2% Shareholder Fringe Benefits: Tax Rules

An S corporation provides a structure that blends the liability protection of a corporation with the pass-through taxation of a partnership. This means the company’s profits and losses are passed directly to the shareholders’ personal tax returns, avoiding corporate-level taxes. As part of their compensation, employees, including shareholders, often receive fringe benefits, which are non-cash forms of pay for services.

For individuals who work for and own a significant portion of their S corporation, specific tax rules can alter the tax-free nature of many common fringe benefits. These regulations are designed to treat shareholder-employees similarly to partners in a partnership for fringe benefit purposes. The tax treatment for many benefits hinges on whether the individual is classified as a 2% shareholder.

Determining 2% Shareholder Status

An individual is considered a 2% shareholder if they own more than two percent of the S corporation’s outstanding stock or stock with more than two percent of the total combined voting power on any day of the year. This status triggers a different set of tax rules for many fringe benefits that are tax-free to other employees. The determination is not limited to the shares an individual owns directly.

The tax code employs attribution rules, which treat stock owned by certain family members as being owned by the shareholder. For these purposes, an individual is considered to own the stock held by their spouse, children, grandchildren, and parents. This means a person who directly owns only 1% of the stock would be a 2% shareholder if their spouse owns another 1.1% or more.

For example, if a shareholder-employee owns 1.5% of the S corporation’s stock and their child owns 1%, the shareholder-employee is treated as owning 2.5%. This makes them a 2% shareholder. Similarly, if an individual owns no stock but their spouse owns 100%, the individual is treated as a 100% owner and is subject to the 2% shareholder rules if they are also an employee.

Tax Treatment of Health and Accident Insurance Premiums

For a 2% shareholder-employee, health, dental, and accident insurance premiums paid by the S corporation are not a tax-free benefit. The S corporation must include the full cost of the premiums paid on behalf of the shareholder as part of their wages. This amount is subject to federal and state income tax.

While these premium amounts are considered wages for income tax purposes, they are exempt from Social Security and Medicare (FICA) and Federal Unemployment (FUTA) taxes. This exemption applies as long as the insurance is a corporate plan that provides coverage for other employees or is established by the corporation. This prevents the shareholder and the corporation from incurring payroll taxes on the health benefits.

After the premium amount is included in their W-2 wages, the 2% shareholder may be eligible to take a deduction for the full amount on their personal tax return. This is known as the self-employed health insurance deduction. This “above-the-line” deduction reduces the shareholder’s adjusted gross income (AGI), making the health insurance premiums tax-neutral for income tax purposes.

The policy can be in the name of either the S corporation or the shareholder. If the shareholder pays the premiums directly and is reimbursed by the corporation, the reimbursement is still added to their W-2 wages. The corporation must either pay or reimburse the cost and report it as wages for the shareholder to be eligible for the personal deduction.

Taxability of Other Common Fringe Benefits

Beyond health insurance, the tax-free status of several other common fringe benefits is reversed for a 2% shareholder. These benefits become taxable wages:

• The exclusion for the first $50,000 of group-term life insurance coverage does not apply. The entire premium paid by the corporation for the shareholder’s coverage must be included in their taxable wages and is subject to FICA taxes.
• Employer contributions to a Health Savings Account (HSA) are included in the shareholder’s gross income. The shareholder may then be able to deduct the contribution on their personal return, but the initial corporate payment is considered taxable compensation.
• Disability insurance premiums paid by the S corporation are treated as taxable wages. A consequence of this treatment is that if the shareholder later receives disability benefits from the policy, those benefits are received tax-free because the premiums were paid with after-tax dollars.
• Dependent care assistance programs are fully taxable to a 2% shareholder. Likewise, the value of any personal use of a company-provided car is considered taxable compensation.

Allowable Tax-Free Fringe Benefits

Despite the numerous benefits that become taxable, several important fringe benefits remain tax-free for 2% shareholders, just as they are for other employees. Understanding which benefits retain their tax-free status is important when structuring a compliant and effective compensation package.

The following benefits can be provided tax-free:

• Working condition benefits, which qualify if the employee could have deducted the cost as a business expense had they paid for it themselves. Examples include dues for professional organizations or the business-use portion of a company-provided cell phone.
• De minimis benefits, which are items of minimal value provided so infrequently that accounting for them is impractical. Examples include occasional personal use of a company copy machine or holiday gifts with a low fair market value.
• Educational assistance programs that pay for an employee’s education expenses, up to the annual exclusion limit of $5,250.
• S corporation contributions to qualified retirement plans, such as a 401(k) or a SEP IRA. These follow the general guidelines applicable to all participating employees.

Corporate and Shareholder Reporting Procedures

The proper reporting of taxable fringe benefits involves both the S corporation and the shareholder-employee. The corporation is responsible for calculating the value of the taxable benefits and including that amount in Box 1 of the shareholder’s Form W-2, “Wages, tips, other compensation.”

For informational purposes, many corporations also list the specific amount of the fringe benefit, such as health insurance premiums, in Box 14, “Other,” on the Form W-2. It is the S corporation’s responsibility to ensure these amounts are included in Box 1, as failure to do so can result in the corporation losing its deduction for the expense.

On the shareholder’s side, the total wage amount from Box 1 of the W-2 is reported on their personal tax return, Form 1040. For health and accident insurance premiums included in wages, the shareholder can then claim the self-employed health insurance deduction on Schedule 1 of Form 1040.

This deduction directly reduces the shareholder’s adjusted gross income, which lowers their overall tax liability. Other taxable fringe benefits, such as group-term life insurance or dependent care assistance, do not have a corresponding deduction and remain part of the total taxable wage income.