Some unique income tax rules apply to S corporations regarding compensation and fringe benefits paid to shareholders who own greater than 2% of the corporation. Under these S corp income tax rules, a greater than 2% shareholder is taxed as a partner in a partnership for fringe benefits received. The Internal Revenue Code (IRC) establishes that officers, who also are shareholders, are considered employees for employment tax.
Reasonable Compensation
Shareholders providing personal services to the S corp should be compensated with a reasonable wage as opposed to solely receiving non-wage distributions. The wages paid to a shareholder are subject to employment taxes (Social Security, Medicare, federal and state income tax, and unemployment) and reportable on Form W-2, Wage and Tax Statement. If a reasonable wage for services is not paid, the S corp runs the risk of having distributions paid to the shareholder reclassified as wages. While the IRC and income tax regulations do not provide details on what constitutes reasonable compensation, various courts have addressed this issue and have established the IRS has the authority to reclassify payments. When ruling on this issue, the courts have considered the following facts:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to nonshareholder employees
- Timing and manner of paying bonuses to key people
- Pay for similar services by comparable businesses
- Compensation agreements
- The use of a formula to determine compensation
Health & Accident Insurance
Health and accident insurance premium amounts paid for or reimbursed by the S corp for the benefit of the greater than 2% shareholder should be included as compensation to the shareholder. These company contributions should be reported on Form W-2 in Box 1 (wages). Depending on the state, the amount also may go in Box 16 (state wages). The amount can be noted in Box 14 (other). The health and accident amounts paid by the S corp on behalf of the greater than 2% shareholder are not subject to Social Security, Medicare, or unemployment taxes. The employer is not required to withhold federal income tax on the benefit. If the medical insurance paid for by the S corp is properly reported on the shareholder’s Form W-2, the greater than 2% shareholder may be able to take the self-employed health insurance deduction on their personal return. The S corp can deduct the expenses as wages.
Cafeteria Plans
For purposes of Section 125 of the IRC, shareholders are considered self-employed. Self-employed individuals are not entitled to participate in cafeteria plans. Therefore, any greater than 2% shareholders are not eligible to participate in the S corp’s cafeteria plan. Greater than 2% shareholders will need to take health savings account and health insurance deductions on their personal return, not as pre-tax contributions. Attribution rules also apply to cafeteria plans. As a result, a greater than 2% shareholder’s spouse, children, parents, and grandparents are not eligible to participate in the plan either. Participation by any of these individuals will jeopardize the tax-exempt payments of other participants in the plan.
Group-Term Life Insurance Coverage
While employers can normally exclude the cost of the first $50,000 of group-term life insurance coverage on an employee’s life from compensation, this exclusion does not apply to greater than 2% shareholders of S corps. The cost of premiums for a greater than 2% shareholder should be included as compensation to the shareholder. The amounts are subject to employment taxes (Social Security, Medicare, federal and state income tax, and unemployment).
Other Considerations
The meals and lodging convenience rule does not apply to greater than 2% shareholders. The value of any meals and lodging provided for the employer’s convenience should be included in compensation to the greater than 2% shareholder. Greater than 2% shareholders can participate in qualified retirement plans.
If you would like more information on these unique rules or the implications at the state level, please reach out to a professional at Forvis Mazars or submit the Contact Us form below. Explore our Outsourced Accounting Services page for additional information.