After more than 20 years of uncertainty regarding how to handle shareholder health insurance rules for S corporations, the IRS recently modified and clarified what arrangements are allowed and how they are to be reported.

Our experience has been that most S corporations haven't been following the previous rules correctly, and because enforcement of the rules was lax, we didn't make much of an issue with how our clients handled it. With the heightened enforcement action recently by the IRS related to S corporations, and the simplicity and clarity of the new rules, it's time to make it right. S corporations, partnerships and self-employed businesses cannot deduct the cost of accident and health insurance as a business expense on their Form 1120S or 1065. It's one of the expenses that must be listed separately and passed through to the owner's return. The confusion has come especially for S corporation shareholders as to how that expense is to be recorded on their tax return, especially when it's not a company sponsored policy.

According to IRS Notice 2008-01 Insurance For Sub S Shareholders, a shareholder, including a 2% and greater shareholder, is entitled to the 100% deduction "above the line," that's on page one of your personal return, if the S corporation is paying the premium for the health insurance or if the S corporation is reimbursing the shareholder/employee for the premiums. The notice provides four examples that illustrate how to handle the deduction:

Example 1: For 2008, shareholder A obtains an accident and health insurance policy in the name of shareholder A and makes the premium payments on the policy. The S corporation makes no payments or reimbursements with respect to the premiums. A plan providing medical care for shareholder A HAS NOT been established by the S corporation and shareholder A IS NOT entitled to the deduction under §162(1).

Example 2: For 2008, the S corporation obtains an accident and health insurance plan in the name of the S corporation. The health plan provides coverage for shareholder B, B's spouse and dependents. The S corporation makes all the premium payments to the insurance company. The S corporation reports the amount of the premiums as wages on shareholder B's Form W-2 for 2008 and shareholder B reports that amount as gross income on Form 1040 for 2008. A plan providing medical care for shareholder B has been established by the S corporation and shareholder B IS allowed the deduction under §162(1) for 2008.

Example 3: For 2008, shareholder C obtains an accident and health insurance policy in the name of shareholder C. The S corporation makes all the premium payments to the insurance company. The S corporation reports the amount of the premiums as wages on shareholder C's Form W-2 for 2008 and shareholder C reports that amount as gross income on Form 1040 for 2008. A plan providing medical care for shareholder C has been established by the S corporation and shareholder C IS allowed the deduction under §162(1) for 2008.

Example 4: For 2008, shareholder D obtains an accident and health insurance policy in the name of shareholder D. Shareholder D makes the premium payments to the insurance company and furnishes proof of premium payment to the S corporation. The S corporation then reimburses shareholder D for the premium payments. The S corporation reports the amount of the premium as wages on shareholder D's Form W-2 for 2008 and shareholder D reports that amount as gross income on Form 1040 for 2008. A plan providing medical care for shareholder D has been established by the S corporation and shareholder D IS allowed the deduction under §162(1) for 2008.

A taxpayer who did not claim deductions for these fringe benefits as described can amend open year returns. The statement "Filed Pursuant to Notice 2008-1" should be written at the top of the amended return.

Fundamentally, the corporation must pay the health insurance premiums, either directly as a company sponsored policy or by reimbursement to the shareholder, during the tax return year to qualify the premium as a self-employed premium deductible by the shareholder. If that's done correctly, then the only allowable way to report that deduction is by adding the premium to the gross W-2 for each shareholder for that year as taxable gross income, but exempt from FICA and Medicare tax. This provides a business deduction to the corporation. To offset the additional income reported by the shareholder, that same premium amount is then shown as a pass-through deduction on the corresponding K-1, which is deducted on page one of the tax return. Not following this procedure could put your deduction for health insurance premiums at risk.

This ruling is important and needs to be followed. The notice encourages filing amended payroll and income tax returns if these procedures haven't been followed in the past. If you need assistance with its implementation, contact your CPA. We don't want any small business to risk losing this material deduction.