Schedule K-1 (1120S) Medical Insurance Premium for more than 2% shareholders - Deductibility

[bill6]

A client received a Schedule K-1 for an S Corp for which he is a more than 2% shareholder. He is also an employee of this company. He indicated to me that the medical insurance premiums paid for his coverage are not included in his W2 income. However, in the additional information it states "medical insurance premiums for more than 2% shareholders" is $9k.

My understanding is that this is an above the line deduction for self-employed taxpayers if it is included in box 1 of his W2. Again, he is said it is NOT included on his W2.

My question is if this is not included in W2 income and therefore, not deductible to him, then why would the person preparing the S Corp return even include this in the additional information? Am I missing something here?

[qbteachmt · Accepted solution]

"He indicated to me that the medical insurance premiums paid for his coverage are not included in his W2 income."

Just how wrong did the employer get it? Who prepared the 1120S? They should have checked for this provision.

"However, in the additional information it states "medical insurance premiums for more than 2% shareholders" is $9k"

Do you see it as part of Box 1, or not? You mention "the additional info" but what is that from?

Have you talked to that S Corp provider, or the payroll person? They can make late amended/corrected filings.

Here are nice references to email to them; the second one has nice imagery:

https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical...

https://www.rmncpas.com/~rmncpas2/files/S%20corp%20health%20insurance%20rules.pdf

[bill6]

That's what I thought too because I read the same section of that IRS publication.

To answer your questions:

I think they got it wrong to the tune of the full $9k. Box 1, 3 and 5 of the W2 are the exact same dollar amount which shouldn't be. 

When I said additional information, I was really referring to Box 17 other information and the related supporting schedule that explains what what in that box. In Box 17 there is code "AD". When you look at the detail pages for explanation, AD is explained as ""medical insurance premiums for more than 2% shareholders" and the amount is $9k.

Again, my client insists what shown on W2 is his normal compensation and does not include health insurance premium and he seems to be right based on the fact that boxes 1, 3 and 5 of the W2 are the same.

What you are saying is they screwed up his K-1 and possibly the 1120S altogether, correct? I have talked to the S Corp filer accountant before and he is a little defensive. How would you handle this and still report on time?

[qbteachmt]

"is his normal compensation and does not include health insurance premium and he seems to be right based on the fact that boxes 1, 3 and 5 of the W2 are the same."

Well, that's not very well worded, to help you.

It could be that they pay his insurance from his base pay and he doesn't even realize he is paying with Post-tax dollars. In other words, this is not an additional fringe paid by his employer; they are "doing the banking" by making his premium payment, most likely because it is under their group plan.

"I have talked to the S Corp filer accountant before and he is a little defensive."

We simply need to understand the employer's benefit package. It might be really simple.

You earn $120,000 a year gross.

We compute taxes.

We then deduct for your health insurance.

You get the difference = your take home.

[TaxGuyBill]

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@bill6 wrote:

 Again, he is said it is NOT included on his W2.

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It is required to be on the W-2.  The W-2 should be corrected.

[qbteachmt]

I have taught payroll and done payroll for lots of companies. You might not be surprised at how employees have no idea what is what and they cannot even describe their employment financial terms between them and their employer. Him stating it is not on his W2, doesn't give me much comfort, unless you can examine, for instance, a Paystub to see deduction details. Because the W2 doesn't show you how the benefits are managed. The final paystub for 2020 is where I would start looking.

[bill6]

After talking with my client and having him provide me with his paystubs for the last three years, there is no indication that health insurance premiums have been added to his W2 income. It seems like his assertion that they are not included in w2 income is correct. 

In this case, he would not deduct them as self-employment health insurance premiums on his 1040 because the S Corp received the benefit of all employee healthcare premiums through a deductions from ordinary income.

It is still odd that the employer included medical insurance premiums for more than 2% on his K-1. Seems irrelevant to the tax return, at least.

Any thoughts?

[qbteachmt]

If the payroll math is:

Gross wages minus tax withholding (no health deductions) = takehome

Then the employer has made a pretty significant error. If there is a missing amount between this math takehome and the Net on the total paychecks, that is likely the health insurance, then it would be the same as if he paid it personally using post-tax dollars, out of his gross wages; you just don't see it stated on the W2 for clarity, but the taxes would be correct.

"for the last three years"

What do the prior years' tax forms show for how this got handled? Were the prior W2s also like this?

"because the S Corp received the benefit of all employee healthcare premiums through a deductions from ordinary income."

Sort of, but not exactly. The one has nothing to do with the other; there should be compliance to both issues. He can't deduct something he has no proof that he paid for, and he didn't pay, because his employer doesn't show the responsibility was shifted to him personally. The employer totally whiffed that ball from a payroll perspective.

"It is still odd that the employer included medical insurance premiums for more than 2% on his K-1. Seems irrelevant to the tax return, at least."

I supposed the person preparing the 1120S isn't giving them guidance, or giving them the wrong guidance, and we don't know if this is why Payroll is wrong, but they reported on the K-1 as they always have. It's sort of like, "Who's on first?" for who is supposed to tell whom about how to do things right.

Many, many, many years ago, you would see Distributions reported for that shareholder-employee, as how the medical premiums got paid. That's no longer allowed.

[bill6]

I'll bring this to his attention, thank you. 

"What do the prior years' tax forms show for how this got handled? Were the prior W2s also like this?"

Because he gave me the payroll transaction history for 2018-2019 in one file, I didn't tie it back dollar-for-dollar to his 2019 w2; but, the accountant from the company said that the accounting firm they use to prepare the returns and payroll has been doing it this way for years. 

I think my best course of action is to bring this error to his attention, report the wages as indicated on his w2 and not deduct the health insurance premiums. It seems by doing this I have done as much I can and the rest should fall on the employer to investigate. Fair?

[qbteachmt]

"report the wages as indicated on his w2 and not deduct the health insurance premiums. It seems by doing this I have done as much I can and the rest should fall on the employer to investigate. Fair?"

I would describe that as your safest course of action.

"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."

Treating that payment either as a distribution to the Shareholder-employee, to then make their own premium payment or as the reimbursement, bypassing the W2 box 1 entry, turns this into a personal policy and not qualifying for tax deduction as "if the medical care coverage was established by the S corporation and the shareholder met the other self-employed medical insurance deduction requirements."

https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical...

"On the other hand, if the corporation obtains and pays for health insurance in its name, covers the shareholder under the policy, and reports the premiums as W-2 wages to the shareholder, then the shareholder is allowed an above-the-line deduction. Similarly, 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."

BTW, I found a succinct answer from another forum (a benefits forum) that puts your two issues together, and additionally, how this impacted retirement plan contribution calculations.

"There is no 2% shareholder-employee compensation to be added to their W-2 Box 1 compensation to base employer retirement plan contributions on. Even worse, the self-employed health insurance deduction is only available for 2% shareholder-employees if the the premiums were paid or reimbursed by the S-Corp and included in their W-2 Box 1 wages. See IRS Notice 2008-1*, claiming the deduction in these circumstances would be tax evasion.

*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.

If the health insurance premiums were paid or reimbursed by the S-Corp and CPA is claiming the 2% shareholder-employees health insurance premiums as S-Corp deductions on Form 1120S would be fraudulent. Pass-thru business owners can never be the beneficiary of pre-tax health benefits. Regardless the paid or reimbursed health insurance premiums must be still reported as taxable wages. I'm not sure if failure to include the health insurance premiums as Officer compensation would be fraudulent, but it would inflate the S-Corp's ordinary income used to calculate the QBI deduction. Failure to include the compensation and report it on Form W-2 could also be a reporting error.

I would think most plan documents would require plan compensation to be that compensation claimed by the business and reported on Form W-2 Box 1. Here again, failure to include the health insurance premiums in Officer compensation and included in W-2 Box 1 wages, precludes taking the Self-employed health insurance deduction on Form 1040."

So, all kinds of wrong, here.

I haven't had cause to dive into this so deeply for a while. I never even considered the retirement planning aspect of this error.