IRS offers opportunity for 2% shareholders of S corp.

• Author: Kegerreis, Angela

The IRS recently issued Notice 2008-1, offering an opportunity for 2% shareholders of an S corporation to receive a deduction for health insurance premiums under Sec. 162(1). A 2% shareholder is defined as a person who owns directly or constructively under Sec. 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 (Sec. 1372(b)).

Sec. 162(1)(1)(A) states that when computing adjusted gross income, an employee is allowed to take a deduction for medical insurance paid by the S corporation on behalf of the employee, the employee's spouse, and dependents. The deduction would not be allowed if the employee was eligible to participate in a subsidized plan provided by an employer of the taxpayer or the taxpayer's spouse. Previously, a 2% shareholder was not considered an employee under Sec. 106; therefore, the shareholder was not eligible to exclude insurance premiums paid by an employer from income by way of a deduction afforded to other employees.

When dealing with fringe benefits, an S corporation is treated as a partnership under Sec. 1372(a), which means the 2% shareholder is treated as a partner. In general, when a partner receives payment of insurance premiums as compensation for services, that income is treated as a guaranteed payment under Sec. 707(c). The S corporation is allowed a deduction for the premium payments if the rules of Sec. 162(a) are satisfied. The payments are required to be reported as income by the employee under Sec. 61(a).

Under Notice 2008-1, a 2% shareholder is allowed an above-the-line deduction on Form 1040, U.S. Individual Income Tax Return, 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...