S-Corporations
The following information is provided “as is” to give you ideas of what might be involved. A qualified attorney should be retained to prepare appropriate documents for signature. We are not attorneys, we do not practice law and we do not recommend acting until you retain a qualified attorney on your own.
“2-percent shareholder” in the following generally really means “greater than 2-percent shareholder”
Because of many practitioners touting tax planning benefits in recent years, we have seen an increase of inquiries about the benefits of forming an S-Corporation as a Lone-Out Corporation to lower taxes.
Read the fine print and you will see that generally speaking, S-Corps do not result in net lower income taxes. But S-Corps can be used to lower the Self-Employment tax (a/k/a S/E tax, SECA, Social Security, Medicare and Additional Medicare tax). Now, I believe that as a general rule until you have more than $75,000 annual net earnings, the direct costs, overhead, and the hassles of tax traps and red tape can make it undesirable to have an S-Corp. Furthermore, an S-Corp does not lower these taxes for Traders in Financial Instruments since trading gains, by definition, are already exempt from that tax by default.
[Note: Traders may still want to use an S-Corp when there is only one owner because partnerships / LLC-partnerships require more than one owner]
Once you look past the touts who are trying to sell you something for a good fee, what’s the deal (for you)? Self-Employment tax starts at 15.3% (12.4% + 2.9%) up until the annual gross income limit (adjusted for inflation), then Medicare tax continues at 2.9% and the Additional Medicare tax on higher incomes starts a little later by adding 0.9% bringing this up to 3.8%.
On $100,000 net income this tax could equal $14,129 as a sole-proprietor. But if you run the business through an S-Corp, and you hire Gusto for $500 to $900 per year to run formalized payroll of let’s say $60,000, then the tax would only be about $9,180. That’s a savings of $4,949 before the cost of several hundred dollars in Secretary of State fees and maybe $1,000 for CPA fees. After all these costs, you are still ahead of the game by at least $2,000 in many States. (CA and NY and a few others have higher costs). If your business earns $200,000 or more, then the savings can go even higher (not linearly but at a slower pace once the annual gross income limit is reached, that limit was $147,000 for 2022).
So is it worth it? It is perhaps $2,000 free money every year after the monetary costs and after the hassles of red tape and tax traps inherent with S-Corps. Note that today’s real tax savings may eventually result in the future with you receiving lower Social Security retirement benefits and other benefits otherwise available to you because those retirement benefits are based on your wages and earned income, which the S-Corp is lowering.
Anyone touting additional tax savings should be looked at closely. For one example out there, plaintiff attorneys who win a structured settlement award for their clients might use an S-Corp to defer paying tax on their legal fees for several years … by deferring receipt of their money while it is held in a structured settlement. Can you say J.G. Wentworth?
Other benefits touted claiming available tax deductions because you have an S-Corp, can generally be obtained with other business structures. The real “trick” to such tax deductions is to operate a valid trade or business operation. Corporations, LLCs or Sole Proprietorships are typically used for this. The S-Corp tax election can be made by most Corporations and LLCs.
The Trader Status Mark-to-Market tax election can be made by most qualifying active trader Corporations, LLCs, General Partnerships and Sole Proprietorships.
[Note: Some businesses may want an S-Corp when there is only one owner because partnerships / LLC-partnerships require more than one owner – even though it can be easy to obtain an additional owner with a wholly-owned C-Corporation or a close family member]
Other S-Corporation information is found on the Partnership Agreement webpage.
On that webpage, be sure to read about disallowance of a deduction for unreimbursed expenses
And read about the deduction for reimbursed expenses
And read about the disallowance of a deduction for an office in the home
S Corporation Tax Basis Reporting
Beginning with 2018, individual’s who receive a Schedule K-1 from an S-corporation may need to attach a computation of their tax basis when: “… you report a loss, receive a distribution, dispose of stock, or receive a loan repayment from an S corporation, you check the box in column on line 28 and attach the required basis computation.”
S Corporation Shareholders are Required to Compute Both Stock and Debt Basis
S Corporation Distributions
S Corporations and their shareholders are required to properly report the tax consequences of distributions. IRS has identified three issues that are part of a compliance campaign.
- The first issue occurs when an S Corporation fails to report gain upon the distribution of appreciated property to a shareholder.
- The second issue occurs when an S Corporation fails to determine that a distribution, whether in cash or property, is properly taxable as a dividend.
- The third issue occurs when a shareholder fails to report non-dividend distributions in excess of their stock basis that are subject to taxation. The treatment streams for this campaign include issue-based examinations, tax form change suggestions, and stakeholder outreach.
S Corporation Officer Loans
Normally, interest on loan balances exceeding $10,000 must charged and collected at a reasonable rate. But for a solo-shareholder, for example, interest may be waived pursuant to IR Reg §1.7872-5T(b)(14) – Exempted loans (temporary) “Loans, the interest arrangements of which the taxpayer is able to show have no significant effect on any Federal tax liability of the lender or the borrower, as described in paragraph (c)(3) of this section.”
An example might be a 100% shareholder who generates flow through business interest expense with offsetting interest income. Net effect is zero and therefore no interest need be paid or imputed.
This Temp Reg section came before the NIIT rules. Might the interest income generate NIIT? If so then there is no longer a net zero tax effect.
S Corporation Compensation and Medical Insurance Issues
When computing compensation for employees and shareholders, S corporations may run into a variety of issues. The information below may help to clarify some of these concerns.
Reasonable Compensation
S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.
The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense which are subject to employment taxes.
| Authority to Reclassify | Joly vs. Commissioner, 211 F.3d 1269 (6th Cir., 2000) |
| Reinforced Employment Status of Shareholders | Veterinary Surgical Consultants, P.C. vs. Commissioner, 117 T.C. 141 (2001)
Joseph M. Grey Public Accountant, P.C. vs. Commissioner, 119 T.C. 121 (2002) |
| Reasonable Reimbursement for Services Performed | David E. Watson, PC vs. U.S., 668 F.3d 1008 (8th Cir. 2012) |
The key to establishing reasonable compensation is determining what the shareholder-employee did for the S corporation. As such, we need to look to the source of the S corporation’s gross receipts.
The three major sources are:
- Services of shareholder,
- Services of non-shareholder employees, or
- Capital and equipment.
If the gross receipts and profits come from items 2 and 3, then that should not be associated with the shareholder-employee’s personal services and it is reasonable that the shareholder would receive distributions along with compensations.
On the other hand, if most of the gross receipts and profits are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation.
In addition to the shareholder-employee direct generation of gross receipts, the shareholder-employee should also be compensated for administrative work performed for the other income producing employees or assets. For example, a manager may not directly produce gross receipts, but he assists the other employees or assets which are producing the day-to-day gross receipts.
Some factors in determining reasonable compensation:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
Treating Medical Insurance Premiums as Wages
Health and accident insurance premiums paid on behalf of a greater than 2-percent S corporation shareholder-employee are deductible by the S corporation and reportable as wages on the shareholder-employee’s Form W-2, subject to income tax withholding.
However, these additional wages are not subject to Social Security, or Medicare (FICA), or Unemployment (FUTA) taxes if the payments of premiums are made to or on behalf of an employee under a plan or system that makes provision for all or a class of employees (or employees and their dependents). Therefore, the additional compensation is included in the shareholder-employee’s Box 1 (Wages) of Form W-2, Wage and Tax Statement, but is not included in Boxes 3 and 5 of Form W-2.
A 2-percent shareholder-employee is eligible for an above-the-line deduction in arriving at Adjusted Gross Income (AGI) for amounts paid during the year for medical care premiums if the medical care coverage was established by the S corporation and the shareholder met the other self-employed medical insurance deduction requirements. If, however, the shareholder or the shareholder’s spouse was eligible to participate in any subsidized health care plan, then the shareholder is not entitled to the above-the-line deduction. IRC § 162(l).
Health Insurance Purchased in Name of Shareholder
The insurance laws in some states do not allow a corporation to purchase group health insurance when the corporation only has one employee. Therefore, if the shareholder was the sole corporate employee, the shareholder had to purchase his health insurance in his own name.
The IRS issued Notice 2008-1, which ruled that under certain situations the shareholder would be allowed an above-the-line deduction even if the health insurance policy was purchased in the name of the shareholder. Notice 2008-1 provided four examples, including three examples in which the shareholder purchased the health insurance and one in which the S corporation purchased the health insurance.
Notice 2008-1 states that if the shareholder purchased the health insurance in his own name and paid for it with his own funds, the shareholder would not be allowed an above-the-line deduction. On the other hand, if the shareholder purchased the health insurance in his own name but the S corporation either directly paid for the health insurance or reimbursed the shareholder for the health insurance and also included the premium payment in the shareholder’s W-2, the shareholder would be allowed an above-the-line deduction.
The bottom line is that in order for a shareholder to claim an above-the-line deduction, the health insurance premiums must ultimately be paid by the S corporation and must be reported as taxable compensation in the shareholder’s W-2.
ACA Impact
The Affordable Care Act (ACA) did not change the above rules regarding the federal tax treatment of health and accident premiums paid for a 2% shareholder.
However, for tax years after 2013, the ACA imposes penalties on the S corporation if the S corporation offers a health plan that fails to comply with certain market reform provisions, which may include plans under which the S corporation reimburses employees for the cost of individual health insurance premiums. The potential excise tax is $100 per day, per employee, per violation.
Among the ACA market reform provisions is a requirement that a group health plan must not impose annual limits on essential health benefits. In Notice 2013-54, the IRS indicated that a health plan under which an employer reimburses employees for the cost of individual health insurance premiums (referred to as an “employer payment plan”) will generally be treated as failing this requirement because the employer payment plan is treated as imposing a limit up to the cost of the individual policy premium.
The excise tax for failure to satisfy the ACA market reforms generally will not be imposed on an S corporation in the following two situations:
- The S corporation provides medical benefits under a health plan that satisfies the ACA market reform requirements(for example, a group health plan that does not provide for reimbursement of individual policy premiums); or
- No more than one active employee participates in the employer payment plan under which the S corporation reimburses the cost of individual policy premiums.
The ACA market reform provisions do not apply to plans that cover fewer than two participants who are active employees. IRC § 9831(a)(2).
Notice 2015-17 Transition Relief
On February 18, 2015, the IRS issued Notice 2015-17, which provides transition relief for S corporations that sponsor employer payment plans covering 2-percent shareholders.
Notice 2015-17 provides that, unless and until additional guidance provides otherwise, S corporations and shareholders may continue to rely on Notice 2008-1 with regard to the tax treatment of 2-percent shareholder-employee and their healthcare arrangements for all federal income and employment tax purposes. The Department of Labor and the IRS are contemplating publication of additional guidance on the application of the market reforms to a 2-percent shareholder-employee healthcare arrangement.
Until such guidance is issued, the excise tax under IRC § 4980D will not be asserted for any failure to satisfy the market reforms by a 2-percent shareholder-employee healthcare arrangement.
Further, unless and until additional guidance provides otherwise, an S corporation with a 2-percent shareholder-employee healthcare arrangement will not be required to file IRS Form 8928 (regarding failures to satisfy requirements for group health plans under chapter 100 of the Code, including the market reforms) solely as a result of having a 2-percent shareholder-employee healthcare arrangement.
Note: To the extent that a 2-percent shareholder is allowed both the above-the-line deduction and the premium tax credit, Rev. Proc. 2014-41 provides guidance on computing the deduction and the credit.
Fewer Than Two Participants Who Are Current Employees Exception
As discussed above, market reforms do not apply to plans that cover fewer than two active employees. Notice 2015-17 explains that if the S corporation employs more than one employee, where the additional employee is a spouse or child of the shareholder and all employees are covered under a reimbursement arrangement with family coverage under the same plan, the arrangement would be considered to only cover one employee and would not be subject to the market reforms. As such, an S corporation with only family employees covered by the same plan may continue to reimburse for a family plan and fall under the “fewer than two participants who are current employees” exception to the market reforms.
With respect to coverage of employees who are not 2-percent shareholders, Notice 2015-17 explains that if an S corporation maintains more than one reimbursement arrangement covering both 2-percent shareholder-employees and non-2-percent shareholder-employees, the arrangements would be considered a group health plan and would not be exempted under the “fewer than two participants who are current employees” exception to the market reforms. Such a plan would generally fail to satisfy the ACA market reform requirements and thus may trigger the excise tax under IRC § 4980D with respect to the non-2-percent shareholder employees. However, Q&A-1 of Notice 2015-17 provides that no penalties under § 4980D will be assessed under such an arrangement until at least June 30, 2015.
Part III – Administrative, Procedural, and Miscellaneous
Special Rules for Health Insurance Costs of 2-Percent Shareholder-Employees
Notice 2008-1
PURPOSE
This notice provides rules under which a 2-percent shareholder-employee in an S corporation is entitled to the deduction under §162(l) of the Internal Revenue Code for accident and health insurance premiums that are paid or reimbursed by the S corporation and included in the 2-percent shareholder-employee’s gross income.
LAW AND ANALYSIS
Section 1372(a) provides that, for purposes of applying the income tax provisions of the Code relating to employee fringe benefits, an S corporation shall be treated as a partnership, and any 2-percent shareholder of the S corporation shall be treated as a partner of such partnership. For purposes of § 1372, the term ”2-percent shareholder” is any person who owns (or is considered as owning within the meaning of § 318) on any day during the taxable year of the S corporation more than 2 percent of the outstanding stock of such corporation or stock possessing more than 2 percent of the total combined voting power of all stock of such corporation. Section 1372(b).
Accident and health insurance premiums paid or furnished by an S corporation on behalf of its 2-percent shareholders in consideration for services rendered are treated for income tax purposes like partnership guaranteed payments under § 707(c) of the Code. Rev. Rul. 91-26, 1991-1 C.B. 184. An S corporation is entitled to deduct the cost of such employee fringe benefits under § 162(a) if the requirements of that section are satisfied (taking into account the rules of § 263). The premium payments are included in wages for income tax withholding purposes on the shareholder-employee’s Form W-2, Wage and Tax Statement, but are not wages subject to Social Security and Medicare taxes if the requirements for exclusion under section 3121(a)(2)(B) are satisfied. See § 3121(a)(2)(B); Ann. 92-16, 1992-5 I.R.B. 53. The 2-percent shareholder is required to include the amount of the accident and health insurance premiums in gross income under § 61(a).
Section 106 provides an exclusion from the gross income of an employee for employer-provided coverage under an accident and health plan. A 2-percent shareholder is not an employee for purposes of §106. Treas. Reg. §1.106-1; section 1372(a). Accordingly, the premiums are not excludible from the 2-percent shareholder-employee’s gross income under §106.
Section 162(l)(1)(A) allows an individual who is an employee within the meaning of § 401(c)(1) to take a deduction in computing adjusted gross income for amounts paid during the taxable year for insurance that constitutes medical care for the taxpayer, his or her spouse, and dependents. The deduction is not allowed to the extent that the amount of the deduction exceeds the earned income (within the meaning of section 401(c)(2)) derived by the taxpayer from the trade or business with respect to which the plan providing the medical care coverage is established. Section 162(l)(2)(A). Also, the deduction is not allowed for amounts during a month in which the taxpayer is eligible to participate in any subsidized health plan maintained by an employer of the taxpayer or of the spouse of the taxpayer. Section 162(l)(2)(B).
A 2-percent shareholder-employee in an S corporation, who otherwise meets the requirements of section 162(l), is eligible for the deduction under section 162(l) if the plan providing medical care coverage for the 2-percent shareholder-employee is established by the S corporation. Rev. Rul. 91-26, 1991-1 C.B. 184. A plan providing medical care coverage for the 2-percent shareholder-employee in an S corporation is established by the S corporation if: (1) the S corporation makes the premium payments for the accident and health insurance policy covering the 2-percent shareholder-employee (and his or her spouse or dependents, if applicable) in the current taxable year; or (2) the 2-percent shareholder makes the premium payments and furnishes proof of premium payment to the S corporation and then the S corporation reimburses the 2-percent shareholder-employee for the premium payments in the current taxable year. If the accident and health insurance premiums are not paid or reimbursed by the S corporation and included in the 2-percent shareholder-employee’s gross income, a plan providing medical care coverage for the 2-percent shareholder-employee is not established by the S corporation and the 2-percent shareholder-employee in an S corporation is not allowed the deduction under § 162(l).
In order for the 2-percent shareholder-employee to deduct the amount of the accident and health insurance premiums, the S corporation must report the accident and health insurance premiums paid or reimbursed as wages on the 2-percent shareholder-employee’s Form W-2 in that same year. In addition, the shareholder must report the premium payments or reimbursements from the S corporation as gross income on his or her Form 1040, U.S. Individual Income Tax Return.
EXAMPLES The following examples illustrate these rules. The following examples assume that each shareholder is a 2-percent shareholder-employee in an S corporation, whose earned income from the S corporation exceeds the amount of the premiums for the accident and health insurance policies covering the shareholder, his or her spouse and dependents. None of the shareholders in the following examples are eligible to participate in any subsidized health plan maintained by an employer of the shareholder or the shareholder’s spouse.
Example 1. (i) For 2008, shareholder A obtains an accident and health insurance policy in the name of shareholder A and makes the premium payments on the policy. The S corporation makes no payments or reimbursements with respect to the premiums.
(ii) A plan providing medical care for shareholder A is not established by the S corporation and shareholder A is not entitled to the deduction under § 162(l).
Example 2. (i) For 2008, the S corporation obtains an accident and health insurance plan in the name of the S corporation. The health plan provides coverage for shareholder B, B’s spouse and dependents. The S corporation makes all the premium payments to the insurance company. The S corporation reports the amount of the premiums as wages on shareholder B’s Form W-2 for 2008 and shareholder B reports that amount as gross income on Form 1040 for 2008.
(ii) A plan providing medical care for shareholder B has been established by the S corporation and shareholder B is allowed the deduction under § 162(l) for 2008.
Example 3. (i) For 2008, shareholder C obtains an accident and health insurance policy in the name of shareholder C. The S corporation makes all the premium payments to the insurance company. The S corporation reports the amount of the premiums as wages on shareholder C’s Form W-2 for 2008 and shareholder C reports that amount as gross income on Form 1040 for 2008.
(ii) A plan providing medical care for shareholder C has been established by the S corporation and shareholder C is allowed the deduction under § 162(l) for 2008.
Example 4. (i) For 2008, shareholder D obtains an accident and health insurance policy in the name of shareholder D. Shareholder D makes the premium payments to the insurance company and furnishes proof of premium payment to the S corporation. The S corporation then reimburses shareholder D for the premium payments. The S corporation reports the amount of the premium reimbursements as wages on shareholder D’s Form W-2 for 2008 and shareholder D reports that amount as gross income on Form 1040 for 2008.
(ii) A plan providing medical care for shareholder D has been established by the S corporation and shareholder D is allowed the deduction under § 162(l) for 2008.
AMENDED RETURNS FOR PRIOR TAXABLE YEARS
Taxpayers who did not claim deductions for fringe benefits described in this Notice may file timely amended tax returns to claim the deduction under § 162(l) if the taxpayers satisfy the requirements of this Notice. The statement “Filed Pursuant to Notice 2008-1” should be written on the top of any amended return.
The Service does not consider payments of accident and health insurance premiums by an S corporation on behalf of 2-percent shareholder-employees to be distributions for purposes of the single class of stock requirement of §1361(b)(1)(D).