IRS allows two-percent S-corporation shareholders to deduct health insurance premiums

An S corporation’s two-percent shareholder/employee can deduct health insurance premiums that are paid or reimbursed by the S corporation, the IRS recently has ruled. Now, for the first time, S corporation owner-employees have been given the green light to purchase their own health insurance and obtain full tax benefits.

Under the new ruling, the S corporation’s payments are included in the income of the employee, who can deduct “above-the-line” the amounts under Code Sec. 162(l), which provides a deduction for medical insurance to a self-employed individual who is treated as an employee. Payments by an employer are treated as if the employer had established the individual employee’s plan.

One caveat: The deduction is not allowed during a month in which the taxpayer is able to participate in a subsidized health plan of the employer or a spouse’s employer.

Medical care plan

A two-percent shareholder/employee can take the Code Sec. 162(l) deduction if the S corporation establishes the medical care plan for the shareholder. A plan has been established by an S corporation if: (1) the S corporation pays the premiums for the accident and health insurance policy in the current year, or (2) the shareholder pays the premiums, provides proof of payment to the S corporation and the S corporation reimburses the shareholder in the current year.

An S corporation that pays accident or health insurance premiums for services rendered by a two-percent shareholder/employee can deduct the premium as an employee fringe benefit under Code Sec. 162(a). The payments are included in the shareholder’s income.

Traditionally, tax-free employer payments could only be made to a plan established and maintained by the employer – that ruled out direct payments by S shareholder employee … until now. Recent cafeteria plan regulations permit employees to purchase individual insurance policies, which in turn opened the door to convincing the IRS to issue its ruling.  Going forward, any employer has the option of paying the employee’s premiums, tax-free, or reimbursing the employee for the premiums, again tax-free.

(Notice 2008-1)