S corporation's treatment of employee-shareholder fringe benefits.

• Author: Ellentuck, Albert B.

Facts: Bigcorp has been an S corporation since 1984. Matt and Sam each own 50% of the stock. During the current year, Bigcorp pays health and accident insurance premiums of $5,000 for Matt and $7,500 for Sam and his family, in accordance with a written agreement between Bigcorp and the shareholders. Issue: How much income does each S shareholder report because of the fringe-benefit payments?

Analysis

Fringe benefits are employment-related benefits provided to an employee in addition to regular compensation. They must be included in taxable income unless specifically excepted under another Code section.

A fringe benefit that can be provided tax free may be a particularly good way to compensate employees. The employee receives a benefit free from income tax, while the employer generally deducts the benefit's cost. Tax-free fringe benefits are also free from payroll taxes (i.e., Federal (and in some cases, state) unemployment tax, and Social Security and Medicare tax).

Fringe Benefits for C Employee-Shareholders

C corporations can offer a number of tax-advantaged fringe benefits to their employees (who, in closely held businesses, are frequently also the owners). The corporation can deduct the benefits; the employees can exclude them from taxable income.

Fringe Benefits for S Employee-Shareholders

The rules governing fringe benefits for S corporation employee-owners are not as favorable as those applicable to C corporations; rather, they are similar to the rules for partnerships. For employee fringe-benefit purposes, Sec. 1372 states that S corporations are treated as partnerships; any S shareholder owning (directly or indirectly) more than 2% of the stock on any day during the tax year is treated as a partner.

The Code does not define "employee fringe benefits." Further, the S corporation rules do not always parallel the partnership rules. The following benefits are available on a tax-advantaged basis (i.e., deductible by the S corporation and excludible from the income of 2% employee-shareholders), because such benefits are available to partners:

1. Dependent care assistance under Sec. 129.

2. Educational assistance programs under Sec. 127.

3. Qualified employee discounts, no-additional-cost services, working-condition fringe benefits, on-premises athletic facilities and de minimis fringe benefits, under Sec. 132.

   Conversely, the following fringe benefits provided to 2% employee-shareholders are treated as additional employee compensation:

1. ...