ONE OF THE big reasons an entrepreneur might choose to start an S-Corp is the protection it affords to your personal assets in the event the company goes out of business. Any shareholder of an S-Corp can typically take a smaller salary and pay income taxes with regular payroll deductions before taking the remainder of profit as a distribution via their stake in the ownership.
But S-Corporation owners who deduct the cost of health insurance that their corporation puts on its W-2s need to keep an important rule in mind about their ‘earned income.’ S-Corp owners looking to take advantage of the self-employed health insurance deduction on Schedule 1 of Form 1040, must consider their earned income and how it is entered.
It’s important to remember that S-corporations can deduct the cost of health insurance for which it pays or provides more-than-a-2% as W-2 wages. When filling out the W-2, the cost of health insurance is added to the wage in box 1 – but not to the wages reported by box 3 or box 5.
On the other hand, the (misleading) instructions on Form 1040 talks about how the more-than-2-percent shareholder deducts the health insurance premiums. However, it is only when you turn to the next page that you discover if you were a more-than-2-percent shareholder in the S-corporation under which the insurance plan is established, earned income are your Medicare wages (box 5 of Form W-2) from that corporation.
Two Key Examples
No salary, but the S-Corp picks up health insurance. The sole owner of an S Corporation is reimbursed $18,000 for his family’s health insurance plan. This would mean $18,000 would be put in box 1 of the W-2 and subsequently $0 in box 5 for Medicare wages. The kicker is that Form 1040 tax deduction for their self-employed health insurance would be ZERO. Why so? Because the earned income for health insurance is equal to Medicare wages – $0.
Lesson: S-Corp owners could pay taxes on the dollar amount of their health insurance in any years they don’t take a salary, but the S-Corp reimburses the owner for their health insurance.
Reasonable compensation and exceeds insurance costs. The sole owner is paid a salary of $107,000 and is reimbursed $22,000 for their individually purchased family health insurance. The S Corporation lists $129,000 in box 1 as wages and $107,000 in box 5 as wages subject to Medicare taxes. The owner can only deduct $22,000 on their Form 1040 for self-employed health insurance because their income of $107,000 exceeds the $22,000 of insurance costs. Their reasonable compensation is $129,000 – wages plus the cost of health insurance.
Lesson: S corporation owners seeking to take a full self-employed health insurance deductions must ensure that their S corporation Medicare wages in box 5 are equal to or greater than what the S corporation paid or reimbursed you for health insurance.
For owners with more than 2% in their S-Corp, the tax code definition of the box 5 Medicare wages as earned income can create issues for those with little or no Medicare wages in box 5 of their W-2.
Business owners operating as an S-Corporations seeking to take a full self-employed health insurance deduction need the S corporation Medicare wages in box 5 to be equal to or greater than the payment or reimbursement from the S-Corp paid you for your health insurance.
Every situation is different, so Myriad advises S-Corp owners to check with your tax advisor before making any decisions. Throughout the course of helping countless advisors navigate issues like this, we’ve established a professional network you can rely on. Call us at 515.850.1226 or e-mail email@example.com firstname.lastname@example.org to learn about the different types of strategy tax advisors that can help address your specific needs!