Download AICPA Proposes Revenue Ruling on S Corporation Shareholder

American Institute of Certified Public Accountants
A Proposed Revenue Ruling to Clarify/Modify Existing Guidance on Circumstances in
Which an S Corporation Shareholder is Entitled to an Above-the-Line Deduction for
Health Insurance Premiums for the Self-Employed
(A response to IRS Headliner Volume 163, dated May 15, 2006)
Drafted, Reviewed and Approved by the S Corporation Taxation Technical Resource Panel
Approved by the Tax Executive Committee
Submitted to the Internal Revenue Service
December 27, 2006
PROPOSED REVENUE RULING
ISSUE
Is a shareholder-employee of an S corporation allowed an above-the-line deduction under
section 162(l) of the Internal Revenue Code for health insurance premiums paid with
respect to a policy purchased in the shareholder's own name?
FACTS
An individual is the sole employee of an S corporation. He is also a shareholder of the
corporation and owns more than two percent of the corporation's stock. The shareholder
lives in a state which does not allow a corporation to purchase a group health plan with
only one participant. This prevents the S corporation from acquiring a health plan and it
requires the shareholder to purchase an individual policy in his own name. Neither the
shareholder nor the shareholder's spouse is covered by another subsidized health plan.
Situation 1: The shareholder-employee purchases a health insurance policy in his own
name and he makes the premium payments with respect to said policy. The S corporation
makes no payments with respect to the policy.
Situation 2: The S corporation adopts a subsidized health plan for employees and their
dependents that requires the sole shareholder-employee to purchase a health insurance
policy and requires the corporation to make all premium payments.
Situation 3: Same as situation 2 except that the shareholder-employee makes the premium
payments and the S corporation is obligated to reimburse the shareholder for the premium
payments upon proof that the insurance is in force and is being paid for by the shareholderemployee.
Situation 4: Same as situations 2 and 3 except that state law does not prohibit a corporation
from purchasing a group health plan with only one participant. However, the cost of a
group health plan with only one participant exceeds the cost of an individual health
insurance policy. For business reasons (lower cost), the corporation adopts a health plan
that requires the sole shareholder-employee to purchase a health insurance policy and
requires the corporation to make all premium payments or to reimburse the shareholderemployee for the premium payments upon proof that the insurance is in force and is being
paid for by the shareholder-employee.
LAW AND ANALYSIS
For certain fringe benefits paid by an S corporation, including health insurance premiums,
section 1372(a) holds that the S corporation will be treated as a partnership and any
shareholder who owns more than two percent (a two percent shareholder) of the S
corporation stock will be treated as a partner of such partnership. Revenue Ruling 9l-26,
1991-1 CB 184, holds that accident and health insurance premiums paid by a partnership
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on behalf of a partner are guaranteed payments under section 707(c) of the Code if the
premiums are paid for services rendered in the capacity of a partner and to the extent the
premiums are determined without regard to partnership income. As guaranteed payments,
the premiums are deductible by the partnership under section 162 (subject to the
capitalization rules of section 263) and includable in the recipient-partner's gross income
under section 61.
The health insurance premiums paid by the S corporation would be deductible by the S
corporation as compensation to the two percent shareholder. The health insurance
premiums paid by the S corporation for the two percent shareholder would be included in
the two percent shareholder's Form W-2 as wages but not for purposes of Social Security
and Medicare taxes. See Announcement 92-16, 1992-5 IRB 53.
Section 162(l)(5) allows S corporation shareholders who are treated as partners under
section 1372 the same above-the-line deduction for health insurance costs as self-employed
individuals, assuming all of the other provisions of section 162(l) are met.
Under section 162(l)(2) an above-the-line deduction is not allowed for any calendar month
for which the shareholder is eligible to participate in any subsidized health plan maintained
by any other employer of the shareholder or the spouse of the shareholder.
In Situation 1, the S corporation has not established a plan to provide medical care
coverage, and there is no fringe benefit paid by the corporation to or on behalf of the two
percent shareholder.
Therefore, the provisions of section 1372 do not come in to play. The S corporation is not
treated as a partnership and the shareholder is not treated as a partner for purposes of this
deduction. Since the shareholder is not treated as a partner, the shareholder is also not
treated as self-employed under section 162(l)(5) and is not eligible for an above-the-line
deduction. The shareholder is still able to deduct the health insurance premiums under
section 213 as an itemized deduction subject to the 7.5 percent adjusted gross income
limitation.
In Situations 2 and 3, the corporation has established a subsidized health plan. The state
law limitation that prevents a single-employee corporation from purchasing a group health
plan does not negate principles of federal tax law regarding health benefits for employees.
In other words, a state law prohibition against the purchase of a group health plan by a
single-employee corporation, does not prohibit federal tax benefits if the corporation, in
complying with the state law, pays, directly or indirectly, the health insurance premiums of
its employee. Reimbursements by an employer to its employees for their hospital and
medical insurance premiums are considered contributions by the employer to accident or
health insurance plans pursuant to Rev. Rul. 61-146, 1961-2 CB 25. The payments made
by the corporation are considered to be fringe benefits paid to, or on behalf of, the two
percent shareholder and the provisions of section 1372 apply. Thus, the S corporation
would be treated as a partnership and the shareholder would be treated as a partner for this
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purpose. Therefore, the shareholder would be treated as self-employed and would be
eligible for the above-the-line deduction treatment under section 162(l).
In situation 4, the corporation has established a subsidized health plan. The fact that
business reasons mandate that the employee purchases the health insurance policy does not
prohibit federal tax benefits if the corporation pays, directly or indirectly, the health
insurance premiums of its employee pursuant to the adoption of a corporate subsidized
health plan. The results would be the same as in situations 2 and 3, discussed above.
HOLDING
Under Situation 1, the shareholder-employee is not entitled to deduct health insurance
premiums as a self-employed individual under section 162(l), but may be entitled to an
itemized deduction under section 213.
In Situations 2, 3, and 4 the shareholder-employee will have the health insurance premium
payments made (or reimbursed) by the corporation included in W-2 wage income (but not
in Social Security and Medicare wages) and is entitled to deduct health insurance
premiums as a self-employed individual under section 162(l).
EFFECT ON OTHER DOCUMENTS
Revenue Ruling 9l-26, 1991-1 CB 184, and Announcement 92-16, 1992-5 IRB 53, are
amplified. Headliner Volume 163, dated May 15, 2006 is amplified.
EFFECTIVE DATE
For payments made pursuant to subsidized, group health plans adopted by S corporations
effective for years beginning after 1991.
DRAFTING INFORMATION
The principal author of this proposed revenue ruling is ___________________. For
questions regarding this ruling, Mr./Ms. _____________ can be reached at (202) 622XXXX (not a toll-free call).
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