A Healthy Deduction for 2% Shareholders

in Notice 2008-1, the IRS has offered an opportunity for 2% shareholders of an S corporation to receive a deduction for health insurance premiums under IRC § 162(l). A 2% shareholder is defined in section 1372(b) as a person who owns directly or constructively under section 318 on any day of the S corporation’s tax year more than 2% of the corporation’s outstanding stock or more than 2% of the combined voting power of all the corporation’s stock. Previously, a 2% shareholder could not deduct such payments and had to recognize them in income.

Section 162(l)(1)(A) allows an employee to take a deduction for medical insurance paid by the S corporation on behalf of the employee, the employee’s spouse, and dependents. Previously, a 2% shareholder was not considered an employee; therefore, the shareholder was not eligible to deduct the insurance premiums paid by the S corporation. When dealing with fringe benefits, an S corporation is treated as a partnership, which means the 2% shareholder is treated as a partner. In general, when a partner receives payment of insurance premiums as compensation, that income is treated as a guaranteed payment under section 707(c) and must be reported as income by the shareholder under section 61(a).

AN ESTABLISHED PLAN
Under Notice 2008-1, a 2% shareholder is allowed an above-the-line deduction for accident and health insurance premiums paid under a plan that is “established by the S corporation.” This poses the question: What are the requirements for a plan to qualify as being “established by the S corporation”? A plan can satisfy this requirement in two ways: The S corporation makes the payments on behalf of the qualifying 2% shareholder, or the shareholder makes the payments and is then reimbursed by the S corporation.

For the 2% shareholder to deduct the premiums on his or her individual return, the S corporation must include the premium payments in the employee’s Form W-2 for the tax year in which it is paid, and the shareholder must report those wages as income on Form 1040. In addition, the employee’s earned income from the S corporation must exceed the cost of the premiums under the policy for the shareholder-employee and spouse or dependents, if applicable.

The deduction is also available for prior tax years. If a qualifying taxpayer would have been allowed a deduction in a previous tax year using the new rules, an amended return may be timely filed to claim the deduction by writing “Filed Pursuant to Notice 2008-1” at the top of the amended return.

ONE CLASS OF STOCK RULE
An S corporation can have only one class of stock (see section 1361(b)(1)(D)). Generally, a corporation is treated as having only one class of stock if all outstanding shares of the corporation’s stock confer identical rights to distribution and liquidation proceeds (see Treas. Reg. § 1.1361-1(l)(1)). Notice 2008-1 states that accident and health insurance payments made on behalf of 2% shareholders will not be considered distributions with respect to the S corporation single class of stock requirement.

For a detailed discussion of the issues in this area, see “IRS Offers Opportunity for 2% Shareholders of S Corporation,” by Angela Kegerreis, CPA, in the May 2008 issue of The Tax Adviser .

— Alistair M. Nevius, editor-in-chief
The Tax Adviser

Also read articles on the following topics in the May 2008 issue of The Tax Adviser:

• A review of the revised disciplinary process under Circular 230.
• A report on the Mortgage Forgiveness Debt Relief Act of 2007.
• A practical guide to qualified offers.

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