Updated: ACA’s Thorny Impact On More-Than-2% S Corporation Shareholders

November 10, 2014 | Kristy S. Maitre and Kristine A. Tidgren

Note: This article has been superseded by information contained in Notice 2015-17 issued on February 18, 2015. Please review article update here: https://www.calt.iastate.edu/article/irs-notice-2015-17-provides-some-li...


The issue of reimbursing health care premiums for more-than-2% S corporation shareholders in the wake of the ACA was an issue we addressed briefly during the case studies at our August 22, 2014, Affordable Care Act (ACA) Seminar.  Because this issue has sparked a number of questions, we wanted to follow-up with additional information.

Note:  This area of the law is not well-defined and the IRS has not specifically addressed the issue.  Instead, practitioners have been left to sort out the ACA fallout for these more-than-2% shareholders by reading and applying the relevant statutes and revenue rulings in light of known ACA requirements.  The American Institute of Certified Public Accountants has requested formal guidance on the issue from the IRS.  Until formal guidance is issued, we recommend advising your clients to err on the side of caution.   It is also important to point out that the background law has not changed:

Background Law

To thoroughly analyze this complex issue, a review of the applicable background law is necessary:

Taxation of Fringe Benefits Generally

  • Employer-provided fringe benefits are taxable and must be included in the recipient’s pay unless the law specifically excludes them.
  • Taxable fringe benefits are generally included in an employee’s wages in the year the benefit is received pursuant to IRC §451(a). Taxable fringe benefits are reported as W-2 wages for an employee, or as a Form 1099-MISC payment for an independent contractor.

Exclusion from Income for Employer-Provided Health Benefits Generally

  • Under IRC §105, amounts received as reimbursements by employees under an accident or medical insurance plan, and under §106, employer-provided health benefits (including reimbursement and insurance) are generally excluded from the income of employees.

Included as “Wages” for More-Than-2% Shareholder-Employees of S Corporation

  • Where health insurance premiums are paid by an S corporation, however, IRC §1372(a) requires that the S corporation be treated as a partnership and that any “more-than-2% shareholder-employees” be treated as partners..
  • Thus, health insurance premiums paid by the S corporation would be deductible by the S corporation as compensation to the more-than-2% shareholder-employee and included in the more-than-2% shareholder's Form W-2 as wages.

I.R.C. §162(l) Above-the-Line Deduction

  • IRC §162(l)(5) allows the more-than-2% shareholders the same above-the-line deduction for health insurance costs as self-employed individuals (even though 2% shareholder’s wages are treated as earned income), assuming that all of the other provisions of I.R.C. §162(l) are met. Under I.R.C. §162(l)(2)(B), an above-the-line deduction is not allowed for any calendar month for which the shareholder is eligible to participate in any subsidized health plan maintained by any other employer of the shareholder or the spouse of the shareholder.
  • For the requirements of I.R.C. §162(l)(5) to be met, I.R.C. §1372 (partnership taxation rules detailed above) must apply. In order for I.R.C. §1372 to apply, the S corporation must “establish” a “plan providing medical care coverage.” If the shareholder purchases his or her own health insurance with his or her own funds, a plan has not been “established” by the S corporation, and an I.R.C. §162(l) deduction would not be allowed.
  • In late 2007, the IRS issued Notice 2008-1, which sets forth the criteria for more-than-2% shareholder-employees to qualify for the I.R.C. §162(l)(5) deduction. The Notice provides that a “plan providing medical care coverage” is “established” by the S corporation (and thus allows the shareholder to take the §162(l)(5) deduction) if:
    • The S corporation makes the premium payments for the accident and health insurance policy covering the 2-percent shareholder employee (and his or her spouse or dependents, if applicable) in the current taxable year; or
    • The 2-percent shareholder makes the premium payments and furnishes proof of premium payment to the S corporation and then the S corporation reimburses the 2-percent shareholder-employee for the premium payments in the current taxable year.

Note: If the accident and health insurance premiums are not paid directly by the S corporation or reimbursed to the employee by the S corporation and included in the 2-percent shareholder-employee’s gross income, a plan providing medical care coverage for the 2-percent shareholder-employee is not established by the S corporation and the 2-percent shareholder employee is not allowed the deduction under §162(l).


Although the health insurance premiums paid by an S corporation on behalf of its more-than-2 % shareholder-employees are included as “wages” for income tax purposes, the value of these premiums has long been excluded from “wages” for FICA purposes. IRS Announcement 92-16 clarified that accident and health payments “made under a plan to benefit employees” are exempt from FICA tax, pursuant to I.R.C. §3121(a), which states as follows:

(a) Wages. For purposes of this chapter, the term "wages" means all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash; except that such term shall not include

(2) the amount of any payment (including any amount paid by an employer for insurance or annuities, or into a fund, to provide for any such payment) made to, or on behalf of, an employee or any of his dependents under a plan or system established by an employer which makes provision for his employees generally (or for his employees generally and their dependents) or for a class or classes of his employees (or for a class or classes of his employees and their dependents), on account of—

 (B) medical or hospitalization expenses in connection with sickness or accident disability.

This statute thus exempts from FICA tax liability those payments “made to employees generally” “under a plan or system established by an employer” on account of “medical or hospitalization expenses…” Announcement 92-16 states, “For this exclusion to apply, the payments must be made under a plan or system for employees and their dependents generally or for a class (or classes) of employees and their dependents. Thus, whether amounts of this type are actually subject to social security or Medicare tax depends on whether in the particular case the taxpayer satisfies the requirements for the exclusion.”

ACA Impact

The above background law has not changed. What has changed is the ability of S corporations to reimburse their employees (including more-than-2% shareholder employee) for health insurance premiums used to purchase an individual health insurance policy without running afoul of ACA market reforms. As detailed in the seminar and in this article, employer premium payment plans (used to purchase insurance other than employer-provided group health care insurance) are considered group health plans that violate the market reforms of the ACA, thus subjecting their sponsors to potential fines of up to $100 per day per employee per violation.  That could amount to $36,500 per year per employee per violation.

Note: It is important to remember that if an employer (including an S corporation) has only one participant in a group health plan, ACA market reforms do not apply. Consequently, a single-employee S corporation may continue to reimburse a more-than-2% shareholder-employee for health insurance premiums as before. The amount is included in wages, an above-the-line deduction is allowed to the shareholder, and FICA need not be charged. If the company has more than one shareholder, but only one is reimbursed for insurance, that shareholder’s reimbursement may also be treated the same way.

As was discussed at the seminar, S corporations with more than one employee (and other small businesses) that have traditionally reimbursed their employees on a pre-tax basis for their individual health care premiums must now either (1) eliminate their health benefits entirely or (2) establish group health insurance coverage for their employees.

Note that if the S corporation chooses to offer group health insurance coverage to its employees, the taxation rules for that benefit as applied to more-than-2% shareholders have not changed. The health insurance premiums paid on behalf of more-than-2% S corporation shareholder-employees are deductible and reportable by the S corporation as wages, the payments are included in the shareholder’s wages for income tax purposes, and the benefits are not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes.

But may an S corporation reimburse its S corporation shareholders for health insurance premiums outside of a group health plan? Do the same rules preventing this reimbursement to regular employees apply to S corporation shareholders?

The answer is that we do not know. The Departments have provided no guidance on this issue. We can only set forth what is known at this point (which is ever-changing).

New Department of Labor Q & A Creates New Concern

Although they don't reference S corporations or their more-than-two percent shareholders at all (no guidance on this issue has done so), Department of Labor Q & A's released on November 6, 2014, raise concern that the act of reimbursing more-than-two-percent shareholders (outside of an employer-provided group health insurance arrangement) in the manner required under 2008-1 for a section 162(l) deduction may be viewed by the Department as establishing a group health plan subject to ACA market reforms. The Q & A at issue reads:

Q1: My employer offers employees cash to reimburse the purchase of an individual market policy. Does this arrangement comply with the market reforms?

No. If the employer uses an arrangement that provides cash reimbursement for the purchase of an individual market policy, the employer's payment arrangement is part of a plan, fund, or other arrangement established or maintained for the purpose of providing medical care to employees, without regard to whether the employer treats the money as pre-tax or post-tax to the employee. Therefore, the arrangement is group health plan coverage within the meaning of Code section 9832(a), Employee Retirement Income Security Act (ERISA) section 733(a) and PHS Act section 2791(a), and is subject to the market reform provisions of the Affordable Care Act applicable to group health plans. Such employer health care arrangements cannot be integrated with individual market policies to satisfy the market reforms and, therefore, will violate PHS Act sections 2711 and 2713, among other provisions, which can trigger penalties such as excise taxes under section 4980D of the Code. Under the Departments' prior published guidance, the cash arrangement fails to comply with the market reforms because the cash payment cannot be integrated with an individual market policy.

This Q & A makes clear that the Department is not basing its determination of the existence of an illegal employer payment plan on whether the reimbursement is made on a pre-tax or post-tax basis. What seems to matter to the Department is simply whether the employer is reimbursing the employee under an arrangement that could meet the definition of a "group health plan." I.R.C. §5000(b)(1) (which sets forth the applicable definition under I.R.C. §9932(a)) defines a "group health plan" as:
a plan (including a self-insured plan) of, or contributed to by, an employer (including a self-employed person) or employee organization to provide health care (directly or otherwise) to the employees, former employees, the employer, others associated or formerly associated with the employer in a business relationship, or their families.
Given the breadth of the definition, it is arguable that employer reimbursement of shareholder premiums establishes a group health plan subject to the ACA market reforms. Again, neither the DOL nor IRS has set forth guidance relating to S corporations and their reimbursements of health insurance premiums for more-than-two percent shareholders. Arguments can be made to support the continued reimbursement of premiums to S corporation more-than-two percent shareholders so that they can receive their section 162(l) deduction. Nonethess, the stakes are high. Thus, we believe that the best guidance in the wake of this Q & A is to avoid all employer reimbursements of health care premiums outside of an employer-provided group health care plan, including those to more-than-two percent shareholders, until further guidance is issued by the Departments. This latest communication has affirmed the Administration's clear policy to eliminate such benefits.


Please let us know if you have any follow-up questions regarding this information. It is a thorny issue that will evolve. We will keep you informed of any further communication we receive concerning the issue. As we know, it is of great importance to you and your clients as you move forward to comply with the ACA provisions. We are hopeful that IRS will issue clarifying guidance in the near future.

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Tags: Agricultural Law Tax Affordable Care Act