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Section 199A W-2 Safe Harbors
By Jason Watson, CPA
Posted Wednesday, November 1, 2023
This is one of the dorky accountant questions… which number on the W-2 do I use? The IRS defined three safe harbors for the use of Section 199 Domestic Production deduction back when that was a thing. Later, in IRS Notice 2018-64 released August 8, 2018, the IRS scratched in the letter A like Hester Prynne and used the same safe harbors for Section 199A. Here are the three W-2 safe harbors-
- Unmodified Box Method– lessor of Box 1 or Box 5.
- Modified Box Method– start with Box 1 and make adjustments for things like sick pay, 401k or 403b, deferral, etc.
- Tracking Method– start with total wages subject to federal income tax withholding and adds Box 12 coded D, E, F, G and S. D and E are the most common… 401k and 403b.
This is all very exciting. Frankly, using Box 5 in 99% of the situations out there will work just fine. Box 5 = Box 1 + Box 12. But wait! There’s more… if you are a greater than 2% shareholder in an S corporation you must add self-employed health insurance (SEHI) premiums and HSA contributions to Box 5 for determining the Section 199A deduction. Huh?
Here is a blurb from IRS Notice 2018-64–
Section 199A(b)(4)(C) provides that W-2 wages shall not include any amount that is not properly included in a return filed with the Social Security Administration (SSA) on or before the 60th day after the due date (including extensions) for such return.
Here is another blurb from IRS Notice 2008-1–
Accident and health insurance premiums paid or furnished by an S corporation on behalf of its 2-percent shareholders in consideration for services rendered are treated for income tax purposes like partnership guaranteed payments under § 707(c) of the Code. Rev. Rul. 91-26, 1991-1 C.B. 184. An S corporation is entitled to deduct the cost of such employee fringe benefits under § 162(a) if the requirements of that section are satisfied (taking into account the rules of § 263). The premium payments are included in wages for income tax withholding purposes on the shareholder-employee’s Form W-2, Wage and Tax Statement, but are not wages subject to Social Security and Medicare taxes if the requirements for exclusion under section 3121(a)(2)(B) are satisfied.
Ok. So what do we have here? A mess, Yes, correct. IRS Notice 2008-1 is stating that self-employed health insurance premiums are considered wages subjected to income tax withholding purposes. IRS Notice 2018-64 states that wages must be included on a return filed with the SSA and by filing a W-2 (W-3 transmittal) this is satisfied.
Further in IRS Notice 2018-64 under the modified box method (see above) states-
W-2 wages under this method are calculated as follows—
(A) Total the amounts in Box 1 of all Forms W-2 filed with SSA by the taxpayer with respect to employees of the taxpayer for employment by the (B) Subtract from the total in paragraph .02(A) of this section amounts included in Box 1 of Forms W-2 that are not wages for Federal income tax withholding purposes, including amounts that are treated as wages for purposes of income tax withholding under section 3402(o) (for example, supplemental unemployment compensation benefits within the meaning of Rev. Rul. 90-72);
There is also similar language in IRS Notice 2005-8 which speaks to Health Savings Accounts (HSA). Therefore, self-employed health insurance (SEHI) and (HSA) amounts are considered wages for Section 199A purposes. Another way to look at this is on Schedule C.
Let’s say you didn’t have an S Corp election on your LLC since the business was new and only earned $30,000 in net income with $10,000 in self-employed health insurance premiums. The premiums would not reduce your net business income and therefore your Section 199A deduction would be 20% of $30,000 or $6,000, but your pay income taxes on $20,000. Same thing here.
Keep in mind that typically most shareholder’s reasonable salary will be much higher than 27.9% such that self-employed health insurance premiums do not affect the calculus. In turn, you will then be limited by net business income for the Section 199A deduction rather than W-2 wages.
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