporation

Health plan benefits for a C corporation shareholder-employee are generally subject to fewer restrictions, but are subject to Section 105(h) nondiscrimination and the market reform overlay above. They work the same as for a sole proprietor or a partner who employs a spouse, where the spouse is the covered employee and the owner is covered as the spouse’s dependent.

Two limits on that strategy deserve emphasis. A husband-and-wife partnership does not work, because both spouses are partners rather than employees. An S corporation does not work, because Section 318 attributes the owner’s stock to the spouse and the spouse becomes a more-than-2% shareholder. If the business has employees other than the spouse, Section 105(h) nondiscrimination testing enters as well, and the one-participant ACA exception is no longer available.

Correcting an error

When an employer discovers a tax error in an employee benefit health plan, these rules apply:

1. Section 4980D provides no excise tax where the employer neither knew nor should have known of the failure, or where the failure was due to reasonable cause and not willful neglect and was corrected within 30 days of the date the employer knew or should have known. Past that window, the employer self-reports on Form 8928, due with the income tax return. An unfiled Form 8928 never starts the limitations period, so declining to look back leaves the exposure open indefinitely rather than closing it.
2. The IRS said it would not assert the excise tax against a 2-percent shareholder healthcare arrangement, and would not require Form 8928 solely on account of this, until further guidance issued. The IRS confirmed in 2016 correspondence that none had been issued, and none has been issued in the decade since.

This process resolves the problem:

1. Determine the open years under the limitations period for each affected return.
2. Issue Form W-2c for each open year, moving the premium into Box 1 and leaving Boxes 3 and 5 alone.
3. File Form W-3c with the corrected statements.
4. Amend the shareholder’s Form 1040 for each year, picking up the wage inclusion and claiming the offsetting Section 162(l) deduction on Form 7206.
5. Confirm whether the corporation’s Form 1120-S needs no change, which is the usual outcome where the premium was already deducted as compensation on the return.
6. Update the plan document so the Notice 2008-1 requirements are satisfied for the current year.

Because the wage inclusion and the deduction largely offset, this may produce a refund rather than a tax due.

Tax Preparer’s responsibility

There is no general statutory duty to amend a filed return. Circular 230 Section 10.21 requires a practitioner who learns of a client’s error or omission to promptly advise the client of the error and of its consequences, and the AICPA tax standards impose a parallel obligation. The duty is to advise. The decision to amend belongs to the client. That is a professional responsibility framework rather than a correction procedure as covered in this article, and the two work processes should not be confused.

In other words, I could advise you that I am required to discuss the error and possible cosequences. I am not required to advise you to amend prior tax returns.

An additional note for New Jersey

Since I am writing from and practicing in New Jersey, it is useful to consider that our state allows a parallel deduction for taxpayers who are self-employed for federal purposes or who received wages from an S corporation in which they were a more-than-2% shareholder, subject to the same earned income cap and the same subsidized-plan limitation. One divergence matters at preparation time. The federal rule permits premiums for a child under 27 who is not a dependent, and New Jersey permits that amount only if the child was actually a dependent.