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.
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.)