Relative of 2-Percent Shareholder May Deduct Cost of Health Insurance

Certain individuals who receive health care coverage from an S corporation must include the cost of the coverage in their income because of their relationship to the owner of the S corporation. However, they are then permitted to deduct the cost on their personal tax returns, according to IRS Chief Counsel Memorandum 201912001.

Facts: The owner of an S corporation employs a family member through the S corporation. The S corporation provides a group health plan to all employees. The IRS was asked if it is permissible for the relative/employee to deduct the amount paid for his health insurance from his personal taxes.

Law: The general rule is that any owner-employee (including a partner), and any non-employee, must include in compensation the value of any health insurance coverage received. However, an owner-employee or self-employed individual can then deduct the cost of the health care on his or her own individual income tax return.

IRS Memorandum: The IRS said that an S corporation is treated as a partnership, and any "2-percent shareholder" of the S corporation is treated as a partner of the partnership and is therefore an owner-employee. For purposes of this rule, the term "2-percent shareholder" means any person who owns (or is considered as owning), on any day in the taxable year, more than 2 percent of the outstanding stock of the corporation or stock possessing more than 2 percent of the total combined voting power of all stock of the S corporation.

Further, for purposes of determining who is a 2-percent shareholder, an individual is considered as owning the stock owned, directly or indirectly, by or for (i) his spouse, or (ii) his children, grandchildren, or parents.

Health insurance premiums paid by an S corporation for its 2-percent shareholders (including the above family members), in consideration for services rendered, are treated as income to the shareholders. An S corporation is entitled to deduct the cost of such employee fringe benefits, but the premium payments are included in wages for income tax purposes on the shareholder's Form W-2. Because a 2-percent shareholder is not an employee, the premiums are not excludable from the 2-percent shareholder's gross income.

A separate section of the Internal Revenue Code, however, permits an owner-employee to deduct the amount of these health insurance premiums on his personal income tax return, if certain conditions are met. Therefore, if the employed individual, because of his family relationship to the owner, is considered to be a 2-percent shareholder, he cannot exclude the cost of premium payments from his reportable income but can deduct the amount on his Form 1040.