Reporting Health Insurance for S Corporation Shareholders

NEW! 2013 Update Post 

The following is an excerpt from my book, The Pocket Small Business Owner’s Guide to Taxes, and is important information for S corporation shareholders as 2012 is starting to wind-down.  This is especially important if you use a payroll processing company, as they will need to include your health & dental insurance on your last payroll run.  This is a time-sensitive matter, and failure to report your premiums correctly can be a very costly mistake.

The reporting of health insurance premiums for a more than 2 percent S corporation shareholder can be a little confusing; however, it is crucial that it is reported correctly if you want to maximize your deduction. If you miss a few simple steps before the end of the year, you could end up limiting or losing your deduction all together.

The self-employed health insurance deduction allows self-employed individuals to deduct their health insurance premiums on the front of the 1040 as an adjustment against income. Even though an S corporation shareholder is not technically self-employed, the IRS requires a more than 2 percent S corporation shareholder to report the deduction as if they were self-employed and not on the S corporation return.

Simple Steps to Maximize Your Deduction

Below are the steps that have to be taken in order to get the self-employed health insurance deduction. Make sure you follow them closely as an error can result in the loss of substantial tax savings.

  • An S corporation cannot deduct health, dental, and other medical premiums for a shareholder who owns more than 2 percent. Their premiums should be tracked separately in the accounting system throughout the year.
  • If the corporation did not pay the premiums during the year, make sure the corporation reimburses them before the end of the year.
  • Before the final payroll run of the year, calculate the total shareholder health, dental, and other medical insurance premiums paid or reimbursed by the corporation as this figure will be needed for the final payroll and the shareholder’s W-2.
  • The amount of premiums for the year is paid to shareholder as payroll, but there is special payroll tax treatment for this payment. The amount is subject to Federal and State withholding, but it is not subject to social security or Medicare tax. If you use a payroll service, they will have a pay item for this specific payment.
  • On the W-2, the amount of the premiums is recorded in box 1 wages, in the state wages, and in box 14 as “S/H Health Ins” or a similar description.
  • Finally, on the shareholder’s individual tax return, make sure the amount of shareholder health insurance is deducted as self-employed health insurance on the front of Form 1040.

The end result is that the payroll payment for the premiums is deducted as a wage on the corporation return, the wage is taxed as income on the individual return, and the self-employed health insurance deduction is taken on the personal return, which all nets out to a deduction in the amount of the premiums. This may seem like a whole lot of unnecessary paperwork, but it is much better than the treatment that results if you do not follow these steps.

Tax Consequences of Incorrect Reporting

If a more than 2 percent shareholder fails to include their health insurance premiums on their W-2, technically the IRS will not allow the self-employed health insurance deduction on the individual return, and the shareholder would have to claim the premiums as a medical expense on Schedule A, which unfortunately is subject to a haircut of 7.5% of adjusted gross income (10% starting in 2013). This means that your deduction is reduced by an amount equal to 7.5% of your adjusted gross income, and if there is anything left then you get a deduction for the remaining amount. If you run the numbers, this is huge loss of deduction and a horrible penalty for not following the IRS rules.

Given the high cost of health insurance premiums these days, it is very important that you make sure and follow the steps listed above each year. Have your tax professional help you and do not wait until tax time as amended W-2s can be costly to prepare.

For more S corporation shareholder tax advice like this, refer to Chapter 9 in my book.

Update on S-Corporation Failure to File Penalty

I had previously discussed this issue in my 1/22/09 post entitled “S-Corporation Failure to File Penalty”, but there have been so many comments and updates since January that I felt I should post a formal update.  It is an important issue now that the the first few rounds of IRS abatement request responses have been sent out and the fact that we still do not have a Rev Proc similar to 84-35 (automatic abatement for partnerships) issued to address this penalty.

Just to quickly review the basics from the previous post, this penalty is charged to S-Corporations that failed to file their 1120S return timely, which means you either failed to extend your return and filed after the March 15th deadline, or you extended but did not file by the September 15th extended deadline.  Other details of note on the penalty:

  • Begins for returns filed after 12/20/07
  • $85 per shareholder per month late ($89 for returns due after 12/31/08)
  • Applies to any entities taxed as an S-Corporation

I recently sent an abatement letter for a client that used some of the language from Rev Proc 84-35, and even though the IRS abated the penalty, they made a point about the fact that they did not base the decision on any reasoning from 84-35.  In the response letter, the IRS stated that the abatement was ”based solely on the fact that you have a good history of timely filing and timely paying”. They also stated the removal was a “one-time consideration” and that future penalties would only be abated if the information met the “reasonable cause criteria”.

The thrill of getting the penalty abated quickly faded as I realized that this is not good news for S-Corporations if a Rev Proc similar to 84-35 is not forthcoming.  Based on recent reports of plummeting Federal tax revenues, I doubt we will see a Rev Proc anytime soon that would provide automatic abatement for small S-Corporations like we have for partnerships, so I would definitely suggest a few things with regard to requesting abatement of this penalty:

  • If you request abatement of penalties, do not use any language from Rev Proc 84-35 – you are just inviting a short lecture from the IRS.
  • If you have a history of timely filing and paying, state this in the letter as the reasoning for your abatement request along with an apology or two.
  • If you do not have a good history – hopefully you have a sad story of unusual circumstances that will work as reasonable cause.  In my experience, the IRS rarely abates penalties for reasonable cause.

Lastly – in the future, FILE TIMELY!  March 15th is the deadline and if you are not going to be able to file by that date, make sure you call your CPA or accountant to make sure an extension is filed.

If you received a penalty notice and would like assistance in dealing with the IRS, feel free to contact us to find out more about our services.

S-Corporation Failure to File Penalty

Back in December of 2007, the 110th Congress passed HR4351 or the “AMT Relief Act of 2007”, which was the aftermath of the showdown regarding alternative minimum tax that I posted about at the time.  The bill had a lot of small print regarding new revenue raisers – one in particular: Sec 223 regarding failure to file penalties for S-Corporation returns.

For returns required to be filed after 12/20/07, there is a penalty of $85 per shareholder per month that the IRS can charge ($89 for returns due after 12/31/08).  This means that if you filed your 2007 S-Corporation return after 3/15/08 (or 9/15/08 if extended), then you either have received an IRS penalty notice or will soon enough.  I personally have not seen one of the notices yet as our firm filed everyone timely; however, if you have received one, please let me know.  This is the first round of the notices and strategies have not been tested like with the partnership penalties, so I am curious as to the wording of the letters.

I had a comment on my recent partnership penalty post asking if Rev Proc 84-35 would work for getting S-Corporation penalties abated, and while my immediate answer is “no” since 84-35 pertains particularly to 1065 returns, the concepts behind the Rev Proc may work in your abatement request letter to the IRS, so try using the concept – just do not quote the Rev Proc.  I did read the actual IRS code on the new penalty, and according to IRC Sec 6699(a)(2), if “reasonable cause” can be shown, then they may abate the penalty.  This is usual language with many of the IRS penalties, so this is not much help.  For now, I would write a solid letter outlining the unusual events outside of your control that prevented you from filing by the deadline and emphasize that you are a small S-Corporation with less than 10 or less shareholders and that all shareholder timely filed their returns with their share of S-Corporation income and deductions.  If they deny abatement, try again – there are many, many different employees at the service centers and persistence can pay off.

I will let you know if I hear about any other strategies that emerge as practitioners try their hand at abatement requests with the first round of penalty notices.  If you received a penalty notice, call your CPA or accountant as ignoring these notices will only create more problems.

Incorporation Breakeven Point?

1120S

In talking with non-incorporated small business owners that are not clients of our firm, I often ask why they have not formed an S-Corporation for their business.  A common response I have been hearing is that their accountant or CPA told them that they had not reached the “breakeven point” for incorporating.  Some have even told me that their accountant or CPA actually quantified the “breakeven point” at a specific sales dollar amount.

Now, while I agree that some smaller businesses are better off as sole proprietorships, I disagree with this type of broad recommendation and concentrating too much on income as your deciding factor on whether to incorporate or not.  There are many other factors and benefits to consider…

1) Reduction of Audit Risk

Many often overlook this benefit of incorporation because they think it will never happen to them or they just don’t like thinking about it; however, it is definitely a benefit of forming a corporation and it is especially beneficial for industries with high audit risk like construction and restaurants.

Last year the IRS hired a large number of auditors in Portland and cities around the country and really ramped up compliance audits.  Having been through several audits of sole proprietorships reported on a Schedule C in the last few years, I have witnessed first hand the the inconvenience and cost related with going through an audit.  It is very “taxing” mentally, emotionally, and physically even when you have a CPA or lawyer to represent you, so I would definitely consider these costs when considering incorporation if you are in a high risk industry.

I am not suggesting that S-Corporations are free from audit risk; in fact, they have their own audit issues like reasonable compensation and excess distributions.  Rather, in general the audit risk is simply lower than with a businesses reported on Schedule C.  Also, corporations require much more detailed records and reporting, so usually the chances of errors are much lower.  I have seen some accountants make some fairly material errors simply because it was a Schedule C and a balance sheet was not required.

2) Limitation of Liability

Many business owners overlook this benefit as they believe they are protected by their insurance, or they simply think it will never happen to them.  However, in today’s litigious society with lawsuits abounding, you need to protect your personal assets and a corporation clearly separates corporate and personal assets and limits your liability in most cases to the assets of the corporation.  You should always seek the counsel of a lawyer regarding the specifics of your circumstances; however, if a business owner is in a field that has high risk of lawsuits, then an S-Corporation could really minimize that risk as opposed to staying a sole proprietor and running the risk of facing a lawsuit that can reach your personal assets.

3) Better Financial Documentation

The fact that you have to report more financial data to the IRS and keep more accurate records is often looked on as a downside to S-Corporations; however, I have seen an upside with this in the S-Corporation clients I have worked with over the years – the S-Corporation pushes you in the direction of better bookkeeping.

Sole proprietorships tend to have very poor books and records primarily because they do have to report a balance sheet.  Often, sole proprietors submit a list of expenses, a box of receipts, or even worse – an inter-mingled mess of business and personal expenses that you are magically suppose to be able to separate.  This lack of internal organization and separation of the business entity leads to poor decision making as there is nothing close to a financial statement that the business owner could review and base decisions on.  As a CPA, I see this all the time and you have to wonder how people stay in business like this.

It may take a few years after incorporation, but most small S-Corporation owners have to start keeping better records.  Loans have to be tracked and reconciled, shareholder activity has to be documented and recorded accurately, payroll has to be processed, and reimbursements have to be made for expenses paid personally.  Over time, and with the help of software, this becomes easier for the business owner and eventually they are using the internal financial statements and reports in business decisions and planning.  Yes, it is much more costly and time-consuming, but I see the S-Corporation as the much needed motivation to force us into effective business operation as financial reporting is vital to a successful business.

4) Wage & Payroll Tax Considerations

Another factor you have to look at is the industry the business owner operates in and the level of wages that would be considered “reasonable” for work that the business owner performs.  In some industries and in some positions, an average, reasonable wage that you would find in a salary guide is going to be much lower than others – which means greater tax savings with an S-Corporation since you only pay the equivalent of self-employment tax on the wages paid to the shareholder.  A dentist or doctor is going to have to have a much higher wage than a contractor or a consultant, so again – you cannot look purely at a sales volume breakeven point.

You also have to look at the number of employees that the business will have and the turnover.  With the Oregon Employment Department, if you only have minimal number of employees and low turnover, then after two years you could qualify for the lowest state unemployment rate – which is now at 0.7%.  Savings from incorporating will be much greater than a business owner with high turnover .

The Bottom Line

I admit, I am quite partial to the S-Corporation; however, it is not right for every business and situation.  However, the most important thing to remember with incorporation or any tax decision is to consider more than just the tax dollar savings.  There are always many other factors to consider and I strongly recommend talking with your accountant or CPA and have them walk through all the costs and benefits with you.  If you are looking for a CPA in the Portland area, we would be love to talk to you.  www.PandGCPA.com