Fringe Benefits for More Than 2% Shareholders of an S Corporation — Benefit Minute
Generally, many fringe benefits provided to employees are excluded from taxable income. However, this favorable tax treatment is not available to an S corp shareholder who owns more than 2% of the stock of the corporation on any day of the corporation’s tax year (referred to as a 2% shareholder). Section 1372 of the Internal Revenue Code (Code) requires that 2% shareholders be treated as partners in a partnership for this purpose, making them self-employed individuals instead of employees. This Benefit Minute summarizes how certain fringe benefits offered to 2% shareholders are treated.
Section 125 Cafeteria Plans/Health Savings Accounts
A cafeteria plan is a written plan established under Section 125 of the Code that allows an employee to choose between non-taxable benefits and taxable benefits (including cash). Employees can pay for qualified benefits (including medical, dental and vision insurance) on a pretax basis via salary reduction. It also allows for salary reduction for flexible spending accounts (FSAs) and health savings accounts (HSAs). However, the tax benefit of salary reduction contributions is only available to employees. Since 2% shareholders are treated as self-employed individuals and not employees, they may not participate in a Section 125 cafeteria plan. This means they are ineligible to make pretax contributions for insurance, FSAs and/or HSAs. However, a 2% shareholder is permitted to contribute to an HSA on a post-tax basis and may be entitled to an above-the-line deduction on the Form 1040.
Health and Accident Insurance/Health Reimbursement Arrangement
Health and accident insurance premiums paid by the S corp on behalf of the 2% shareholder are reportable as wages on their Form W-2 and subject to income tax withholding (included in Box 1 wages). However, these additional wages are not subject to FICA or FUTA taxes (not included in Box 3 or Box 5 wages) if the payments are made under a plan that provides health and accident insurance for all or a class of employees of the corporation. Any premium contributions paid by the 2% shareholder himself must be made on a post-tax basis due to the cafeteria plan considerations described above.
A 2% shareholder may be eligible for an above-the-line deduction on Form 1040 for all premiums paid by him or on his behalf if the medical coverage was established by and paid for by the S corp and the 2% shareholder met other self-employed medical insurance deduction requirements. The above-the-line deduction is not available if the 2% shareholder or spouse is eligible to participate in any subsidized health care plan.
In addition, 2% shareholders cannot participate in a Health Reimbursement Arrangement (HRA) because HRAs are only available to current/former employees, and 2% shareholders are treated as self-employed individuals for this purpose.
Group Term Life Insurance
Under Section 79 of the Code, employees may exclude from taxable income the cost of up to $50,000 of employer-paid group term life insurance coverage. The cost of life insurance coverage above $50,000 (based on IRS Table I) is taxable income to the employee. However, the exclusion is not available to 2% shareholders, so their taxable income as reported on Form W-2 must include the full cost of all S corp life insurance paid by the S corp.
Disability insurance premiums paid by the S corp on behalf of a 2% shareholder are includable in the taxable income of the shareholder. As a result, any disability benefit payments received by the 2% shareholder are tax-free.
Other Taxable Fringe Benefits
Other fringe benefits that are taxable to 2% shareholders include:
- qualified transportation fringe benefits under section 132(f) of the Code
- adoption assistance programs under section 137 of the Code
- employee achievement awards under Code section 74
Family Attribution Rules
The family attribution rules of section 318 of the Code apply to 2% shareholders. This means that S corp stock owned by an individual is also considered to be owned by the shareholder’s spouse, child, parent and grandparent. To the extent that any of these family members also work for the S corp and receive fringe benefits, the same taxability of benefits will apply to these family members. However, pursuant to IRS guidance, a family member receiving taxable fringe benefits due to attribution may be entitled to claim an above-the-line-deduction in the same manner as the 2% shareholder.
Non-taxable Fringe Benefits
Certain types of fringe benefits remain non-taxable, even for 2% shareholders. These include:
- qualified retirement plans (such as a 401(k) plan)
- educational assistance programs under section 127 of the Code
- dependent care assistance programs under section 129 of the Code (cannot be paid for with salary reduction contributions)
- working condition fringe benefits, qualified employee discounts, and no-additional-cost services under Code section 132
These fringe benefit rules do not apply to C corporation shareholder-employees since fringe benefits are generally deductible at the corporate level and shareholder-employees are not treated as self-employed individuals.
For more information, contact PSA Insurance and Financial Services.