S corporations are a very popular form of business entity, accounting for over 43 percent of business entity tax return filings in 2011. In fact, S corporations nearly doubled C corporation filings (arguably what most people think of when they hear the term “corporation”). Although S corporations are clearly in favor, some of their governing regulations can present unsuspected consequences.
An S corporation is a ‘flow-through’ entity, aptly named as its tax effects flow through to the owners’ individual tax returns. It is this blend of business and individual tax that leads to some of their most complex rules. The advantages to S corporations of avoiding double-taxation and the potential to minimize payroll taxes are well documented. However, the intricate and restrictive rules over its owners are relatively less understood and could be costly if not complied with.
For the purposes of this article, the term “owners” refers to greater-than-2-percent S corporation shareholders.
Health Insurance-Related Items
In order for owners’ health insurance premiums to qualify as deductible expenses, the plan must be established through the business. This is not to say that the plan needs to be in the business name. However, the payments must filter through the business, either from reimbursement to the owner or paid directly by the corporation. Also, an owner or their spouse must not be eligible for coverage through another employer in order to receive the deduction.
Perhaps the most convoluted regulation over S corporation owners involves the reporting of health insurance, long-term care, and health savings account (HSA) contributions paid on their behalf. Health insurance-related benefits are required to be treated as compensation taxable to the owners on their W-2.
However, if actual wages are received up to the amount of premiums paid, the owner is then allowed to deduct them on his/her personal tax return. Why include health insurance as income and then a few lines down allow it as a deduction? The likely answer is to prevent passive investors (not receiving wages) from using the entity to deduct their insurance premiums.
Section 125 Plans and Flexible Spending Arrangements
Both section 125/cafeteria plans and a derivative of them, Flexible Spending Arrangements, can save employees thousands of dollars annually. However, owners’ participation in the plan could cause its disqualification and render all benefits provided by the plan as taxable to the respective employees.
Disability and Life
Disability and life insurance premiums paid by an employer are generally deductible by the business. However, if owners want any potential proceeds to receive tax-free treatment, they are effectively not allowed a deduction for the share of premiums paid on their behalf. Such premiums should be included in their income through their W-2.
Unlike health insurance premiums, disability and life insurance expenses do not become deductible on the owners’ individual returns to offset the inclusion in W-2 income.
Shareholder Loan Documentation
Although the brevity of this article prevents us from discussing the details of why, loans between the owners and the S-corporation can provide tax benefits to the owner loaning the money. But, this is only true if the loan is properly evidenced by formal written documents that specify a qualifying purpose of the loan, collateral, interest rates, etc. Otherwise, repayment of a “loan” to the owners may carry some harsh and unintended tax consequences.
One of the advantages of S corporations over partnerships is that payroll taxes are avoided on the S-corporations taxable income; only the wages paid to the S corporation owners are subject to payroll tax. To prevent S corporation owners from abusing this benefit through deflating their salaries, the IRS requires that the business pay the owners “reasonable compensation” in light of the owners’ duties. The definition of “reasonable compensation” is not clearly defined and often varies from one situation to the next.
Owner Home Offices
There are multiple regulations in place that greatly diminish or otherwise eliminate tax benefits from an owner charging the S corporation rent or from the owner claiming a home office deduction involving the corporation’s business.
As with most things tax-related, there are sometimes exceptions to these general rules (which also may have exceptions). We encourage you to consult your tax advisor if your business participates in any of these activities, in order to see how they may affect you and to avoid any unintended consequences.
Content contributed by Potter & Company, a local certified public accounting firm offering core services of audit, tax, business consulting and financial analysis. Content written by Dan Huskes, CPA. For more information, contact him or John Kapelar, CPA, Partner, at 704-662-3146 or visit www.GoToPotter.com.