FOR OWNERS, BOOKKEEPERS OR TAX PREPARERS
What is it?
IRS Notice 2008-1, titled “Special Rules for Health Insurance Costs of 2-Percent Shareholder-Employees” regulates exactly how accident and health insurance premiums should be handed for flow-through tax entities. In summary, accident and health insurance expenses paid by an S-corporation on behalf of shareholders who hold more than 2% ownership in the entity, are subject to income tax for the owners. But this is actually a good thing, even though it seems like a penalty. Even if the corporate owner pays out of pocket, it is usually advantageous to have the company reimburse the owner and report the amounts as income on the paystub.
What taxes does it affect?
Reporting S-corp medical income on the owner’s W2 affects only Box 1 and 16, taxable federal and state wages. It does NOT increase FICA (Medicare or Social Security) tax expense for either the employee or the company. FUTA and SUTA (federal and state unemployment) are also usually not affected because these are capped at a relatively small wage base.
Why is it better to have the company pay the medical expenses on behalf of the shareholder, than for the owner to claim medical expenses on the itemized deductions?
Some research would help you realize it’s all the same income. Because the business reimburses the shareholder, their K1 income is reduced by the same amount in which the shareholder W2 is increased. Both are ordinary income and taxed the same. However, shareholders will utilize box 29 on Schedule 1 of the 1040 on their personal return to take a “self-employed health insurance deduction.” This amount reduces the total amount (line 7) of Adjusted Gross Income (AGI). It is always better to take allowable deductions “above AGI” than “below AGI” because AGI sets limits on the amount of deduction the taxpayer can take on most other itemized deductions. If the shareholder takes the medical deduction on Schedule A instead, the amount will most likely be limited or not allowed at all.
How to handle booking S-corp medical?
To be booked properly, health care “expenses” paid for on behalf of a business owner (or reimbursed to a business owner) are reported on the shareholder’s W2.
A journal entry should be made to recognize the expense from S-corp medical, and to reconcile the book wage expense to the W3. The journal entry should debit (increase) wage expense and credit (reduce) whatever account was used to pay the medical premiums for the shareholder throughout the year. The company should NOT double-count health insurance expense and wage expense for these premiums. In fact, instructions for claiming health care expenses on the company’s 1120S return specifically exclude health expenses of this type, because they are assumed to be counted in wage expense.
In the case of the shareholder paying “out of pocket” using personal funds, the account to credit could be cash – as in a reimbursement check – or to reduce distributions. Just be sure to follow the golden rule of keeping distributions balanced pro-rata for all shareholders.
Special thought must be given if the shareholder chooses to have premiums, or some portion of premiums, deducted from their paycheck. In the certain health care plans, the owner may need to pay the same percentage of premiums that all employees pay. These deductions must be done post-tax for the owner, even if they are done as Section 125 pre-tax deductions for employees.
These amounts are then already included in taxable income (and wage expense) so they WILL NOT need to be recorded as S-corp medical income and require no additional journal entry. For the owner to get tax credit for the amounts paid out of pocket in this case, they need to claim the out of pocket expenses which are not reimbursed by the company on their personal return, Schedule A, Itemized Deductions.
If there is no requirement imposed on the shareholder to contribute to the cost of the premiums, Turn Key Office recommends having the entity fully pay the cost, recording it as wage expense, and report the total paid on the shareholder’s W2. This provides maximum tax benefits and minimal bookkeeping.
How do I reconcile book wage expense to federally filed W2/W3s?
Assuming S-corp medical was reported on the owner’s W2 and journaled properly as instructed above, book total wage expense minus all pre-tax deductions will equal Box 1 of the W3. Note, the W3 will not include all totals from all employees’ W2s including S-corp medical, health care pre-tax deductions etc., so you will have to obtain the pre-tax deduction totals from the payroll report register. If it doesn’t tie, you’ll have some troubleshooting to do. The following notes may help.
S-corp medical would properly be noted in Box 14 of each affected W2 and should already be included in Box 1 and 16. This amount is what probably needs to be journaled to wage expense on the books. Note that S-corp medical amounts are not included in Box 3 (taxable Social Security Wages) or Box 5 (taxable Medicare Wages) totals. Pretax deductions, such as 401(k), HSA, pre-tax medical and FSA, reduce box 1 and 16, but do not generally reduce box 3 or 5. Pay close attention to the expense accounts used to report imputed income on fringe benefits, such as taxable group term life insurance and disability insurance or car allowance. Taxable fringe should be wage expense to match the W3. It is also a good practice to ensure any accrued payroll entries are using ledgers distinct from actual payroll.