The Ugly Rule for S Corporation Owners: Unlock the Secrets to Maximizing Your Health Insurance Deductions!

An ugly rule applies to how S corporation owners deduct the cost of health insurance that a corporation puts on its W-2s.

The words that make this an ugly rule are “earned income,” and this is unusual because you generally think of earned income as a good thing.

But for the S corporation owner who hopes to deduct his or her health insurance as a self-employed health insurance deduction on Schedule 1 of the ownerʼs personal Form 1040, the term “earned income” can create ugly results (hence the “ugly rule”).

Applying the Ugly Rule

As you likely know from our prior articles, the S corporation deducts as W-2 wages the cost of health insurance it pays or reimburses to the more-than-2-percent shareholder.

On the shareholderʼs W-2, the cost of the health insurance adds to the wage amount in box 1 of the W-2 but not to the wages reported in box 3 or box 5.

The Form 1040 instructions (which are incorrect, or misleading at best) for how the more-than-2-percent shareholder deducts the health insurance premiums state:

You can deduct the premiums only if the S corporation reports the premiums paid or reimbursed as wages in box 1 of your Form W-2 . . . and you also report the premium payments or reimbursements as wages on Form 1040 or 1040-SR, line 1a.

If you quit reading the Form 1040 instructions at this point, which could be a logical stopping point, you could easily conclude that box 1 wages control the deduction.

But no, that would be wrong. It would be too logical!

On the next page of the instructions, you find a footnote in the “Self-Employed Health Insurance Deduction Worksheet” that states:

If you were a more-than-2-percent shareholder in the S corporation under which the insurance plan is established, earned income is your Medicare wages (box 5 of Form W-2) from that corporation.

What happened? The ugly rule makes Medicare wages the “earned income.”


Example 1: Ted is the sole owner of his S corporation. The corporation reimburses Ted $18,000 for his family health insurance plan, putting the $18,000 as wages in box 1 of the W-2 and $0 in box 5 for Medicare wages.

The $18,000 is Tedʼs sole compensation from the S corporation for the year.

Tedʼs Form 1040 tax deduction for his self-employed health insurance is zero.

Why zero? His earned income for the health insurance deduction is zero—equal to his Medicare wages.

Key Point: This problem can exist when someone starts a new S corporation and does not take a salary the first year, but does have the corporation pick up the tab for the shareholderʼs health insurance.


Example 2: Janet is the sole owner of her S corporation. The corporation pays her a salary of $107,000 and reimburses her $22,000 for her individually purchased family health insurance.

The S corporation puts $129,000 ($107,000 + $22,000) in box 1 as wages and $107,000 in box 5 as wages subject to Medicare taxes.

Janetʼs Form 1040 tax deduction for her self-employed health insurance is $22,000.

Why $22,000? Her earned income of $107,000 exceeds the $22,000 of insurance costs.

Reasonable Compensation: Janetʼs reasonable compensation is $129,000 (wages plus the cost of the health insurance).

Key Point: If you operate your business as an S corporation and want your full self-employed health insurance deduction, you need S corporation Medicare wages in box 5 equal to or greater than what the S corporation paid or reimbursed you for your health insurance.


Example 3: Kenʼs S corporation suffered a downturn in business, which created a $180,000 loss for the year. Because the business had a bad year, Ken did not take a salary, but the S corporation reimbursed his health insurance.

Too bad for Ken! He gets zero as a self-employed health insurance deduction, and depending on his circumstances, he could pay taxes on the dollar amount of the health insurance that landed in box 1 of his Form 1040.


Example 4: Avaʼs S corporation had $790,000 in net income, paid Ava $80,000 in salary, and paid $20,000 for her family health insurance.

The S corporation reports on Avaʼs K-1 $690,000 of net income ($790,000 – $80,000 – $20,000). Her W-2 shows $100,000 as wages in box 1 and $80,000 in box 5.

Because Avaʼs box 5 wages of $80,000 are greater than the $20,000 of health insurance, Ava deducts her $20,000 of health insurance as a self-employed health deduction on line 17 of Schedule 1 of her Form 1040.

Reasonable Compensation: Avaʼs reasonable compensation is $100,000.


Takeaways

The tax code definition of the box 5 Medicare wages as earned income for the more-than-2-percent S corporation shareholder creates trouble for the shareholder who has little or no Medicare wages in box 5 of his or her W-2.

And this problem can exist when someone starts a new S corporation and does not take a salary the first year, but does have the corporation pick up the tab for the shareholderʼs health insurance.

If you operate your business as an S corporation and want your full self-employed health insurance deduction, you need S corporation Medicare wages in box 5 equal to or greater than what the S corporation paid or reimbursed you for your health insurance.


Navigating the world of self-employed health insurance deductions as an S corporation owner can be complex and full of pitfalls. The “ugly rule” of relying on Medicare wages as earned income creates challenges for shareholders who may find themselves with limited or no deduction for their health insurance premiums.

Understanding the nuances of this rule is crucial if you want to maximize your self-employed health insurance deduction.

At Morris + D’Angelo, we specialize in providing expert financial guidance and assistance to business owners like you. If you have questions or concerns about how you might navigate the complexities of self-employed health insurance deductions, ensuring you make the most of the available deductions while staying compliant with the tax regulations, our expert team is here to help.

Don’t let complex tax laws hold you back – contact us at Morris + D’Angelo to learn how we can support your financial success! This is our Expertise!


Parts of this article are published with permission from Bradford Tax Institute, © 2021 Daniel Morris, Morris + D’Angelo


Daniel Morris
Daniel frequently provides Media Content via Workshops, Podcasts, and Printed Articles on topics like Bitcoin and Cryptocurrency, Wealth Preservation and Planning, Global Banking, and many other high-level financial topics that serve and demonstrate the Value of our Global Network that should be of interest to those who need Private High-Wealth Services.

If you would like Daniel to speak to you or your Professional Group and bring clarity about the new frontier of the new business tax law changes. Please contact us.

Morris+D’Angelo is the industry leader for many High-Wealth Customers and Organizations.

Daniel Morris, Managing Director, Chief Dragon Slayer707 SW Washington St., Suite 1100
Portland, Oregon, 97205

503.749.6300 – Portland Office
408.292.2892 – San Jose Office

Daniel Morris, Dan Morris, CPA, Portland Oregon, Dragon Slayer


No Replies to "The Ugly Rule for S Corporation Owners: Unlock the Secrets to Maximizing Your Health Insurance Deductions!"


    Got something to say?

    Some html is OK

    This site uses Akismet to reduce spam. Learn how your comment data is processed.