How to Report Employee Benefit Programs on Form 1120-S
Understand how shareholder status in an S corp recharacterizes employee benefits and the specific steps required for correct tax reporting and deductions.
An S corporation provides business owners with the benefits of a corporation while being taxed as a pass-through entity, where profits and losses are passed directly to the owners’ personal tax returns. This structure avoids the double taxation common with C corporations. However, this advantage introduces specific rules for how employee benefits are handled for shareholders who are also employees, requiring careful reporting on the corporation’s tax return, Form 1120-S.
The More-Than-2% Shareholder Rule
S corporation benefit taxation is governed by the “more-than-2% shareholder” rule. A person falls into this category if they own more than two percent of the corporation’s stock or voting power on any day of the tax year. The tax code applies attribution rules, meaning an individual is considered to own stock held by their spouse, children, grandchildren, and parents. If these family members are employed by the S corporation, they are also subject to the same benefit limitations.
The primary consequence of being a more-than-2% shareholder is that many fringe benefits, which are typically tax-free to other employees, become taxable income. For fringe benefit purposes, the IRS treats these shareholders similarly to how partners are treated in a partnership. This means the value of certain company-provided benefits must be included in the shareholder’s gross wages. The corporation can still deduct the cost of these benefits.
Tax Treatment of Specific Fringe Benefits
The rules for more-than-2% shareholders impact how common fringe benefits are taxed, with health and accident insurance being a primary example. The S corporation pays the health insurance premiums and deducts the full cost as a business expense. The premium amount must then be included in the shareholder-employee’s taxable wages on their Form W-2.
This inclusion in wages allows the shareholder-employee to claim the self-employed health insurance deduction on their personal tax return. This deduction is taken on Schedule 1 of Form 1040, which reduces the shareholder’s adjusted gross income (AGI). To qualify, the insurance plan must be established by the S corporation, and the shareholder cannot be eligible to participate in another employer-subsidized health plan.
Other benefits receive varied tax treatment. Contributions made by the S corporation to a Health Savings Account (HSA) for a more-than-2% shareholder are also considered taxable income and must be included in their W-2 wages. Employer-paid disability insurance premiums must also be included in the shareholder’s W-2 wages for income tax purposes. However, these premiums are not subject to Social Security and Medicare (FICA) taxes. Because the shareholder pays income tax on the premiums, any disability benefits received are generally tax-free. For group-term life insurance, the entire premium paid by the corporation is included in their taxable income and is subject to FICA taxes.
Retirement Plan Considerations
Retirement plans operate under a different set of rules than the fringe benefits previously discussed. More-than-2% shareholders are permitted to participate in qualified retirement plans sponsored by the S corporation, such as a 401(k) or a SIMPLE IRA. Contributions made by the corporation to these plans for a shareholder-employee are generally not treated as taxable wages. This allows the corporation a deduction and the shareholder to benefit from tax-deferred retirement savings.
However, contributions must be based on the shareholder’s W-2 compensation, not on profit distributions they receive from the corporation. Shareholder distributions are investment returns, not earned income, and cannot be used to fund a retirement plan. A distinct restriction for S corporation owners involves plan loans. Loans to a more-than-2% shareholder are considered prohibited transactions, which can result in significant excise taxes.
Reporting Requirements for Shareholder Benefits
The S corporation must include the cost of taxable fringe benefits in the shareholder-employee’s wages on Form W-2. The specific tax treatment dictates how they are reported.
For benefits like health insurance, HSA contributions, and disability insurance, the cost is added to Box 1 (Wages, tips, other compensation). These amounts are subject to income tax withholding but are exempt from Social Security and Medicare (FICA) and Federal Unemployment (FUTA) taxes. Therefore, they should not be included in Box 3 or Box 5.
The cost of group-term life insurance, for example, is subject to FICA taxes and must be included in Boxes 1, 3, and 5. For informational purposes, many companies also list the value of various benefits in Box 14 (Other). The corporation then deducts the total amount as compensation on its Form 1120-S.
On the personal side, the shareholder-employee reports the total wages from Box 1 of their W-2 on their Form 1040. To offset the income inclusion from the health insurance premiums, the shareholder can claim the self-employed health insurance deduction. This is done by reporting the premium amount on Schedule 1 (Form 1040), Additional Income and Adjustments to Income. This ensures the shareholder receives the deduction without having to itemize, ultimately reducing their AGI and overall tax liability, provided all eligibility requirements are met.