Issue #1: Reasonable Compensation of the S Corporation Shareholder-Employee
Shareholders of a corporation often have two distinct relationships with the company: Employee and Shareholder.
As an employee, shareholders must receive reasonable compensation in return for services that the employee provides to the corporation before the shareholder relationship is paid a non-wage distribution. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.
Distributions and other payments by an S Corporation to the shareholder-employee must be treated as wages to the extent the amount are reasonable compensation for the services rendered to the corporation. Because the S Corporation annual tax return (Form 1120S) discloses both the wages paid to officers and distributions paid to shareholders, it is fairly easy to compute the ratio of wages to distributions. Several court cases support the authority of IRS to reclassify non-wage distributions to a shareholder-employee as wages subject to employment taxes. This issue can easily become problematic and expensive in the event of an IRS audit.
Some factors in determining what is reasonable compensation include:
Training and experience
Duties and responsibilities
Time and Effort devoted to the business
Dividend history
Payment 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
Therefore, we always instruct our S Corporation shareholders to satisfy their relationship as an employee before taking any profits as a shareholder. We also recommend that rate of wages paid to the shareholder-employee be documented in light of the above factors.
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Issue #2: Health Insurance of a More than 2% Shareholder of an S Corp
General Rule. An S corporation is entitled to deduct health and accident insurance premiums paid on behalf of its shareholder-employees, their spouses, and dependents. The cost of these premiums is not included in the gross income of a shareholder who owns 2 percent or less of the S corporation stock.
Special Rule for More than 2 Percent Owners. The cost of insurance premiums is included in the gross income of a shareholder that owns more than 2 percent. Rev. Rul. 91-26, 1991-1 CB 184. Such shareholders may deduct an amount equal to the applicable percentage of the amount paid during the year for health insurance coverage. Code Sec 162(l)(5). The applicable percentage is 100 percent for the year 2007 and thereafter. Code Sec. 162(l)(1)(B). The amount of the deduction cannot exceed the taxpayer's wages from the S corporation. Code Sec. 162(l)(2)(A). Thus, the net effect is on the personal return is zero.
Medical insurance premiums treated as wages. The health and accident insurance premiums paid on behalf of the greater than 2 percent S corporation shareholder/employee are deductible by the S corporation as compensation on line 7 of form 1120S and are reportable as wages for income tax withholding purposes on the shareholder/employee's Form W-2. They are not subject to FICA or FUTA taxes. Therefore, this additional compensation is included in Box 1 (Federal Wages) and Box 16 (State Wages) of the form W-2, Wages and Tax Statement, issued to the shareholder, but would not be included in Boxes 3 or 5 of Form W-2. Payments of the health and accident insurance premiums on behalf of the shareholder may be further identified in Box 14 (Other) of the Form W-2. Neither Schedule K-1 nor Form 1099 should be used as an alternative to the Form W-2 to report this additional compensation.
A two-percent shareholder/employee is eligible for an above-the-line deduction for amounts paid during the year for medical care premiums if the medical care coverage is established by the S corporation. Previously, "established by the S corporation" meant that the medical care coverage had to be in the name of the S corporation. In Notice 2008-1, the IRS stated that if the medical coverage plan is in the name of the two-percent shareholder and not in the name of the S corporation, a medical care plan can be considered to be established by the S corporation if the S corporation either paid or reimbursed the more-than two-percent shareholder for the premiums and reported the premium payment or reimbursement as wages on the two-percent shareholder's Form W-2.
Keep in mind that no deduction is allowed for any month in which the taxpayer is eligible to participate (whether or not the taxpayer actually participates) in any other subsidized health plan maintained by the employer of either the taxpayer or the taxpayer's spouse. Code Sec. 162(I)(2)(B).
Click the following link below for a simplified example assuming the following facts:
One shareholder owns all of the outstanding stock.
Corporation net income before wages and health insurance for the owner is $60,000.
The shareholder receives wages of $60,000.
The company pays $5,000 of health insurance premiums on behalf of the shareholder.
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