Employee fringe benefits paid on behalf of a 2% S corporation shareholder are subject to special rules. A 2% shareholder is one who owns more than 2% of the corporation’s outstanding stock on any day of the corporation’s tax year, considering direct and constructive ownership. Under the family stock attribution rules, a person is considered to own the stock owned by that person’s spouse, children, grandchildren, and parents. However, stock that is constructively owned by one family member cannot be reattributed to a second family member when applying the family stock attribution rules to that second family member.
While there is some uncertainty regarding which fringe benefits are subject to these special 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, 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 IRS Code section, and are excluded from the 2% shareholder’s income.
Health and accident insurance premiums paid on behalf of a 2% shareholder are reported as additional compensation to the shareholder. The value (normally cost) of the fringe benefit is added to the 2% shareholder’s wages. (However, the premiums can avoid employment taxes if made under a plan for employees and their dependents, or for a class of employees and their dependents.)
Since the 2% shareholder is not considered an employee for fringe benefit purposes, he or she cannot exclude the cost of the health insurance premiums from gross income as employer-provided coverage. However, the 2% shareholder may be able to claim the self-employed health insurance deduction. The deduction is not available for calendar months in which the 2% shareholder or spouse is eligible to participate in another employer-subsidized health insurance plan. Furthermore, the deduction is limited to the 2% shareholder’s earned income (i.e., the social security wages the shareholder receives from the corporation). Any portion that exceeds the earned income limitation is deductible as an itemized deduction, subject to the 7.5% (in 2012) of AGI floor for itemized medical deductions.
When taxable fringe benefits are included in wage income, all shareholders will share in the corporation’s additional compensation deduction, according to each shareholder’s percentage ownership in the corporation (under the normal per-share, per-day allocation rules). However, if one person owns all of the stock, his or her compensation is increased, but pass-through income from the S corporation is decreased by the same amount.
Fortunately, payments of health insurance premiums for shareholders will not be considered distributions for purposes of the one-class-of-stock rule. Furthermore, fringe benefit programs are not considered “governing provisions;” therefore, providing fringe benefits will not create a second class of stock unless they are part of a plan to circumvent the one-class-of-stock rule.
This article provides just a brief overview of these complicated and confusing rules. Please contact us if you would like information on the 2% S corporation shareholder rules or have tax planning or compliance questions.