AICPA Proposes Revenue Ruling on S Corporation …



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 shareholder-employee.

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 shareholder-employee 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 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 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) 622-XXXX (not a toll-free call).

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