A new notice explains when a 2% shareholder-employee in an S corporation is entitled to the Code Sec. 162(l) above-the-line deduction for health insurance premiums that are paid or reimbursed by the S corporation and included in his gross income.

OBSERVATION: Without affirmatively saying so, Notice 2008-1 effectively repudiates guidance appearing in an article on IRS's web site last year.  That guidance had concluded that an S corporation's sole shareholder-employee couldn't buy health insurance in his own name and get the above-the-line deduction for the premium expense. As explained below, if certain requirements are met, such a deduction is now possible and may be gained for a prior year by filing an amended return.

Background. For purposes of applying the income tax provisions relating to employee fringe benefits, an S corporation is treated as a partnership, and any 2% shareholder of an S corporation is treated as a partner of the partnership. (Code Sec. 1372(a)) For this purpose, a “2-percent shareholder” is any person who owns (or is considered as owning under the constructive ownership rules of Code Sec. 318) on any day during the S corporation's tax year more than 2% of the outstanding stock of the corporation or stock possessing more than 2% of the total combined voting power of all stock of such corporation. (Code Sec. 1372(b))

Accident and health insurance premiums paid or furnished by an S corporation on behalf of its 2% shareholders in consideration for services rendered are treated for income tax purposes like partnership guaranteed payments under Code Sec. 707(c). (Rev Rul 91-26, 1991-1 CB 184) An S corporation may deduct the cost of such employee fringe benefits under Code Sec. 162(a) subject to the capitalization rules of Code Sec. 263).

A 2% shareholder is not an employee for purposes of the Code Sec. 106 exclusion for employer-provided health coverage. (Reg. § 1.106-1; Code Sec. 1372(a)) Accordingly, the premiums are not excludible from his gross income under Code Sec. 106.

The premium payments are included in wages for income tax withholding purposes on the shareholder-employee's Form W-2 but are not wages subject to Social Security and Medicare taxes if the requirements for exclusion under Code Sec. 3121(a)(2)(B) are met. (Ann. 92-16, 1992-5 IRB 53) The 2% shareholder is required to include the amount of the health insurance premiums in gross income.

A self-employed individual can deduct as a business expense 100% of the amount paid during the tax year for medical insurance on himself, his spouse and his dependents. (Code Sec. 162(l)(1)) However, no deduction is allowed for a self-employed individual's health insurance costs to the extent that the deduction exceeds his earned income (within the meaning of Code Sec. 401(c), i.e., net earnings from self-employment) derived from the trade or business with respect to which the plan providing the medical care coverage was established. (Code Sec. 162(l)(2)(A))

The deduction isn't available to any taxpayer for any calendar month for which the taxpayer is eligible to participate in any subsidized health plan maintained by any employer of the taxpayer or of the spouse of the taxpayer. (Code Sec. 162(l)(2)(B))

A 2% shareholder-employee in an S corporation, who otherwise meets the requirements of Code Sec. 162(l), is eligible for this deduction if the plan providing medical care coverage for him is established by the S corporation. (Rev Rul 91-26)

Eased position. A plan providing medical care coverage for a 2% shareholder-employee is established by the S corporation if: (1) the corporation makes the premium payments for the health insurance policy covering the 2% shareholder-employee (and his spouse or dependents, if applicable) in the current tax year; or (2) the 2% shareholder makes the premium payments and furnishes proof of payment to the corporation and it then reimburses him. If the health insurance premiums are not paid or reimbursed by the S corporation and included in the 2% shareholder-employee's gross income, a plan providing medical care coverage for the 2% shareholder-employee is not established by the S corporation and he is not allowed the Code Sec. 162(l) deduction.

Thus, under Notice 2008-1, in order for a 2% shareholder-employee to deduct the amount of the health insurance premiums, the S corporation must report the health insurance premiums paid or reimbursed as wages on his Form W-2 in that same year. In addition, the shareholder must report the premium payments or reimbursements as gross income on his Form 1040. Notice 2008-1 illustrates this in four example that are set forth below. The examples assume that each shareholder is a 2% shareholder-employee in an S corporation, whose earned income from the S corporation exceeds the amount of the premiums for the health insurance policies covering the shareholder, his spouse and dependents. No shareholder is eligible to participate in any subsidized health plan maintained by an employer of the shareholder or his spouse. All examples involve tax year 2008.

Illustration 1: Shareholder Andy obtains a health insurance policy in his name and pays the premium on the policy. The S corporation makes no payments or reimbursements with respect to the premiums. Result: A plan providing medical care for Andy is not established by the S corporation and he may not deduct the premiums under Code Sec. 162(l).

Illustration 2: The S corporation obtains a health insurance plan in its name. The plan provides coverage for shareholder Betty, her spouse and dependents. The S corporation pays all premiums and reports them as wages on Betty's Form W-2 for 2008 and she reports them as gross income on Form 1040 for 2008. Result: A plan providing medical care for Betty has been established by the S corporation and she may take the Code Sec. 162(l) deduction for 2008.

Illustration 3: Shareholder Carl obtains a health insurance policy in his name. The S corporation pays all premiums and reports them as wages on shareholder Carl's Form W-2 for 2008. Carl reports them as gross income on his Form 1040 for 2008. Result: A plan providing medical care for Carl has been established by the S corporation and he may take the Code Sec. 162(l) deduction for 2008.

Illustration 4: Shareholder Donna obtains a health insurance policy in her name. She pays the premiums and furnishes proof of payment to the S corporation, which reimburses her for the payments. The S corporation reports the amount of the premium reimbursements as wages on shareholder Donna's Form W-2 for 2008 and she reports them as gross income on Form 1040 for 2008. Result: A plan providing medical care for Donna has been established by the S corporation and she may take the Code Sec. 162(l) deduction for 2008.

Amended returns for prior tax years. A taxpayer who did not claim a deduction for health insurance coverage described in Notice 2008-1 may file a timely amended tax return to claim the Code Sec. 162(l) deduction if he satisfies the notice's requirements. The statement “Filed Pursuant to Notice 2008-1” should be written on the top of the amended return.

Effect on single class of stock requirement. Notice 2008-1 states that IRS does not consider payments of health insurance premiums by an S corporation on behalf of 2% shareholder-employees to be distributions for purposes of the single class of stock requirement of Code Sec. 1361(b)(1)(D).     - Notice 2008-1, 2008-2 IRB