Understanding Fringe Benefits for S-Corp Shareholders

Navigating fringe benefits in an S corporation can feel like a minefield, especially for anyone who owns more than 2% of the company. A 2% owner includes you, your spouse, children, grandchildren, and parents. The tax treatment for these benefits is different for significant shareholders than for regular employees, but when done right, you can still reap many of the benefits.

The special rule for 2% owners

While an S corporation is a business entity, the IRS treats 2% shareholders more like self-employed partners for many fringe benefits. This means that some benefits that are tax-free for ordinary employees become taxable income for you.

The good news is that this doesn't mean you miss out entirely. You just have to follow a specific process to get the tax deduction on your personal tax return.

What happens with your health insurance?

This is one of the most important and common fringe benefits affected by the 2% rule. For a typical employee, health insurance premiums paid by the company are a tax-free benefit. But for you, as a 2% owner, it's a different story.

Here's the step-by-step breakdown:

The S-Corp pays the premiums. Your company can pay for your health, dental, or vision insurance premiums directly or reimburse you for them.
The S-Corp adds it to your W-2. The amount of the premium payment is included in your wages in Box 1 of your W-2. This makes the premiums subject to federal and state income tax withholding.
It avoids some taxes. The premiums are not subject to Social Security, Medicare (FICA), or federal unemployment (FUTA) taxes. This is a key tax advantage.
You get a personal deduction. When you file your personal tax return (Form 1040), you can take an "above-the-line" deduction for the amount of the health insurance premiums. This deduction lowers your adjusted gross income (AGI), which is a significant tax benefit.

Important caveat: You and your spouse cannot be eligible for a subsidized employer health plan elsewhere to claim the personal deduction.

What about other fringe benefits?

The 2% owner rule impacts more than just health insurance. Here's a look at how other common fringe benefits are affected:

Generally Taxable for 2% Owners:

Group-term life insurance: The cost of group-term life insurance is taxable to 2% owners, even the first $50,000 of coverage that is tax-free for regular employees.
Meals and lodging: The value of meals and lodging provided by the company is generally taxable to a 2% owner.
Cell phone use: For most employees, a company-provided cell phone is a tax-free "working condition" fringe benefit if it's primarily used for business. For a 2% S-corp owner, however, the rules are different.
- Business use: Any portion of your cell phone bill that is strictly for business purposes can be considered a working condition fringe benefit and is tax-free.
- Personal use: The value of your personal use of the company-provided cell phone is considered a taxable benefit and must be included in your W-2 wages. This can be a headache to track and calculate, but it's important to get it right.
Internet access: The rules for internet access are similar to those for cell phones.
- Business use: If you use your home internet for your S-corp business, the portion of your internet bill that is for business use is generally a tax-free working condition fringe benefit.
- Personal use: Any portion of the internet access used for personal reasons is a taxable benefit and should be included in your W-2. Again, accurate record-keeping of business vs. personal use is essential.

Generally Tax-Free for 2% Owners:

Working condition fringe benefits: Think company vehicles used for business, or other work-related equipment.
De minimis fringe benefits: Small, infrequent items like holiday gifts, occasional snacks, or company picnic costs.
Qualified employee discounts: Discounts on goods or services offered by the S-Corp.
Retirement plan contributions: Contributions to qualified retirement plans, like a 401(k), are generally not subject to these special 2% rules.

What if you get it wrong?

Incorrectly reporting fringe benefits can cause headaches down the road. Common mistakes include forgetting to add health insurance premiums to your W-2 or including them in the wrong boxes. The IRS could disallow your deduction and impose penalties. Your best bet is to work with an accountant or payroll professional to ensure you're handling the reporting correctly.

Keep meticulous records: Always track your business versus personal use of assets like cell phones, internet, and vehicles.

By understanding and following these special rules, you can effectively manage your tax obligations and maximize the value of your benefits as an S-Corp owner.

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