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Tax Savings with Health Insurance

Article ID: 268
Last updated: 23 Nov, 2018
Revision: 32
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By Jason Watson ()
Posted November 23, 2018

When your S corporation pays for your self-employed health insurance (SEHI), including coverage for your family, that amount is added to Box 1 Wages on your W-2. So, your income is artificially increased by the annual amount of premiums. However, there are two huge concepts you need to embrace.

First, Box 3 Social Security Wages and Box 5 Medicare Wages do not get increased by the amount of premiums paid. Here is a silly looking, but illustrative W-2.

Box 1 Wages

50,000

Box 2 Federal Tax Withholdings

21,735

Box 3 Social Security Wages

40,000

Box 4 SS Withholdings

2,480

Box 5 Medicare Wages

40,000

Box 6 Medicare Withholdings

580

Box 16 State Wages

50,000

Box 17 State Tax Withholdings

4,347

Don’t get tweaked on the Federal and State tax withholdings. We’ll explain that in a later chapter (spoiler alert- we increase income tax withholdings to help budget for the K-1 income that is combined with your W-2 income on your individual tax return).

Your focus should be on Box 3 and Box 5- these are the boxes that we want to reduce to the best of our abilities and with reasonableness.

Subsequently Box 4 and Box 6 is the calculation of the Social Security and Medicare taxes based on the amounts in Box 3 and Box 5. As you can see, your compensation is $50,000 but only $40,000 is being used to compute Social Security and Medicare taxes. Why is this? Some taxable fringe benefits, such as health care benefits (self-employed health insurance premiums and HSA contributions), is only added to Box 1 Wages, and not Box 3 or Box 5. Boom!

Explained another way; if we all decide that $50,000 is reasonable shareholder salary, and your self-employed health insurance premiums are $10,000, then only $40,000 is ran through payroll. But, the $40,000 and the $10,000 are combined to reflect total shareholder salary.

How does this translate to the corporate tax return? Line 7 of Form 1120S is “Compensation of officers” and the $50,000 in Box 1 above would be entered there (we’ll chat about the effects of solo 401k plan deferrals in a bit). Line 21 of Form 1120S is “Ordinary business income.” Line 7 as compared to Line 21 is one of the ways the IRS will consider a challenge of your S corporation with respect to reasonable shareholder salary (the IRS also looks at your K-1, specifically Box 16 Code D, as compared to your W-2, both connected by your Social Security Number).

Got it? Good. Next concept.

The second concept is that self-employed health insurance (SEHI) premiums are effectively deducted on Line 7 of Form 1120S as Officer Compensation. Therefore the salary paid to the shareholders plus health insurance directly reduces Line 21 on Form 1120S which is your taxable ordinary income generated by the S corporation.

However, your W-2 shows $50,000 in taxable wages and this will appear on Line 7 of your Form 1040. Hmmm… how does that work? We know what you are thinking- you are paying income taxes on the full $50,000 since the W-2 shows $50,000 but you were paid $40,000… where is the tax savings? This concern would be true except that you are considered self-employed as a greater than 2% shareholder, and therefore the health insurance premiums are deducted on Line 29 of your Form 1040 as an adjustment to income. This is a dollar for dollar reduction in your gross income to arrive at your adjusted gross income (AGI) on Lines 37 and 38.

Just to reiterate- the deduction and subsequent tax benefit of self-employed health insurance is done on the corporate tax return. The deduction appears on your individual tax return, but it is a net zero as we’ve illustrated above (we accountants call this an in and out).

Said in another way; salary and health insurance end up as Officer Compensation and are deducted together on the S Corp tax return. This amount appears again on your individual tax return, but you get a “reduction” for the health insurance component. Deduction on business return. Net zero on individual tax return.

If this doesn’t resonate quite yet, don’t worry. However, we have seen this screwed up several times when clients run their own payroll and / or prepare their own individual tax returns. Be aware and know that you should have a Line 29 entry on Form 1040 if you are paying self-employed health insurance premiums. Period.

So, we have an artificial increase in salary by the amount of SEHI and our reasonable shareholder salary testing is improved, but Social Security and Medicare taxes are computed on a lessor amount. Winner winner chicken dinner.

There are more examples of this stuff in a later chapter dedicated to reasonable shareholder salary. Also, the handling of self-employed health insurance in this manner is encouraged by the IRS as outlined in Fact Sheet 2008-25.

Here is the blurb if you can’t get enough-

The health and accident insurance premiums paid on behalf of the greater than 2 percent S corporation shareholder-employee are deductible by the S corporation as fringe benefits and are reportable as wages for income tax withholding purposes on the shareholder-employee’s Form W-2. They are not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes. Therefore, this additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder, but would not be included in Boxes 3 or 5 of Form W-2.

A 2-percent shareholder-employee is eligible for an AGI deduction for amounts paid during the year for medical care premiums if the medical care coverage is established by the S corporation.   Previously, “established by the S corporation” meant that the medical care coverage had to be in the name of the S corporation.

In Notice 2008-1, the IRS stated that if the medical coverage plan is in the name of the 2percent shareholder and not in the name of the S corporation, a medical care plan can be considered to be established by the S corporation if: the S corporation either paid or reimbursed the 2percent shareholder for the premiums and reported the premium payment or reimbursement as wages on the 2percent shareholder’s Form W-2.

Payments of the health and accident insurance premiums on behalf of the shareholder may be further identified in Box 14 (Other) of the Form W-2. Schedule K-1 (Form 1120S) and Form 1099 should not be used as an alternative to the Form W-2 to report this additional compensation.

That was IRS Fact Sheet 2008-25 which can be downloaded here-

www.wcgurl.com/8247

Moving on… Here is a summary of the savings assuming a 40% salary and a $10,000 annual health insurance premium.

40% Reasonable Salary, With Health Insurance
The following table highlights the significant savings when factoring self-employed health insurance into the reasonable salary calculations.

Income

Total
SE Tax

Salary

Total
Payroll Tax

Delta

Delta%

30,000

4,239

2,000

306

3,933

13.1%

50,000

7,065

10,000

1,530

5,535

11.1%

75,000

10,597

20,000

3,060

7,537

10.0%

100,000

14,130

30,000

4,590

9,540

9.5%

150,000

18,711

50,000

7,650

11,061

7.4%

200,000

20,050

70,000

10,710

9,340

4.7%

300,000

22,972

110,000

16,830

6,142

2.0%

500,000

29,991

190,000

20,204

9,787

2.0%

35% Reasonable Salary, Without Health Insurance
As mentioned, the previous illustrations are based on a reasonable salary that was 40% of the business income after expenses. If your reasonable S Corp salary is less than this, your savings increase. For grins, the table below shows the results and subsequent savings using a 35% reasonable salary figure. Check out the $150,000 figure! $10k in savings.

Income

Total
SE Tax

Salary

Total
Payroll Tax

Delta

Delta%

30,000

4,239

10,500

1,607

2,632

8.8%

50,000

7,065

17,500

2,678

4,387

8.8%

75,000

10,597

26,250

4,016

6,581

8.8%

100,000

14,130

35,000

5,355

8,775

8.8%

150,000

18,711

52,500

8,033

10,679

7.1%

200,000

20,050

70,000

10,710

9,340

4.7%

300,000

22,972

105,000

16,065

6,907

2.3%

500,000

29,991

175,000

19,769

10,222

2.0%

The salary calculation part of running an S Corp is one of the biggest challenges, but it also allows for most wiggle room for argument if necessary. Our chapter on S Corp salary will touch on the various tools we use to determine a reasonable shareholder salary including-

  • IRS Revenue Ruling 74-44

  • IRS Fact Sheet 2008-25

  • Tax Court Cases

  • Rules of Thumb (Biz Valuation, 1/3 1/3 1/3)

Here is some initial food for thought from a 2013 Tax Court case-

Sean McAlary Ltd. Inc. v. Commissioner, TC Summary Opinion 2013-62- the IRS hired a valuation expert to determine that a real estate agent should have been paid $100,755 salary out of his S Corp’s net income of $231,454. Not bad. He still took home over $130,000 in K-1 income, and avoided some self-employment taxes. The valuation expert had used Bureau of Labor Statistics data to determine the average salary for real estate agents in the taxpayer’s zip code.

Here is the entire Tax Court summary opinion-

www.wcgurl.com/8244

Please don’t be that guy who extrapolates the previous Tax Court case into something else. BLS data is only one aspect of determining a reasonable salary. As mentioned, there is more on the salary stuff in Chapter 6 and pinning your entire argument on BLS data might leave money on the table.

Until then, consider the following summary which outlines the savings at various income levels and salaries (including one with self-employed health insurance)-

Income

40% Salary
No Health Ins.

40% Salary
$10k Health Ins.

35% Salary
No Health Ins.

30,000

2,403

3,933

2,632

50,000

4,005

5,535

4,387

75,000

6,007

7,537

6,581

100,000

8,010

9,540

8,775

150,000

9,531

11,061

10,679

200,000

7,810

9,340

9,340

300,000

4,798

6,142

6,907

500,000

9,497

9,787

10,222

Good stuff!

Why are we belaboring the heck out of this? In other words, does payroll really need to be dialed in this tightly? Consider that paying a salary which is $10,000 too high will cost you $1,410 in unnecessary payroll taxes. Read that again. If you paid yourself $100,000 when a reasonable salary could have been $80,000, you paid $2,820 too much in payroll taxes. What would you rather spend $2,820 on? Lots!

So, payroll calculations need to be just a bit tighter than bar napkin quality and just a hair below NASA precision.

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Avoiding or Reducing Self-Employment SE Taxes       Officer Compensation with Solo 401k Plan Deferral