Many small businesses choose to structure their companies as S-Corporations. S-Corporations have many legal and financial benefits and can be a great option for business shareholders and owners. But there are certain considerations if you are planning to set up a section 105 plan for your S-corp.
Some of the benefits that they offer include limited liability for business owners and shareholders and pass-through taxation. This means that all profits are distributed to owners and taxed on an individual basis according to the individual’s personal income tax bracket.
However, one of the distinct disadvantages of the S-Corporation structure is that it does not allow shareholders or owners of the business with an ownership percentage of 2% or more to receive the tax-free benefits of Section 105 plans.
Under current tax law, spouses and children of a shareholder with an ownership percentage larger than 2% are also treated as shareholders, even if they do not participate in the business at all.
Section 105 S-Corporation: Rules
Owners and their families are still eligible to set up a Section 105 plan even if the business is structured as an S-Corporation. The cost of their premiums will be passed through as taxable wages on Form 1120S. They can then claim a deduction for the cost of the premiums on page one of their Form 1040. This will allow them to reclaim any federal and state tax dollars that were paid on monies that were used for health insurance premiums.
However, they are still subject to FICA taxes of 15.3% – to a maximum of $16,479.60 – in 2019. It should also be noted that the deduction for the health insurance premiums and out of pocket expenses on Form 1040 cannot exceed the amount of earned income derived by the taxpayer from the business.
To avoid federal and state taxation on the payment of health insurance premiums, the business must pay the premiums for the plan directly, unless there is only one sole shareholder with a greater than 2% ownership in the company.
If there are multiple shareholder that pay for their premiums directly and do not receive any reimbursement from the business, then the shareholders can only claim the premiums as a medical expense deduction if they exceed 10% of the shareholder’s adjusted gross income.
In addition, considerations on reimbursement of health care premiums should be made considering the Affordable Care Act (ACA) of 2014. The ACA introduced a ban on employers for reimbursing employees for individual health insurance premiums.
However, there is some confusion on the reimbursement of multiple shareholders with a greater than 2% ownership in S-corporations and on how the ban impacts the reimbursement of policies for owners’ spouses.
Current guidance suggests taking a conservative view – ensure that the health insurance plan is purchased through the company, under the company’s name and premiums are paid directly by the company.
The ban also introduced penalties of $100 per day for employees that are reimbursed for health insurance plans that are not directly paid for by the company. In short, it is best to ensure that health insurance premiums are paid directly by the company to avoid any confusion or non-compliance issues.
Let’s Look at a Medical Reimbursement Example
S-Corporations have the least favorable conditions for electing a Section 105 plan for medical reimbursement of all of the company structures. If the shareholders of the S-corporations own more than 2% of the company, they are unable to participate in the tax-free benefits of the Section 105 plan.
Spouses and children of majority shareholders in an S-corporation are business owners in the eyes of the law, regardless of whether they participate in the affairs of the business at all. However, electing a Section 105 plan can be beneficial to S-Corporations who have employees who are not relatives.
Having such a plan can reduce taxable income to the business and increase employee morale and retention rates. Let’s consider an example business called Smart S-Corp that has forty-nine regular full-time employees. Smart S-Corp’s owner chooses to enact a QSEHRA for the employees, all of which have families and choose to accept the contribution.
Smart S-Corp is generous and grants a full $10,450 contribution to each employee, which they can use to purchase their own qualified medical insurance plans and pay for physician co-pays and prescription medications. The plan is enacted to begin on January 1, 2019.
Each employee chooses a plan that fits their needs and faithfully submits their receipts for reimbursement to the plan administrator. At the end of the taxable year, each employee has used their full contribution allowance.
At Smart S-Corp, each employee works forty hours per week and earns a wage of $15 per hour. Total earnings before deductions for the company is $3,000,000. Using this information, we can calculate the savings the Section 105 plan generates below:
- $3,000,000 earnings
- ($1,528,800) employee salaries
- ($512,050) QSEHRA contributions
- $959,150 total taxable income
This income is carried over to Smart S-Corp’s only shareholder and appears on their 1040. The total self-employment tax that the owner must pay under married filing jointly status is $26,656. They fall into the 37% income tax bracket, so their tax expense is $354,886, plus the $26,656 self-employment tax for a total of $381,542.
Now, if Smart S-Corp had decided to be stingy and not elect the QSEHRA plan, their total taxable income would be $1,471,200, as calculated below:
- $3,000,000 earnings
- ($1,528,800) employee salaries
- $1,471,200 total taxable income
S-Corp Plan Taxation
This income is carried over to Smart S-Corp’s only shareholder and appears on their 1040. The total self-employment tax that the owner must pay under married filing jointly status is $37,660. They fall into the 37% income tax bracket, so their tax expense is $544,344, plus the $37,660 self-employment tax for a total of $582,004.
By electing to participate in the Section 105 medical reimbursement plan, they save $200,462 in tax expense – 40% of the cost of the plan contributions. Their income after taxes does drop by $311,588 if they choose to participate in the Section 105 plan, but they can examine other ways to save on taxes or increase revenues with their CPA. They will also improve employee morale and retention rates throughout the company.