How the S Corp Health Insurance Deduction Works

An S corporation provides business owners with certain tax advantages, but the rules for deducting health insurance premiums for owners are distinct. Unlike regular employees who receive health benefits tax-free, shareholder-employees who own more than 2% of the company stock are subject to a special set of regulations. This treatment affects how the corporation handles the expense and how the shareholder reports it on their personal tax return.

Determining Shareholder Eligibility

The special health insurance deduction rules apply to individuals classified as “more-than-2% shareholder-employees.” A person meets this definition if they own more than 2% of the S corporation’s outstanding stock or more than 2% of its total combined voting power. The IRS applies constructive ownership rules under Internal Revenue Code Section 318, which treat stock owned by family members as owned by the shareholder. These attribution rules include ownership by a spouse, children, grandchildren, and parents. For example, if an individual owns 1% of the stock directly, but their spouse owns another 1.5%, the individual is treated as owning 2.5% and qualifies as a more-than-2% shareholder.

For the deduction to be permissible, the premiums must be for a qualifying accident and health insurance plan, such as medical, dental, or long-term care policies. A primary requirement is that the health insurance plan must be established by the S corporation, meaning the benefit originates from the company.

The S Corporation and Shareholder Deduction Process

The S corporation health insurance deduction is a two-part process affecting both corporate and shareholder tax filings. First, the S corporation pays the health insurance premiums, either directly to the provider or by reimbursing the shareholder for a personally-owned policy. The corporation then deducts the full amount of these premiums as employee compensation on its Form 1120-S tax return.

Next, the S corporation must include the total premium amount in the shareholder-employee’s gross wages on their Form W-2. This amount is reported in Box 1 and is subject to federal and state income tax withholding. However, these premium payments are exempt from Social Security, Medicare (FICA), and Federal Unemployment (FUTA) taxes, provided the plan is established for a class of employees. This means the amounts are not included in Box 3 or Box 5 of the W-2.

The shareholder-employee then takes an “above-the-line” deduction for the health insurance premiums on Schedule 1 of their personal Form 1040 tax return. This deduction for self-employed health insurance is intended to cancel out the wage inclusion for income tax purposes. A limitation applies to the shareholder’s deduction: the amount claimed cannot exceed the shareholder’s W-2 wages received from that S corporation for the year.

Plan Establishment Requirements

A compliance step for the S corporation health insurance deduction is ensuring the plan is properly “established by the S corporation.” This requirement legitimizes the premium payments as a business-provided benefit rather than a personal expense. Failure to meet this standard can result in the IRS disallowing the shareholder’s deduction, even if all other reporting steps were followed correctly.

There are two primary methods to satisfy the plan establishment rule. The first approach is for the S corporation to be the legal owner of the health insurance policy. In this scenario, the policy is in the business’s name, and the corporation pays the premiums directly to the insurance carrier.

The second method involves the shareholder purchasing a policy in their own name. For this to qualify, the S corporation must formally reimburse the shareholder for the exact premium costs under a formal company plan. This is accomplished through a written document, such as a corporate resolution or a Section 105 reimbursement plan, which should be adopted before any reimbursements are made.