Forming an S corporation to run your business provides several tax advantages. Chief among these is the opportunity to lower your Social Security and Medicare taxes. However, when it comes to deducting the cost of health insurance for you and your family, an S corporation is not always so great.
Ordinarily, when you form a corporation to own and operate your business, you'll work as its employee. If you form a regular "C" corporation, your corporation can provide you with health insurance as an employee fringe benefit and deduct the cost as a business expense. And you don't have to pay any tax on the amount of the insurance premiums because they qualify as a tax-free employee fringe benefit.
However, when you elect S corporation tax status for your corporation, special tax rules come into play. Under these rules, anyone who works for an S corporation and owns 2% or more of its stock, must include in his or her wages the cost of certain employee fringe benefits provided by the corporation, including health insurance. This means income taxes must be paid on the amount of the premiums. Social Security and Medicare taxes have to be paid as well unless the procedure described below is followed.
Moreover, you can't get around this rule by employing your spouse and providing him or her with company health insurance that covers you and rest of your family. Your spouse and other family members are considered S corporation shareholders for these purposes, even if they don't actually have any stock in their names. They are treated as if they own all the stock that you own.
The fact that you're not entitled to claim employee health insurance as a tax-free fringe benefit when you have an S corporation is not good. But things aren't all bad for S corporation shareholders. You may still be able to take a personal income tax deduction for the health insurance premiums paid by your corporation.
Self-employed people are allowed to deduct health insurance premiums (including dental and long-term care coverage) for themselves, their spouses, and their dependents. When you're an S corporation owner with more than 2% of the company stock, you're treated the same as a self-employed person when it comes to deducting health insurance premiums.
This is not a business deduction. It is a special personal deduction you take on the first page of your Form 1040 as self-employed health insurance. If you have Medicare coverage, you may deduct your Medicare premiums as part of this deduction—this includes all Medicare parts (not just Part B). Your insurance can also cover your children up to age 27 (26 or younger as of the end of a tax year), whether or not they are your dependents.
Your deduction is limited to the amount of wages you are paid each year by your S corporation. You get the deduction whether you purchase your health insurance policy as an individual or have your S corporation obtain it. However, your S corporation must pay the premiums for you to get the deduction. Thus, if your purchase your policy yourself, you must have your S corporation reimburse you for the cost. If you choose the reimbursement option, be sure to submit your receipts to the corporation along with an expense report.
The amount of the premiums must be included in your employee wages on your annual Form W-2, and you must include the amount as wages on your Form 1040. Your S corporation deducts the amount as employee compensation on its own return.
You must pay income tax on the health insurance premium payments made by your S corporation. However, such payments are not subject to Social Security and Medicare taxes if (1) you're the only employee of your S corporation, or (2) your corporation has other non-owner employees and provides them with health insurance. However, these taxes must be paid on the payments if your S corporation has non-owner employees, but does not provide them with health insurance.