Fringe benefits are usually a good thing—but there’s a catch when you own more than 2 percent of an S corporation. The good news? Federal tax law allows the cost of these fringes as deductible expenses for your S corporation. The bad news? You, the shareholder-employee who owns more than 2 percent, may suffer additional taxes on some of the benefits because the tax code requires your corporation to put selected benefits on your W-2 (sometimes favorable, sometimes not).
Here’s the ugly rule that causes this problem. Under the federal income and employment tax rules for the most popular fringe benefits, tax law treats the more than 2 percent shareholder-employee of an S corporation as a partner. And—we know you are just waiting for this—more bad news: related-party stock attribution rules apply to the S corporation. Under these rules, tax law says that your spouse, parents, children, and grandchildren own the same stock you own—and if you employ them in your S corporation, their fringe benefits suffer the same ugly fate as your fringe benefits.
In this article, we are going to explain the following:
- Four fringe benefits that are (a) deductible by your S corporation, (b) taxable to you as a shareholder who owns more than 2 percent, and then (c) deductible by you on your personal tax return. You can see that navigating this maze is a little crazy, and you have to do it right to make it work—which, of course, we explain how to do.
- Six stinky fringe benefits. These benefits are stinky because, first, you get nothing from them because you are a shareholder-employee who owns more than 2 percent and, worse, you pay extra taxes because the “non-benefit to you” goes on your W-2 subject to FICA.
- Three maybe (but maybe not) fringe benefits. This group of S corporation fringe benefits comes with special rules that can disqualify your eligibility for the benefits.
- Four no-problem fringe benefits.
Four Beneficial but Somewhat Crazy Fringe Benefits
The following four fringe benefits work their way through a tax code maze to eventually produce a personal benefit to the shareholder-employee who owns more than 2 percent. For example, for the more than 2 percent shareholder-employee to get any tax benefit whatsoever from health insurance, he or she needs to follow the exact road map you see in No. 1 below.
- Health Insurance
If you are a shareholder-employee who owns more than 2 percent of an S corporation and you want a tax benefit from your health insurance, you need to follow the three-step path that we lay out in Update: 2018 Health Insurance for S Corporation Owners. The three steps are described below:
- Make the S corporation pay for your insurance premiums, either directly or through reimbursement to you.
- Have the S corporation include the health insurance as wages not subject to FICA on your W-2.
- Deduct (as an individual taxpayer) the cost of the premiums, using the self-employed health insurance deduction on page 1 of your Form 1040.
Warning No. 1—No Section 125 plan. You, as a more than 2 percent S corporation shareholder-employee, can destroy the S corporation’s tax-favored Section 125 cafeteria benefit plan. If you participate in the Section 125 plan, you disqualify the plan and make it taxable to yourself and all employee participants.
Warning No. 2—Beware of employees. The S corporation can pay for or reimburse your individual owned insurance because you are a shareholder who owns more than 2 percent. But your S corporation may not pay for or directly reimburse your employees for individually owned health insurance
An S corporation that directly pays for or reimburses employees for employee-arranged health insurance premiums (as opposed to paying premiums for company-arranged group coverage) faces the Affordable Care Act penalty of $100 a day per affected employee per day ($36,500 per employee per year).
- Health Reimbursement Arrangements (HRAs)
As a shareholder-employee who owns more than 2 percent, you don’t gain any extra benefit from a Section 105 plan or other HRA. If the S corporation reimburses the more than 2 percent shareholder-employee using a health reimbursement plan or account, it simply creates W-2 treatment for the shareholder. If health insurance costs are included in the reimbursement, the shareholder treats the health insurance costs included in his or her W-2 as discussed in No. 1 above.
For medical reimbursements other than health insurance that the S corporation reports on the W-2, the shareholder itemizes those deductions on Schedule A of the Form 1040.
- Health Savings Accounts (HSAs)
The S corporation treats contributions to the more than 2 percent shareholder-employee’s health savings account (HSA) as W-2 income exempt from FICA and Medicare, and the shareholder-employee deducts the HSA on his or her Form 1040.
- Disability Insurance
The S corporation treats the premiums paid for an income replacement disability policy on a more than 2 percent shareholder-employee as wages for withholding tax purposes that are exempt from FICA and unemployment taxes. Under this requirement, the more than 2 percent shareholder-employee actually paid the disability premiums personally because of the W-2 treatment, and that means he or she collects the disability income tax-free.
Six Stinky Fringe Benefits
What makes a fringe benefit stinky? The stinky fringe benefit gives your S corporation a tax deduction for the compensation that it includes on your W-2. Effectively, this gives you a zero tax benefit from the stinky fringe benefit. The stinky fringe benefit increases the corporation’s FICA taxes on the compensation it has to add to your W-2 and the stinky fringe benefit increases your personal FICA taxes because of the compensation added to your W-2.
In summary, the stinky fringe benefit is absolutely NO benefit to you, and it increases both your and your corporation’s FICA taxes. That’s really stinky.
Stinky No. 1: Group Term Life Insurance
Your S corporation treats the cost of any company-provided group term life insurance coverage as wages to you SUBJECT TO FICA. You, the shareholder-employee, have no tax code section that allows you to deduct the group term life insurance on your personal tax return.
To see how good or bad the idea of having the group health insurance cover a more than 2 percent shareholder-employee is, you need to compare the cost savings (if any) of the group insurance with the additional FICA taxes paid by both you and your S corporation. For your S corporation’s regular employees, you can provide up to $50,000 of group term life insurance tax-free.
Stinky No. 2: Qualified Moving Expense Reimbursements
For tax years beginning January 1, 2018, and before January 1, 2026, tax reform eliminates both the fringe benefits and tax deductions for moving expenses. This applies both to employees and to shareholder-employees who own more than 2 percent. If your S corporation provides moving expense reimbursements to a more than 2 percent shareholder-employee, the corporation treats the reimbursement as wages subject to FICA. Having your S corporation reimburse you, the more than 2 percent shareholder-employee, for moving expenses was and is a bad idea because both your S corporation and you, the employee, pay FICA taxes on the amounts included on your W-2.
Planning tip. Pay the moving expenses yourself. That way you save the corporation its FICA, which increases the S corporation income that flows through to you. And second, you save yourself the FICA taxes that apply to you, the W-2 employee.
Stinky No. 3: Qualified Transportation Fringe Benefits
Your S corporation has to treat as wages subject to FICA and FUTA any qualified transportation fringe benefits it pays to you, the more than 2 percent shareholder-employee. As you’ve seen, the inclusion of the monies on your W-2 does more than just eliminate the benefit—it makes you and your corporation pay additional FICA taxes. So, forget this fringe benefit for the shareholders who own more than 2 percent.
Instead, and especially if you are the sole owner of the S corporation, follow a strategy that allows your S corporation to deduct your cost of transportation and more without creating wages for you, as detailed in S Corporation? Office in the Home? Learn How to Escape Taxes.
Rank and file. Note that tax reform has made transportation fringe benefits granted to employees a less attractive offering from the employer perspective.
Stinky No. 4: Meals and Lodging
Meals and/or lodging that are provided by the company to a more than 2 percent shareholder-employee for the company’s convenience (for example, because the shareholder-employee must be on the company premises for overnight duty) are treated as wages subject to FICA. The amounts included in the shareholder-employee’s income are not deductible by the shareholder-employee on his or her personal tax return.
Rank and file. The S corporation may provide lodging and meals for the convenience of the employer to employees who are not shareholders who own more than 2 percent.
Stinky No. 5: Qualified Employee Achievement Program
Your S corporation treats the cost of a qualified employee achievement award given to a more than 2 percent shareholder-employee as wages subject to FICA at both the corporate and employee levels. The more than 2 percent shareholder-employee may not deduct the value of an employee achievement award on his or her Form 1040.
Rank and file. The S corporation may deduct the cost of qualified achievement awards given tax-free to employees other than shareholder-employees who own more than 2 percent.
Stinky No. 6: Qualified Adoption Assistance
If your S corporation pays you, the more than 2 percent shareholder-employee, the adoption assistance fringe benefit, the corporation has to put that payment on your W-2 as wages subject to FICA. You may, of course, claim the adoption tax credit allowed by the tax code on your personal tax return (your IRS Form 1040).
Planning tip. Pay the adoption expenses yourself. Don’t let your S corporation pay the monies and then put those monies on your W-2. By paying the monies yourself, you save both the corporation and yourself the FICA taxes.
Rank and file. Your S corporation may establish an adoption assistance fringe benefit that’s tax-free to employees who are not shareholders who own more than 2 percent.
Three Maybe (but Maybe Not) Fringe Benefits
The three fringe benefits in this section face special tax code disallowance rules that often take these benefits away from the S corporation shareholder-employee who owns more than 2 percent.
Maybe No. 1: Qualified Educational Assistance Program
The qualified educational assistance program fails as a qualified program and is not tax favored for ANY employee when more than 5 percent of the benefits are provided to shareholder-employees who own more than 2 percent or their spouses or dependents.
You may, however, be able to provide this benefit to your child if he or she is an employee and certain other conditions are met. For more on this, see Business Tax Deductions with Section 127 Plan for Child’s College.
Rank and file. The qualified educational assistance program is relatively easy to implement when all the benefits are going to employees who are not shareholder-employees who own more than 2 percent of the S corporation.
Maybe No. 2: Qualified Dependent Care Assistance Program
Your S corporation can implement a qualified dependent care assistance program, but if more than 25 percent of benefits paid for dependent care assistance during the year are provided to those who own more than 5 percent, the program fails as a tax-favored program and the benefits are taxable for all participants.
Maybe No. 3: Working Condition Fringe Benefits
Your S corporation’s ability to provide a working condition fringe benefit to all employees—including you, the more than 2 percent shareholder-employee—is found in tax code Section 132(d), which states:
For purposes of this section, the term “working condition fringe” means any property or services provided to an employee of the employer to the extent that, if the employee paid for such property or services, such payment would be allowable as a deduction under section 162 or 167.
Tax reform adds a fly to the ointment because it does not allow miscellaneous itemized deductions (where you claim employee business expenses) for any taxable year beginning after December 31, 2017, and before January 1, 2026. Does this mean that working condition fringe benefits are not deductible by your S corporation during this period because of tax reform? Maybe, but maybe not.
Planning tip. We think you should proceed as if the working condition fringe benefit requirements were unchanged by tax reform. To us, sloppy drafting of the Tax Cuts and Jobs Act inadvertently overlooked IRC Section 132(d) when disallowing employee business expenses, and we expect that oversight to be corrected.
Working condition fringes that your S corporation can provide to you, the more than 2 percent shareholder-employee, and/or your employees include:
- Use of the corporate-owned car for business purposes
- A smartphone, when provided for non-compensatory reasons
- Job-related education
Four No-Problem Fringe Benefits
Your S corporation can provide you, as a shareholder-employee who owns more than 2 percent, and its other employees with the following fringe benefits, which are tax-free to the employees and deductible by the S corporation:
- De minimis fringe benefits. De minimis fringe benefits include occasional use of the company copy machine, holiday and birthday gifts with a low value, occasional parties and picnics for employees and their guests, and occasional tickets to the theater or sporting events.
- No-additional-cost services. No-additional-cost services are excess capacity services, such as airline, bus, or train tickets; hotel rooms; or telephone services provided free, at a reduced price, or through a cash rebate to employees working in those lines of business.
- Qualified employee discounts. This exclusion applies to a price reduction you give your employee on property or services you offer to customers in the ordinary course of the line of business in which the employee performs substantial services. The employee discounts can be up to 20 percent on services and the gross profit percentage on merchandise.
- On-premises athletic facilities. Your S corporation can exclude the value of an employee’s use of an on-premises gym or other athletic facility from the employee’s wages if substantially all use of the facility during the calendar year is by the corporation’s employees, their spouses, and their dependent children.
As you have learned, you need to pay attention when it comes to the fringe benefits that your S corporation is going to offer you, the shareholder-employee who owns more than 2 percent. And of course, you have to pay attention when your S corporation offers fringe benefits to rank-and-file employees, too.
In “Four Beneficial but Somewhat Crazy Fringe Benefits,” you learned that the corporation puts the fringe benefit on your W-2 free of FICA taxes so that you can obtain a tax deduction on your personal income return.
In “Six Stinky Fringe Benefits,” you learned how to make both yourself and your S corporation pay extra FICA taxes on non-benefits to you. You can think of this as shooting yourself in the foot. It’s unnecessary and painful.
In “Three Maybe (but Maybe Not) Fringe Benefits,” you learned how special benefit rules can (and likely do) rob you of both the educational assistance and the dependent care assistance programs. With the working condition fringe benefits, you found a fly in the ointment caused by the recent tax reform—and why we think you can ignore it.
In the final section, you finally got to smile as you learned about the four no-problem fringe benefits that your S corporation can give tax-free to you and all your corporation’s employees. That’s really what a fringe benefit is supposed to be—a tax-free benefit.