Family-member 2% S-corp shareholders can still take the § 162(l) health insurance deduction

Plain-English summary

This Chief Counsel Advice addresses the self-employed health insurance deduction for a family member who is treated as a 2-percent shareholder of an S corporation only because of family attribution. Under section 1372, an S corporation is treated like a partnership for fringe-benefit purposes, and a "2-percent shareholder" (including anyone who owns more than 2 percent by attribution under section 318, such as the spouse, children, grandchildren, or parents of the real owner) is treated like a partner rather than an employee. That means the S corporation's payments for the person's health coverage are not excludable from income under section 106 and must be included in the shareholder-employee's gross income and reported as wages on the Form W-2. The question was whether such an attributed 2-percent shareholder can then take the above-the-line deduction under section 162(l) for the cost of that coverage. The IRS concluded yes: an individual who is a 2-percent shareholder by attribution under section 318 is entitled to the section 162(l) deduction for premiums the S corporation pays under a group health plan covering all employees and included in the individual's income, provided the individual otherwise meets section 162(l)'s requirements (for example, the earned-income limit and the rule denying the deduction when the person is eligible for other subsidized employer coverage). In short, the family-attribution route to 2-percent-shareholder status does not cost the person the section 162(l) deduction.

Ruling snapshot

• Question: Can an individual who is a 2-percent S corporation shareholder only by family attribution under § 318 claim the § 162(l) self-employed health insurance deduction for premiums the S corporation pays and includes in the individual's income?
• Outcome: advice (yes, if the individual otherwise meets the requirements of § 162(l))
• Key authorities: IRC §§ 162(l), 318(a)(1), 1372, 106, 61(a), 3121(a)(2)(B), 401(c); Rev. Rul. 91-26; Notice 2008-1

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service
Memorandum
Number: 201912001
Release Date: 3/22/2019
CC:TEGE:EB
PRESP-131029-18

UILC:     162.00-00, 162.35-00

date:    December 21, 2018

to:   Daniel C. Munce
Associate Area Counsel
Small Business/Self-Employed

from:    Stephen Tackney
Deputy Associate Chief Counsel (Employee Benefits)
CC:TEGE:EB

subject:   Health Insurance Costs of Employee Family Members of 2-Percent Shareholders

This Chief Counsel Advice responds to your request for assistance. This advice may
not be used or cited as precedent.

ISSUE

Whether an individual who is a 2-percent shareholder of an S corporation pursuant to
the attribution of ownership rules under § 318 of the Internal Revenue Code is entitled
to the deduction under § 162(l) for amounts that are paid by the S corporation under a
group health plan for all employees and included in the individual’s gross income, if the
individual otherwise meets the requirements of § 162(l).

CONCLUSION

An individual who is a 2-percent shareholder of an S corporation pursuant to the
attribution of ownership rules under § 318 is entitled to the deduction under § 162(l) for
amounts that are paid by the S corporation under a group health plan for all employees
and included in the individual’s gross income, if the individual otherwise meets the
requirements of § 162(l).
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FACTS

An individual owns 100% of an S corporation, which employs the individual’s family
member. The family member is considered to be a 2-percent shareholder pursuant to
the attribution of ownership rules under § 318. The S corporation provides a group
health plan for all employees, and the amounts paid by the S corporation under such
group health plan are included in the family member’s gross income.

LAW AND ANALYSIS

Section 1372(a) provides that, for purposes of applying the income tax provisions of the
Code relating to employee fringe benefits, an S corporation shall be treated as a
partnership, and any 2-percent shareholder of the S corporation shall be treated as a
partner of such partnership. For purposes of § 1372, the term “2-percent shareholder”
is any person who owns (or is considered as owning within the meaning of § 318) on
any day during the taxable year of the S corporation more than 2 percent of the
outstanding stock of such corporation or stock possessing more than 2 percent of the
total combined voting power of all stock of such corporation. Section 1372(b). Section
318(a)(1) provides that an individual shall be considered as owning the stock owned,
directly or indirectly, by or for (i) his spouse (other than a spouse who is legally
separated from the individual under a decree of divorce or separate maintenance), and
(ii) his children, grandchildren, and parents.

Accident and health insurance premiums paid or furnished by an S corporation on
behalf of its 2-percent shareholders in consideration for services rendered are treated
for income tax purposes like partnership guaranteed payments under § 707(c) of the
Code. Rev. Rul. 91-26, 1991-1 C.B. 184. An S corporation is entitled to deduct the cost
of such employee fringe benefits under § 162(a) if the requirements of that section are
satisfied (taking into account the rules of § 263). The premium payments are included
in wages for income tax withholding purposes on the shareholder-employee’s Form W-
2, Wage and Tax Statement, but are not wages subject to Social Security and Medicare
taxes if the requirements for exclusion under § 3121(a)(2)(B) are satisfied. See
§ 3121(a)(2)(B); Ann. 92-16, 1992-5 I.R.B. 53. The 2-percent shareholder is required to
include the amount of the accident and health insurance premiums in gross income
under § 61(a). Notice 2008-1, 2008-2 I.R.B. 251.

Section 106 provides an exclusion from the gross income of an employee for employer-
provided coverage under an accident and health plan. A 2-percent shareholder is not
an employee for purposes of § 106. Treas. Reg. § 1.106-1; section 1372(a).
Accordingly, the premiums are not excludible from the 2-percent shareholder-
employee’s gross income under § 106. Notice 2008-1.

Section 162(l)(1)(A) allows an individual who is an employee within the meaning of §
401(c)(1) to take a deduction in computing adjusted gross income for amounts paid
during the taxable year for insurance that constitutes medical care for the taxpayer, his
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or her spouse, and dependents. The deduction is not allowed to the extent that the
amount of the deduction exceeds the earned income (within the meaning of § 401(c)(2))
derived by the taxpayer from the trade or business with respect to which the plan
providing the medical care coverage is established. Section 162(l)(2)(A). Also, the
deduction is not allowed for amounts during a month in which the taxpayer is eligible to
participate in any subsidized health plan maintained by an employer of the taxpayer or
of the spouse of the taxpayer. Section 162(l)(2)(B).

A 2-percent shareholder-employee in an S corporation, who otherwise meets the
requirements of § 162(l), is eligible for the deduction under § 162(l) if the plan providing
medical care coverage for the 2-percent shareholder-employee is established by the S
corporation. Rev. Rul. 91-26, 1991-1 C.B. 184. A plan providing medical care coverage
for the 2-percent shareholder-employee in an S corporation is established by the S
corporation if: (1) the S corporation makes the premium payments for the accident and
health insurance policy covering the 2-percent shareholder-employee (and his or her
spouse or dependents, if applicable) in the current taxable year; or (2) the 2-percent
shareholder makes the premium payments and furnishes proof of premium payment to
the S corporation and then the S corporation reimburses the 2-percent shareholder-
employee for the premium payments in the current taxable year. If the accident and
health insurance premiums are not paid or reimbursed by the S corporation and
included in the 2-percent shareholder-employee’s gross income, a plan providing
medical care coverage for the 2-percent shareholder-employee is not established by the
S corporation and the 2-percent shareholder-employee in an S corporation is not
allowed the deduction under § 162(l). Notice 2008-1.

In order for the 2-percent shareholder-employee to deduct the amount of the accident
and health insurance premiums, the S corporation must report the accident and health
insurance premiums paid or reimbursed as wages on the 2-percent shareholder-
employee’s Form W-2 in that same year. In addition, the shareholder must report the
premium payments or reimbursements from the S corporation as gross income on his or
her Form 1040, U.S. Individual Tax Return. Notice 2008-1.

Pursuant to the rules described above, an individual who is a 2-percent shareholder of
an S corporation pursuant to the attribution of ownership rules under § 318 is entitled to
the deduction under § 162(l) for amounts that are paid by the S corporation under a
group health plan for all employees and included in the individual’s gross income, if the
individual otherwise meets the requirements of section 162(l).

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call (202) 317-6000 if you have any further questions.