Employee Benefits in an S Corporation: Key Issues Every Company Should Know
Electing S corporation status offers significant tax advantages but introduces complications for employee benefits planning. This post highlights the key benefits issues that arise when a company operates as an S corporation.
The Core Issue: Shareholder-Employees and the "More-Than-2% Shareholder" Rule
Under Internal Revenue Code Section 1372, an S corporation is treated like a partnership for fringe benefit purposes with respect to any employee who is a "more-than-2% shareholder." These individuals are treated more like partners than traditional W-2 employees. Attribution rules under Section 318 apply, so stock owned by a shareholder's spouse, children, grandchildren, and parents counts toward the 2% threshold.
The practical consequence is that many tax-favored fringe benefits become taxable compensation when provided to more-than-2% shareholders.
Health and Accident Plans
For rank-and-file employees, employer-paid health insurance premiums are generally excludable from gross income under Section 106. For more-than-2% shareholders, however, these premiums must be included in W-2 wages. They are subject to federal income tax but not FICA taxes under IRS Notice 2008-1.
The shareholder may claim the self-employed health insurance deduction under Section 162(l), which can offset the income inclusion. This requires coordination between the corporation's payroll reporting and the shareholder’s personal tax filing. Failure to include these premiums on the W-2 is a common compliance error.
Cafeteria Plans Under Section 125
Section 125 cafeteria plans allow employees to pay for certain benefits on a pre-tax basis. More-than-2% shareholders are not eligible to participate because they are treated as partners for fringe benefit purposes.
This restriction extends to health FSAs and dependent care assistance programs. If a more-than-2% shareholder improperly participates, it can jeopardize the plan's tax-qualified status for all participants. Plan documents and enrollment processes must be designed to exclude these individuals.
Health Savings Accounts
A more-than-2% shareholder can establish and contribute to an HSA if covered by a qualifying high-deductible health plan. However, employer contributions cannot be excluded from income under Section 106 and must be included in the shareholder’s W-2.
The shareholder may claim a deduction under Section 223 on the individual tax return, but cannot make HSA contributions on a pre-tax basis through payroll. This requires separate tracking by the S corporation.
Qualified Retirement Plans
Qualified retirement plans, including 401(k)s, profit-sharing plans, and defined benefit plans, generally do not present the same difficulties. More-than-2% shareholders can participate on the same basis as other employees, with the same tax-favored treatment for contributions and deferrals.
However, S corporations must remain attentive to nondiscrimination testing under Sections 401(a)(4) and 410(b), and contribution limits under Sections 415 and 404. In closely held S corporations, plan designs that disproportionately favor shareholder-employees may fail testing. Equity-based retirement arrangements must also be structured to avoid violating the single-class-of-stock requirement under Section 1361(b)(1)(D).
Life Insurance and Disability Benefits
The Section 79 exclusion for group term life insurance up to $50,000 does not apply to more-than-2% shareholders. The cost of all employer-provided coverage must be included in taxable wages.
Similarly, employer-paid disability insurance premiums are not excludable. The tax treatment of benefits received may differ depending on whether premiums were included in income.
Fringe Benefits Under Section 132
Certain Section 132 fringe benefits, such as working condition fringes, de minimis fringes, and qualified transportation benefits, may also be affected. The IRS has not issued comprehensive guidance, but the general principle is that more-than-2% shareholders are subject to partner-like treatment. Companies should evaluate each fringe benefit on a case-by-case basis.
Qualified transportation benefits under Section 132(f) warrant particular attention. Whether more-than-2% shareholders may exclude employer-provided transit passes, parking, or bicycle commuting reimbursements remains uncertain.
The One-Class-of-Stock Rule and Its Benefits Implications
S corporations must also consider whether benefits arrangements could create a second class of stock, which would terminate the S election. Under Treasury Regulations Section 1.1361-1(l), arrangements that confer differing distribution or liquidation rights among shareholders may be treated as creating a second class of stock.
Bona fide employment agreements are generally excepted, but the terms must be comparable to those provided to similarly situated employees of comparable employers. Excessively generous benefits packages or arrangements that function as disguised distributions could put the S election at risk.
Compliance Best Practices
S corporations should ensure that plan documents and payroll systems correctly identify more-than-2% shareholders and exclude them from ineligible programs. Shareholder-employees should be educated about the tax treatment of their benefits and available deductions. Annual audits of plan participation and W-2 reporting are advisable.
Conclusion
The S corporation election carries meaningful consequences for employee benefits planning. The more-than-2% shareholder rules affect health insurance, cafeteria plans, HSAs, life insurance, disability coverage, and fringe benefits. The one-class-of-stock requirement adds a structural constraint. Companies and their advisors should approach benefits planning with a thorough understanding of these issues to avoid tax surprises and safeguard the S election.
Key Takeaways
- More-than-2% shareholders of an S corporation are treated as partners, not common-law employees, for purposes of most fringe benefit exclusions, which fundamentally changes how benefits are taxed for these individuals.
- Health insurance premiums paid by the S corporation for these shareholders must be included in W-2 wages, though the shareholder may offset this inclusion by claiming the self-employed health insurance deduction under Section 162(l).
- More-than-2% shareholders are ineligible to participate in Section 125 cafeteria plans, and improper participation can jeopardize the plan's tax-qualified status for all employees.
- HSA contributions made by the employer on behalf of these shareholders are likewise not excludable from income, though an individual deduction under Section 223 may be available.
- Qualified retirement plans generally treat shareholder-employees the same as other participants, but nondiscrimination testing remains a key concern in closely held S corporations.
- Group term life insurance and disability insurance exclusions do not apply to more-than-2% shareholders, requiring income inclusion of employer-paid premiums.
- Benefits arrangements must also be evaluated against the one-class-of-stock rule to ensure they do not inadvertently terminate the company's S election.
- Proactive compliance measures, including proper plan document drafting, payroll coordination, and annual audits, are essential to avoiding costly errors and IRS scrutiny.
Properly structuring employee benefits in an S corporation requires careful attention to tax and compliance rules. To discuss your company's benefits programs and shareholder compensation arrangements, contact FRB's Employee Benefits & Executive Compensation attorneys at (214) 420-6142 or fill out the form below.
DISCLAIMER: This summary is not legal advice and does not create any attorney-client relationship. This summary does not provide a definitive legal opinion for any factual situation. Before the firm can provide legal advice or opinion to any person or entity, the specific facts at issue must be reviewed by the firm. Before an attorney-client relationship is formed, the firm must have a signed engagement letter with a client setting forth the Firm’s scope and terms of representation. The information contained herein is based upon the law at the time of publication.