S Corp health insurance deductions: a practical guide

What is a deduction?

First things first. People are sometimes confused by the difference between a tax deduction and a tax credit, so let’s try to clear things up.

• A tax deduction is something that reduces taxable income, meaning income that’s subject to taxes.
• A tax credit, on the other hand, reduces your tax liability, so it’s applied directly to your tax bill.

A deduction will reduce your tax bill, but it’s a smaller reduction than a credit. Tax deductions are particularly important to small business owners and S corporations because — in many cases — business income is passed through to the owner or shareholder and reported on their personal tax returns.

Every deduction reduces the amount of income that’s taxable to the owner.

When it comes to health insurance, S Corporations can reduce taxes for both the business and its shareholders who are insured under the policy. That’s because employee health insurance is a deductible business expense for the S Corporation.

Now, for certain shareholders who are considered self-employed, they can also deduct the amount paid for health insurance premiums on their personal tax returns, so this can be a win-win for both the S Corp and the shareholder — if it’s handled correctly.

Can my S Corp pay for my health insurance?

If you work for or are a shareholder of an S Corp, you may be wondering if the company can pay for your health insurance. The answer to that question depends on your role in the S Corp. Employees of the business who are not also shareholders can be offered benefits, including health insurance, and the cost of those benefits can be paid by the S Corp and deducted as ordinary business expenses.

When it comes to shareholders? The answer is a bit more complicated. The IRS has carved out special rules for what are called 2% shareholders of an S Corp. A 2% shareholder is as simple as it sounds: it’s someone who owns 2% or more of the S Corp and has comparable voting rights.

The company is allowed to either:

• Pay for health insurance premiums directly to the provider
• Reimburse a 2% shareholder who pays for their own health insurance.

The cost of health insurance should be treated as wages and reported on the shareholder’s W-2 in Box 1.

From there, the S Corp can then deduct the cost of health insurance from its business income as wages paid. There are a couple of things to keep in mind when it comes to health insurance for 2% shareholders, though.

• One is that the cost of the insurance must be less than the total annual wages subject to Medicare taxes.
• The other? The health insurance provided or paid for by the S Corp must be compliant with the Affordable Care Act (ACA) in order to be a deductible expense.

Moving on, let’s find out more about what employees in these scenarios need to keep in mind.

Can an S Corp deduct health insurance premiums for employees?

For S Corp employees who are not owners of the business, the rules are straightforward: the S Corp can pay for health insurance for non-owner employees and deduct the expense as an employee benefit paid by the business.

For 2% shareholders, the rules are a bit different.

Health insurance premiums for shareholder employees that are paid by the company are treated as taxable wages for tax purposes, which means they’re typically reported as wages paid on the S Corp’s P&L statement. Because they’re considered wages for the shareholder employee, they’re included in Box 1 on the employee’s annual Form W-2. The health insurance premiums are, however, exempt from Social Security and Medicare taxes, so the amounts reported in Boxes 3 and 5 of Form W-2 will not include health insurance premiums.

There is a bit of good news for shareholder employees on the tax front, because they’re allowed an above-the-line deduction reported on their personal tax returns for the cost of their health insurance when it’s treated as wages, which reduces their taxable income. The exemption from FICA taxes also benefits the S Corp, since the business doesn’t have to pay the employer portion of Social Security and Medicare taxes on the cost of health insurance.

Group health insurance good-to-know

There’s some additional rules that come into play if the S Corp offers a group health insurance plan instead of reimbursing 2% shareholders for premiums.  A primary consideration is that a group health plan cannot have annual limits on “essential health benefits” or the S Corp will be charged an excise tax of $100 per day per employee, so it’s important to be aware of the rules. That said, an S Corporation can avoid the tax if it either provides a group health plan that meets market reform requirements, or if only one employee participates in a plan under which the employer reimburses the employee for health insurance premiums.

Because health insurance is handled differently depending on business structure, the table below shows how coverage and tax treatment compare at a glance.

Now that we’ve summarized how this works for S Corps, we’ll cover another business structure next.

Is a C Corp owner able to deduct health insurance as well?

In most cases, C Corporations can deduct the cost of health insurance paid for employees as an ordinary business expense. This is true both for owners and for non-owner employees of the C Corp. The deduction can be advantageous for C Corp owners, especially since most C Corps are taxed at the entity level, so owners are likely paying close attention to opportunities for qualified tax deductions for the business. Another benefit? The health insurance premiums are also a tax-free benefit to employees — including owner employees — and are not reported as wages on Form W-2.

While this can offer significant tax savings for C Corp owners, it’s not necessarily the sole reason to consider being taxed as a C Corp vs. an S Corp. Keep in mind that a C corporation generally brings with it more complexity in terms of managing the business finances as well as ensuring compliance with applicable laws. It’s a good idea to discuss the pros and cons of choosing the appropriate entity type with a tax professional who can review your situation and make a recommendation.

How to report S Corp health premiums on Form W-2

It’s important to understand the correct way to report health insurance premiums for 2% shareholders on Form W-2 each January. One of the key things to get right is including the amount paid for health insurance in federal taxable wages in Box 1, but excluding the cost of health insurance from wages subject to Social Security taxes in Box 3 and Medicare taxes in Box 5. If it’s not handled this way, the shareholder may not be able to claim the above-the-line deduction for self-employed health insurance on their personal tax return.

Many S Corps also itemize health insurance premiums in Box 14. This can be helpful when owners prepare their personal tax returns. Since you’re already tracking this information as part of running payroll, it should be straightforward to include this information on the owner’s Form W-2. The table below can help you keep track as well.

Fringe benefit FYI for S Corp Owners

There are a few things to keep in mind when it comes to health-related fringe benefits for owners of S Corporations. For the most part, these fringe benefits are available to non-owner employees but not to 2% shareholders. That includes Section 125 cafeteria plans and Qualified Small Employer Health Reimbursement Arrangements (QSEHRAs).

There’s one exception: health savings account (HSA) contributions. The S Corp can contribute to an HSA on behalf of a 2% shareholder employee, but the contributions are considered taxable wages. The 2% shareholder can then deduct the HSA contributions on their personal tax return, so they still receive the tax benefit.