|Tax Considerations for S Corporations
Recent tax rulings and court cases have changed or clarified the treatment of various tax issues related to S corporations and their shareholders.Below is a discussion of these issues to help you determine if changes are needed in your corporation's treatment of these issues. Although this discussion does not cover all of the possible implications, we would be happy to discuss how these rules affect your particular situation or if you have any questions about any of the issues.
Treating Medical Insurance Premiums as Wages
Health and accident insurance premiums paid on behalf of an owner-employee who owns more than 2% of the S corporation stock are deductible by the corporation and reportable as wages for income tax withholding purposes on the shareholder-employee’s Form W-2.
These benefits are not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes. The additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder-employee, but would not be included in Boxes 3 and 5 of Form W-2.
A 2-percent shareholder-employee is eligible for a self-employed medical insurance deduction on his individual income tax return if the medical care coverage is established by the S corporation and the shareholder meets the other self-employed medical insurance deduction requirements. The deduction is a deduction prior to Adjusted Gross Income (AGI).If, however, the shareholder or the shareholder’s spouse is eligible to participate in any subsidized health care plan then the shareholder is not entitled to the AGI deduction.
A medical plan can be considered established by the S corporation if the S corporation directly paid the premiums or reimbursed the shareholder-employee for premiums in the current taxable year and reported the premium payment or reimbursement as wages on the shareholder-employee’s W-2.
Action Item: S Corporation owner-employees MUST include medical insurance premiums in their W-2 wages or risk being denied the full deduction.
Health Insurance Purchased in Name of Shareholder
The insurance laws in some states do not allow a corporation to purchase group health insurance when the corporation only has one employee. Therefore, if the shareholder was the sole corporate employee, the shareholder had to purchase his health insurance in his own name.
The Internal Revenue Service recently ruled 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. On the other hand, 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.
Action Item: Medical insurance premiums must be paid by the S corporation and included in the shareholder’s W-2 to assure full deduction.
Long-Term Care Insurance
Long-term care insurance premiums are also eligible for the above the line deduction to the extent that the following factors are met.
1. The maximum deductible for long-term care insurance premiums in 2009 is $320 for taxpayers age 40 or less, $600 for taxpayers age 41-50; $1,190 for taxpayers age 51-60; $3,180 for taxpayers age 61-70; and $3,980 for taxpayers age 71 and older.
2. The S-corporation must either pay the premiums, or reimburse the shareholder for the premiums in the current tax year (i.e. pay or reimburse the 2009 premiums in 2009).
3. The premiums paid or reimbursed by the S-corporation must be reported as wages on the shareholder's W-2 (not subject to FICA or FUTA).
4. The long-term care insurance cannot be offered as part of a medical insurance plan through a spouse's employer.
Action Item: Long-term care insurance premiums must be paid by the S corporation and included in the shareholder’s W-2 to assure full deduction.
S corporations often borrow from or lend to their shareholders.In both cases, the issue is whether the transaction is an actual loan or something else designed to look like a loan. A loan to a corporation may be recharacterized as a contribution to capital. A loan from a corporation may be considered a distribution or disguised wages.It may be appropriate to document the debtor/creditor relationship by noting the intent of the loan and providing terms for interest, repayment, and a maturity date in a note.
The Service issued Regulations late in 2008 that address the tax treatment of open account debt, where there is no written note.If the account balance due to a shareholder exceeds $25,000 at the end of the S corporation's year, the loans are treated as separate written notes. So long as the balance of the shareholder's open account debt is $25,000 or less, advances and repayments are netted during the year and treated as one indebtedness. This can affect the shareholder's debt basis and the taxation of repayments, as noted below.
Action Item: Determine whether the money transfers between the company and the shareholder are intended to be repaid. If they are to be repaid, document a line of credit agreement between the company and shareholder with the terms and conditions of the loan.
Shareholder Loan Repayments
Please be aware that the repayment of shareholder loans may be taxable income to the shareholder. Shareholder loans allow corporate losses to be deducted on the shareholder's individual return after the stock basis has been reduced to zero. When this occurs, the shareholder's basis in the debt is reduced to the extent the corporate losses are deducted. If the debt basis is not restored before repayments begin, the shareholder may recognize capital gain if the loan is a formal note or ordinary gain if the loan is an open account. A formal note is evidenced by a written instrument. An open account loan is made up of shareholder advances that are not evidenced by a written instrument and repayments on those advances.
Action Item: Please contact us before you begin repayment of shareholder loans so we can assist you in determining if a gain could result from the repayment.
When a shareholder/employee uses a home office as a place of business for an S corporation, there are various ways to handle the expenses, but most result in little benefit to the homeowner. If the corporation pays rent to the employee, the rent is deductible by the corporation and income to the employee, but there is no opportunity for deducting offsetting expenses. If the employee is required to maintain the office for the convenience of the employer, the expenses are deductible, but most or all of the benefit may be lost as these are itemized deductions, reduced by 2% of adjusted gross income. Recent court cases have disallowed deduction of unreimbursed expenses of a shareholder/employee on Schedule E.
Following is a suggestion that may maximize the tax benefit of home office deductions. A shareholder-employee can calculate home office expenses as if an employee, and then, by written pre-arrangement with the corporation, have the corporation reimburse the shareholder for costs of the home office after they are substantiated in full (amount, time, place, and business purpose of each expense). Assuming the shareholder-employee could have claimed the expenses as business deductions if paid out of pocket, the reimbursement for the expenses is fully deductible by the corporation and is a tax-free accountable-plan reimbursement to the employee. However, the shareholder employee must reduce the itemized deductions for mortgage interest and property tax by the business-related portion if the corporation gives the shareholder a tax-free accountable-plan reimbursement for these items. Otherwise, there would be a double tax benefit-a deduction and tax-free reimbursement-for the same expense.
Action Item: Fully substantiate the shareholder's cost of their home office, prepare a written agreement, and provide corporate reimbursement for these costs.