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S Corporations Treatment of Employee-Shareholder Fringe Benefits
Editor:
Editor’s note: This case study has been adapted from PPC Tax Planning GuideClosely Held Corporations, 15th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Gary W. Brown and Kim L. Saunders, published by Practitioners Publishing Company, Fort Worth, TX ((800) 323-8724; www.ppcnet.com).
Facts: Bigcorp has been an S corporation since 1984. Matt and Sam each own 50% of the stock. During the current year, Bigcorp pays health and accident insurance premiums of $5,000 for Matt and $7,500 for Sam and his family, in accordance with a written agreement between Bigcorp and the shareholders. Issue: How much income does each S shareholder report because of the fringe-benefit payments?
Analysis Fringe benefits are employment-related benefits provided to an employee in addition to regular compensation. They must be included in taxable income unless specifically excepted under another Code section. A fringe benefit that can be provided tax free may be a particularly good way to compensate employees. The employee receives a benefit free from income tax, while the employer generally deducts the benefits cost. Tax-free fringe benefits are also free from payroll taxes (i.e., Federal (and in some cases, state) unemployment tax, and Social Security and Medicare tax).
Fringe Benefits for C Employee-Shareholders C corporations can offer a number of tax-advantaged fringe benefits to their employees (who, in closely held businesses, are frequently also the owners). The corporation can deduct the benefits; the employees can exclude them from taxable income.
Fringe Benefits for S Employee-Shareholders The rules governing fringe benefits for S corporation employee-owners are not as favorable as those applicable to C corporations; rather, they are similar to the rules for partnerships. For employee fringe-benefit purposes, Sec. 1372 states that S corporations are treated as partnerships; any S shareholder owning (directly or indirectly) more than 2% of the stock on any day during the tax year is treated as a partner. The Code does not define employee fringe benefits. Further, the S corporation rules do not always parallel the partnership rules. The following benefits are available on a tax-advantaged basis (i.e., deductible by the S corporation and excludible from the income of 2% employee-shareholders), because such benefits are available to partners: 1. Dependent care assistance under Sec. 129. 2. Educational assistance programs under Sec. 127. 3. Qualified employee discounts, no-additional-cost services, working-condition fringe benefits, on-premises athletic facilities and de minimis fringe benefits, under Sec. 132. Conversely, the following fringe benefits provided to 2% employee-shareholders are treated as additional employee compensation: 1. The cost of accident and health insurance plans under Secs. 105 and 106, including uninsured medical expense reimbursement plans. 2. The expense of meals and lodging furnished for the employers business needs under Sec. 119. 3. The cost of up to $50,000 of group-term life insurance coverage under Sec. 79. 4. Sec. 125 cafeteria plans. According to Rev. Rul. 91-26, an S corporation treats taxable fringe benefits paid on behalf of its 2% employee-shareholders as additional compensation subject to Federal tax withholding (and, generally, subject to employment taxes). However, payments made under a plan providing accident and health coverage (including payments of insurance premiums) and treated as compensation to a 2% employee-shareholder are not subject to employment taxes, because such payments are not deemed wages for such purposes; see Secs. 3121(a)(2) and 3306(b)(2) and Ann. 92-16. However, the additional compensation is subject to Federal income tax withholding. Rev. Rul. 91-26 specifically provides that a 2% employee-shareholder may be eligible for an above-the-line deduction under Sec. 162(l) for the accident and health insurance premiums the corporation paid. The deduction is 100% (for 2003) of the amount paid for medical insurance for the employee-shareholder and his or her spouse and dependents, and is reported as an adjustment to income. However, the deduction is not available for calendar months in which the shareholder or spouse is eligible to participate in another employer-subsidized health insurance plan, nor can it exceed the taxpayers earned income (as defined in Sec. 401(c)(2)). S shareholders can treat their Social Security wages from the S corporation as earned income for purposes of this limit.
Conclusion Because Bigcorp is an S corporation and Matt and Sam each own 50% of the outstanding stock, the health and accident insurance premiums paid on their behalf are treated as wages. Premium costs of (1) $5,000 will be included as wages on Matts Form W-2 and (2) $7,500 on Sams Form W-2. Because the premiums are paid under a plan for a class of employees, the wages are not subject to employment taxes, but are subject to Federal income tax withholding. Additionally, Matt and Sam can claim 100% of the medical insurance premiums on their individual returns as an adjustment to income. |
