One of the most mis-understood parts of the tax code is how to handle fringe benefits when you are a shareholder of a S corporation. Here's a quick primer on life insurance, retirement plans and health insurance:
In general, a business may provide certain tax-free fringe benefits to its employees. One such benefit is group term life insurance up to $50,000, but there are special rules regarding fringe benefits that apply to S corporation 2% shareholder-employees. Generally, a 2% shareholder is a shareholder who owns more than 2% of the S corporation’s stock on any day during the tax year.
(Under §1372 and Rev. Rul. 91-26, for fringe benefit purposes, an S corporation 2% shareholder who is also an employee of the corporation is treated the same way as a partner in a partnership.)
There are some types of fringe benefits, including contributions to qualified retirement plans, that are tax-free or excludable for partners. Likewise, an S corporation’s contributions to qualified retirement plans for 2% shareholder-employees are excludable for the shareholders. They become an expense to the S corporation.
Fringe benefits that would be included in partners’ guaranteed payments are not excludable for 2% shareholder employees. One such benefit is health insurance. The health insurance premiums paid are included in Box 1 of their W-2 wages. They can also claim the self-employed health insurance deduction as an adjustment to income on their Form 1040 tax return just as a partner would. So essentially, you pay taxes on it upfront and then get a credit for it when you do your taxes.
Another benefit that is not tax-free to partners or 2% shareholders is the cost of up to $50,000 of group life insurance. Again, the life insurance premiums must be included in their W-2 wages, but there is no deduction for it on their personal tax returns like there is for health insurance.
The group term life insurance premiums paid is reported on line 7 (compensation of officers) or line 8 (salaries and wages) of Form 1120-S as applicable, rather than on line 18 (employee benefit programs). If the corporation’s receipts are $500,000 or more, Form 1125-E may be needed to show the details of officer compensation. See the line 18 instructions to Form 1120-S.