The Affordable Care Act (also known as Obamacare) makes a number of changes to the way that small businesses account for and treat health insurance expenses.
Accordingly, I’m going to quickly review how the rules apply to Subchapter S corporations and then point out one of the largely ignored issues—the anti-discrimination requirement—that will affect many small S corporations.
To keep all of this information practical and actionable, though, I’m not going to talk about concepts or regulations. And no politics here either. This blog is supposed to be practical and provide how-to information.
So, I’m just going to describe how you handle the three common situations a small business is likely to encounter.
Example #1: The One-person S Corporation
Let’s start by describing the easiest case first: A one-person, one-employee S corporation.
This situation (thankfully) works in a manner that’s fairly straightforward and continues what’s gone on in the past.
Assume, for example, that you own and operate an S corporation that pays its single shareholder (you probably) $40,000 in regular wages and then also pays $10,000 in annual health insurance premiums.
In this case, the health insurance payments end up as a deduction for both income and payroll tax purposes, though the bookkeeping gets a little messy.
Here’s how things are supposed to work. The S corporation deducts $50,000 as wages on its tax return and shows the $50,000 as wages on the shareholder-employee’s W-2 in box 1.
However, in boxes 3 and 5 of the shareholder’s W-2 (which show the wages subject to Social Security and Medicare care taxes), the wages equal only $40,000.
In other words, the full $50,000 is subject to income taxes (potentially—but more on this in a minute). But only the $40,000 is subject to Social Security and Medicare taxes.
And now another wrinkle: That $10,000 of health insurance? You need to report that value in box 14 of the W-2 as self-employed health insurance.
When the shareholder-employee prepares her or his 1040 tax return, the full $50,000 of wages from box 1 of the W-2 gets reported on line 7 of the 1040. But then the $10,000 of health insurance gets treated as a self-employed health insurance deduction on line 29 as long as the employee qualifies for the deduction (more on this in a minute).
The net amount subject to income taxes, in other words, equals $40,000.
Anyway, that’s how the health insurance accounting works with a one-shareholder, one-employee S corporation.
And a couple of general rules about qualifying for the self-employed health insurance deduction:
First, in order to qualify for the self-employed health insurance deduction, the shareholder-employee needs to not be buying, and not be eligible to buy, subsidized health insurance.
Second, the S corporation must either pay the premiums, or if the shareholder-employee has already paid for the premiums, must reimburse the shareholder.
Example #2: Multiple Employees, All Covered
Let’s now look at what happens when a firm employs more than one person. For example, take the simplest case: a two-employee situation where one employee is the shareholder and the other isn’t.
As long as both the shareholder-employee and the non-shareholder-employee receive group plan health insurance from the S corporation (in other words, both the shareholder and non-shareholder get coverage in the same plan), you treat the shareholder-employee’s health insurance the same way as just described for a one-shareholder, one-employee business. (See IRC Code Section 106(a) and if you’re really interested Rev. Rul. 61-146 and Rev. Rul. 2002-3 and Rev. Rul. 2002-80.)
For example, if the shareholder-employee earns $40,000 and receives $10,000 in health insurance, you create the same sort of W-2 as you do for the situation described in example #1.
Things look a little differently for the non-shareholder-employee, but in effect work out the same basic way. Assuming the non-shareholder-employee also makes $40,000 and gets $10,000 of health insurance, what happens is the S corporation deducts the $40,000 as wages expense and then shows that $40,000 on a W-2.
The non-shareholder-employee’s W-2 shows $40,000 in boxes 1, 3 and 5.
The $10,000 of health insurance gets deducted by the S corporation and reported on the S corporation’s tax return as fringe benefits expense.
In both the case of the shareholder-employee and the case of the non-shareholder-employee, the employee pays neither income taxes nor payroll taxes (Social Security, Medicare, etc.) on the insurance.
Note: Small employers don’t need to report the health insurance paid for the employee on the employee’s W-2, but they can (and probably should) do so to highlight the value of the benefit. This health insurance gets reported in Box 12 using a DD code.
Example #3: Covered and Uncovered Employees
Now a more common situation: What happens if the S corporation employs both a shareholder and then also a non-shareholder-employee, or even several employees, but only pays health insurance for the shareholder-employee?
Okay, this is where the Affordable Care Act makes things messy.
While only businesses with 50 or more employees are required to provide employees with health insurance under the Affordable Care Act, the Act also prohibits discrimination with regard to health care benefits—and this prohibition applies to both small and large businesses.
As a practical matter, what this means is that a small business can’t provide piecemeal coverage, insuring some employees and not insuring others.
When the business adds a second employee, therefore, the firm has only two practical responses.
One response is for the employer to begin providing Affordable Care Act compliant insurance for everybody.
The other response is for the employer to stop providing insurance to anybody, including the shareholder-employees.
By the way, you might wonder why you can’t simply provide health insurance to the shareholder-employee. Good question. And here’s the answer: The Affordable Care Act levies a $100 per day, per person penalty for failing to comply with its anti-discrimination rules.
And the penalty for discriminating could be substantial. For a two-employee business which provides health insurance to the shareholder-employee but does not provide health insurance to the non-shareholder-employee, the S corporation could be tagged with a $36,500 penalty.
Note: The IRS says that it won’t begin to assess the discrimination penalties until it writes the regulations. So you probably don’t need to act immediately in 2014… But prudence suggests this risk is big enough, it’s something you want to get your hands on quickly.
Mitigating the Obamacare Discrimination Penalties
So here’s how S corporations need to view (or soon view) their health insurance spending in light of the Affordable Care Act’s penalties.
First, to review, while you aren’t required provide insurance for employees unless you have 50 or more employees, you still need to consider the discrimination penalties that can be levied in situations where you have more than just shareholder-employees as employees.
Note: This business about discrimination isn’t really a new concept. Pension plans have always worked this way—even for very small businesses.
Second, if your S corporation does employ two or more employees, you need to choose between providing no insurance to employees (including shareholder-employees) and providing a group plan to all employees. Only these two options let you avoid the heavy penalties discussed in the preceding paragraphs.
Third, note that you and your employees must obtain health insurance. We’re not discussing the option of “going bare”… the question is whether the employer or the individual pays for the policy.
Fourth, finally, note that if you do terminate employer-provided health, what you can do is adjust people’s compensation levels to mitigate the discontinued benefit. This tweak seems the one practical workaround you have if you cancel insurance. For example, if you cancel a health insurance benefit worth $300 a month, you can perhaps add $300 to the previously covered employee’s wages.
One final comment: You want to stay alert to future clarifications and fine-tuning of the law. What I’m describing here represents our best guess about how things work in early 2014. But thinking may change in the future as both Congress and the Internal Revenue Service gain experience implementing the law.
[hr]
Need Help with the Affordable Care Act’s $100-a-Day Per Employee Penalties?
We’ve got a good blog post about the Obamacare penalties that will surely blindside many small business owners in a month (see here.)
If you’re a tax practitioner advising small business clients about how to navigate the treacherous waters of healthcare reform–and especially how to avoid the catastrophic penalties baked into the Affordable Care Act–you may also be interested in our monograph, Small Businesses and the Affordable Care Act (Obamacare).
This short (30pp-ish) whitepaper describes the issues in detail and is richly footnoted with hyperlinks to primary source authorities and many of the better-quality articles in the business press. The monograph also provides a boilerplate healthcare policy document practitioners can use for their clients, and it supplies example W-2 forms to show how these items should be prepared given the ACA.
As with all of our publications, the Small Businesses and the Affordable Care Act (Obamacare) monograph comes with a money-back guarantee, so if you purchase it and then for whatever reason find it’s not what you need or what you expected, simply email us your refund request. We will happily issue you a refund, no questions and no hassles.
One other point regarding the monograph: Though the monograph is considerably more technical than most small business owners will be comfortable digesting, if you are a tax practitioner and you buy the monograph, you have our permission to distribute a copy of the PDF you purchase to up to 100 of your small business clients. (If you need to distribute more than 100 copies, please contact our offices for quote.)
How does the premium subsidy come into the picture for the one-person S corporation case? If the S corp is buying, is the shareholder still eligible for the premium subsidy? What if the shareholder is buying and getting reimbursed?
Hi Harry, good question. At this point we haven’t been able to slog through all of the rules to be sure there’s definitive literature on this exact issue yet, but as best as we can tell, an S corporation shareholder wouldn’t be eligible for subsidies in either of the cases you’ve mentioned.
The reason we think so is because the ACA has a rule that an individual can’t receive a subsidy to help pay for their premiums if the individual is eligible for other “minimum essential coverage,” such as employer-provided health benefits. And employer-provided health care reimbursement plans such as health FSAs, employer payment plans, HRAs, and other section 105 reimbursements count as employer-provided health benefits. In this situation, it would make logical sense (at least to us) that an S corporation that employs one shareholder would be thought of just like any other employer. Hope this helps!
P.S. We love the finance buff 🙂
Thank you for this post. If the S Corp has employees, you mention the options are provide a company health insurance plan to all, or none. What if the the owners and employees each obtain their own insurance (from different sources, e.g., coverage under a spouses plan). Is it compliant if the company just reimburses each person for what they actually pay?
Excellent post; easy to follow and addresses the uncertainties in a way most advisors avoid. My question is about the Section 125 plan many small S-Corps have (whether they know it or not, they have a plan if they payroll deduct premiums pre-tax) and how to mitigate the risk of non compliance with the discrimination rules that are in effect now. Even if the shareholders stay out of the cafeteria plan, how does the small employer allow employees to use the 125 pretax deductions if some employees are considered highly compensated (HCEs)? Do we advise them to drop the 125 plan if there aren’t enough rank and file to offset the 25% of aggregate deductions limit, or is there a small group exception for 125 plan discrimination rules? I see way too many of these 125 plans that appear to be out of compliance and am hoping I’m simply not aware of a small S-Corp exemption. Thanks in advance for any guidance!
Good questions from both Kathy and Dan.
I think you guys will both want to carefully look over the IRS’s relatively recent Notice 2013-54 (URL: http://www.irs.gov/pub/irs-drop/n-13-54.pdf); this is the IRS’s interpretation of the legality of employee medical reimbursement plans in light of the new ACA rules. In a nutshell, the old reimbursement plans for businesses (other than one-employee businesses) for the most part aren’t allowed anymore. This is because of the new ACA rule that health plans cannot limit what they pay out to the insured on the “essential health benefits” or impose cost-sharing on preventive health care.
An employer with two or more employees *could* set up a reimbursement plan for non-essential benefits, such as dental coverage, as a supplement to an ACA-compliant group plan for the essential health benefits, though. That would work. Or what an employer could *probably* do (how the rules will be enforced is still fuzzy, so no one can be completely sure yet) is give employees a raise to offset the cost of health insurance that the employer is no longer reimbursing, but note of course that these extra wages would be subject to payroll taxes and income taxes.
So in summary, Kathy, we believe that the new rules mean that if your company just reimbursed each employee for what they pay for health insurance, they’re getting hit with that $36,500 per-employee penalty. And Dan, we don’t think there’s really a “small S corp exception” unless “small” only means an S corp of one employee. And that’s because the group plan rules (no essential benefit limits and no preventive care cost-sharing) apply to any plan with two or more employees.
My wife has a small (in revenue) sole-proprietorship with six employees. Only one of the employees is full-time, and we had been offering her a limited-purpose health reimbursement plan to cover her substantiated hospital and medical insurance premiums. (She has a grandfathered individual health insurance plan through our state’s Blue Cross Blue Shield.)
I though we could continue to offer this to her in 2014 and beyond as my wife is a small employer, the only employee eligible for the benefit is not a highly compensated one, we’re only discriminating based on full-time vs part-time, and the only insurance policy involved is a grandfathered plan. But, reading the above IRS Notice 2013-54, it seems such limited-purpose HRAs are now illegal, regardless of business size or structure. Do I have that right?
If so, I guess we’ll just have to offer the employee the benefit as taxable compensation in lieu of tax-free benefit. Stinks for us, stinks for the employee. I understand the non-discrimination aspect of all this (we’re proud sponsors of a 3% match SIMPLE-IRA plan), but this is one case where a very modest income employee will be losing something, and no one will be gaining anything.
Thanks a couple hundred thousand for this Steve. Literally!
Hi Patrick, I think you do (unfortunately) have all this right. And you’re right… this does stink. Especially for the employee.
P.S. Good job on offering the Simple-IRA for people! That’s a great benefit to offer people.
Steve, this is a really important blog post for owners of S Corps. Thank you for raising this issue. The next question is, if the company does not do health insurance, and does not reimburse employees for their cost of health insurance… can the owner deduct what they personally pay for health insurance on page 1 of their 1040? Or, does the health insurance have to be reported on the owner’s W2 in order for the owner to deduct it on page 1 of the 1040?
Hi Kathy, re your last question, unfortunately we don’t really know at this point the answer. People like me guess the IRS will create some new rules that S corporation shareholder-employees will need to follow in order to get the self-employed health insurance deduction. I don’t think congress intended to kill off the deduction ACA. If this all seems frustrating, I would remember that it’s all just part and parcel of rolling out a really complex piece of legislation.
Steve,
Great Article!! Been looking for a long time for someone to explain this. I would like to add a little wrinkle to your aforementioned scenarios. I have an S-Corp myself (100% owner). My wife works for me and the health insurance is in her name. I have been doing this a fringe benefit whereas my corp makes the deduction for her premiums on the K-1. I havnt been adding back the health insurance cost on my W-2. Maybe I have been doing it wrong, I am not so sure.
Anyways, my wife would be eligible for a premium tax credit under Obamacare, but I am not sure how it affects the corporation making the deductions? Is it allowed to at all? Should I take all of the deduction it offers her or should she pay the premium and use the tax credit on the upcoming returns?
Thanks
Shaeffer, I don’t think what you’ve done in past works, er, very well. Sorry. You’re supposed to flow the insurance premiums through your W-2… Also, I don’t think you can get the premium credit if your S corp takes W-2 wages deduction. But as I keep saying I think this is all pretty murky.
The owner/employee of a one person S corporation owner buys a subsidized HSA qualified policy. Can the corporation contribute to the HSA?
I would think so… and you’d treat the HSA contribution as shareholder-employee payroll subject to income taxes but not subject Social Security and Medicare taxes.
BTW, I don’t know that you can get a subsidized policy and deduct that on the corporate tax return. That question’s answer seems sketchy to me because the subsidy is sort of duplicative to the tax deduction benefit.
In example #1, I understand that s corp needs to add the $10,000 premiums to the owner’s payroll and subject that to Fed and State taxes.
However, I am confused as to why s corp would still need to reimburse the $10,000 to the owner (in case where the owner paid the premiums personally). Wouldn’t the reimbursement be a duplicate payment, since this is already included in the payroll?
Hi Dan, In answer to your question, “Wouldn’t the reimbursement be a duplicate payment, since this is already included in the payroll?,” I maybe wasn’t clear. One way or another the corp needs to pay the insurance… so that means that either the corp pays directly (and then adds the payments to the employee payroll)… or if the employee’s already paid personally, the corp can pay back employee (and then add payback payments to employee payroll)… Hopefully that makes sense..
Greg, In answer to your question, “is there any way to keep my tax deduction?” I think your decision to end the group plan is (unfortunately) the right one either now or sometime soon due to the lack of clear, consistent guidance from IRS, the changes in premiums etc… This will mean you lose the payroll tax savings element on your family’s health insurance. I will guess that somehow IRS will restore the self-employed health insurance deduction for S corporation shareholders. But right now, I don’t think we know how that restoration will work.
Steve, my S-Corp. pays for a group plan for all employees, but the renewal cost for me (I have 5 dependents) just went from $1193 to $2975 / month). Single employees group costs are around the same, ~$430. Turns out if we all go to the individual market we save big $’s — monthly reduced to under $2000 for me and to around $270 for employees. I plan to end the group plan and bonus everyone instead for what their new insurance will cost. But is there any way to keep my tax deduction? I think what you said above applies to me, that I will be at the mercy of the IRS making new rules, is that right? Thanks!
Steve, Greg J has an excellent question, and my situation is very similar. We are an S Corp with under 20 employees. Our employees have found policies through the ACA at 1/3 the price of our outrageous group rates. In our state only 2 companies offer group insurance through the ACA, and are more expensive than individual ACA policies. With individual rates as they are, if we were to offer bonuses to offset employee costs, while purchasing an individual ACA compliant policy through an insurance company(NOT through Healthcare.gov, ie no subsidy involved) for myself as >2% shareholder, would this qualify as non-discriminatory and flow through tax deductible as long as my premiums are counted as wages on my W-2?
Yeah, so not sure how to say this any clearer: We don’t think what you suggest works. Sorry.
Steve, my wife has a S-Corp with two employees, herself and one other. I have provided insurance for our family through my work, which the cost is covered by my employer. I am retiring in April and I will be able to purchase retirees medical through my union. I thought I could have the business pay for it, but after looking at the anti discrimination part It looks like I wont be able to because of the second non owner employee. Is there any way around this since its coverage that I cant offer to the second employee?
Maybe Congress will change the rules. But your dilemma appears to be an unintentional consequence of the new law. Know that you have much company…
Great article, but I don’t see this case addressed: Husband and wife each own 50% of S Corp, and they are employees drawing equal salaries. They have no other employees. Their company paid health insurance consists of 2 policies–one covers the husband and their dependent children, one covers the wife only. The respective premiums are included on the W-2s as gross wages and in Box 14. Will this plan continue to work in 2014?
I think that probably does work. I personally would not worry about any client who’s doing what you describe…
In this same situation, but now the husband and wife are losing their group coverage due to the ACA new definition of small groups so they will be purchasing individual insurance. Is this still okay to reimburse via the S-Corp and take the self-employed health insurance deduction?
What if they qualify for a subsidy?
Thanks!
As frustrating an answer as this is, I don’t think anybody knows right now, how you correctly handle the self-employed health insurance deduction for a situation like yours.
I will make this prediction: I think you won’t get both the self-employed health insurance deduction and the subsidy… (BTW, I would happy to be proved wrong on this prediction.)
HI Steve,
Thank you so much for the blog and replies to the questions.
In reference to case #3. It appears the regulations are not final. What if a S-corp has been paying through wages health insurance reimbursements to a shareholder owner and then then shareholder owner pays it’s own health insurance premiums on their own plan. The company is deducting the payroll and the owner is including the payment as wages and then deducts the self employed health insurance deduction on page 1 of 1040. The S-corp does have other employees but doesn’t pay any insurance for them. Will this still be ok? If not is it ok for 2014 since regulations are not final and it has already been done for part of 2014?
Thank you,
Dana
By the way what if the 3 employees are part time but the owners work 40+. Then would it be ok since the employees do not qualify as full time?
I would think you’re on safer ground in this case… again though it’d sure be nice if small businesses had a full complement of regulations and rules from IRS to spell out how all this works.
If you can’t do what you ask about in your comment, the ACA effectively eliminated the self-employed health insurance deduction for many S corporations.
I don’t think Congress intended that… But it appears the ACA produced consequences Congress didn’t quite anticipate.
I would guess you can do what you ask about… I don’t think Congress intended with the ACA to eliminate the self-employed health insurance deduction. But I would sure like some clarification from the IRS on this.
As for Case #3 Covered and Uncovered employees, let’s say a S-corp has 2 employees, one is a shareholder and the other one is a non-shareholder.
If the shareholder is a full-time employee and the non-shareholder is just a part time employee, is it considered a ‘discrimination’ if the company health policy only covers the shareholder employee full time employee?
The reason that the non-shareholder employee is not covered is because he is a part time-employee, not because he is a non-shareholder.
You should be okay in this case. Not covering an employee the ACA doesn’t require the employer to cover is not discrimination.
Thanks for your attention to so many unique circumstances. I share in James’ situation in that my husband and I are owners of an s-corp (making us essentially one owner) and we only have one other employee who works 20 hrs./week. Your answer is encouraging, but is there somewhere in writing that I can be absolutely sure that we will not be penalized for not covering her? She is covered by her parents’ insurance and does not want ours. We would like to do and HRA option, but we do not want to break any laws.
Yeah, sorry, something in writing would be great. Unfortunately, for reasons I won’t speculate on here, the Internal Revenue Service has not provided the written mechanical guidance (in the form of Regulations and similar pronouncements) to people in a timely manner… which is what accountants and taxpayers need in order to effectively plan for the new law.
My husband has an S Corp where he is 100% shareholder. No employees. We pay our family’s health insurance (not currently through the company). Can he deduct our entire family’s health insurance (his, mine and our two children) or just his? I am not a employee of the company. Thank you.
Yes you can. But you need to do the accounting right. Say your husband earns $40,000 as a shareholder-employee in the S corp and that your family’s health insurance equals $10,000 a year.
What you need to do in this case is have S corp directly pay the health insurance… or reimburse the employee for the health insurance.
Then, you add the health insurance to the W-2 (but only in box 1)… so Box 1 of his W-2 shows $50,000.
At this point, your S corp has deducted the health insurance as wages… but shows the health insurance as income in box 1 on the W-2 (so it’s subject to income taxes). Note that Boxes 3 and 5 (which show the income subject to Social Security and Medicare) still show $40,000 in this example though. This is right because the health insurance isn’t subject to Social Security or Medicare taxes.
Then on your husband’s 1040, you take the $10,000 of health insurance that was included in your husband’s W-2 Box 1 income and treat it as a self-employed health insurance deduction. This is an adjustment for “adjusted gross income” so you don’t have to itemize or anything to get it.
You may be able to go back and fix incorrect accounting if your S corp did reimburse the health insurance premiums but you didn’t do the accounting right…
A friendly tip: You may want to figure out if this has been a recurring error in your tax return *why* the current preparation process didn’t do this correctly. You’ve very possibly left thousands of dollars of tax savings on the table.
Steve. Your creation here is great. Thanks.
So it sounds from reading all of your replies here regarding part-time employees, that they CAN be discrimated against regarding health insurance under the ACA stuff.
I have 2 brothers who are 50/50 owners of their S Corp. They have individual health insurance policies. The corporation pays the premiums, and we do the W-2 Box 1, SEHI Box 14 routine so they can deduct th premiums on the front of their Forms 1040.
They have part-time employees.
First question is, of course, can the part-time employees be discriminated against, and can you direct me where in the ACA it refers to this?
Second question is, if there were no non-shareholder employees, under ACA, or even before, are the brothers okay with the corporation paying their individual policies and doing the W-2 mechanism and getting the front page 1040 deduction?
Or in other words, if there is more than 1 shareholder/employee, is the corporation required under ACA, or before, to have a group plan in order to get the SEHI deduction?
Hi Robert,
Somewhat ironically, when I went to grab the text of the affordable care act pdf from the Democrat’s Senate.gov website, the website was down and would not provide the law. So I’m not going to answer your first question with a cite… but not covering employees the act doesn’t require an employer to cover shouldn’t be discrimination.
To answer the second question about whether or not an S corp needs a group plan to get the SEHI deduction, the answer is no… you don’t need that. You should be able to do the whole Box 14 deal… Note however that I’m not sure we’ve got good guidance from IRS about how to handle the self-employed health insurance amouunts inside Box 3 and Box 5 of the W-2.