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You are here: Home > Taxpayers Guide to LLCs and S Corps > Chap 3 - S Corporation Benefits > Tax Savings with Health Insurance

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  • Taxpayers Guide to LLCs and S Corps

    • Introduction

      • About the Author
      • Progressive Updates
      • Introduction Disclaimer
      • Shameless Self-Promotion
      • Book Introduction
      • Quick Reference 2021
      • Quick Reference 2022
    • Chap 1 - Business Entities, LLCs

      • Basic Business Entities
      • Sole Proprietorship
      • Single Member Limited Liability Company
      • Multi-Member Limited Liability Company
      • Partnerships
      • C Corporations
      • Professional Corporations and LLCs
      • S Corporations
      • Section 199A Qualified Business Income Tax Deduction
      • S Corp Versus LLC
      • LLC Popularity (Hype)
      • Formation of an LLC or S Corp
      • Nevada Fallacy of an LLC
    • Chap 2 - Customized Entity Structures

      • Your Spouse as a Partner (Happy Happy Joy Joy)
      • Family Partners
      • Holding Company and Operating Company
      • Parent-Child Arrangement (Income Flows "Up")
      • Parent-Child Arrangement (Income Flows "Down")
      • Multi-Member LLC That Issues Invoices
      • Things to Work Through with Multiple Entities
      • Recap of Benefits with Multiple Entities
      • State Apportionment with Multiple Entities
      • California Multi-Member LLC S Corp Twist
      • Economic versus Equity Interests
      • Structuring Deals with Angel Investors
      • ESOPs and S Corporations
      • Another Employee Ownership Situation
      • Medical C Corp
      • Fleischer Tax Court Case
      • Joint Ventures
      • Loans or Capital Injections
      • Using a Trust in Your Formation Considerations
      • Operating Agreements
      • Exit Plans, Business Succession
      • Liability Protection Fallacy of an LLC
      • Charging Orders
      • Using a Self-Directed IRA to Buy a Rental, Start A Business
    • Chap 3 - S Corporation Benefits

      • Avoiding or Reducing Self-Employment SE Taxes
      • Tax Savings with Health Insurance
      • S Corp Hard Money Facts, Net Savings
      • Officer Compensation with Solo 401k Plan Deferral
      • W-2 Converted to 1099
      • Net Investment Income, Medicare Surtax and S Corps
      • Three Types of Income
    • Chap 4 - The 185 Reasons to Not Have an S Corp or LLC

      • Chapter 4 Introduction
      • Additional Accounting Costs
      • Additional Payroll Taxes
      • SEP IRA Limitations
      • Trapped Assets
      • Distributing Profits, Multiple Owners
      • Other W-2 Income
      • State Business Taxes (Not Just Income Taxes)
      • Deducting Losses
      • Distributions in Excess of Shareholder Basis
      • Stock Classes
      • Vesting and Expanding Ownership
      • Bad Loans to the S Corp
      • Social Security Basis
      • Payroll Taxes on Children
      • C Corp to S Corp Problems
      • Going Concern
      • Recap of S Corp Downsides
      • Growing Business, Debt Service
    • Chap 5 - State Nexus Problems

      • Chapter 5 Introduction
      • Chapter 5 Disclaimer
      • Wayfair Case Part 1
      • Nexus Theory
      • Constitutional and Legislative Standards
      • Sales and Use Tax, Income Tax
      • Physical and Economic Presence, Nexus Attached
      • Wayfair Case Part 2
      • Services and Tangible Personal Property (TPP)
      • Costs of Performance, Market-Based Approach
      • Allocation and Throwback
      • FBA, Drop Shipments, Trailing Nexus Revisited
      • Recap of State Tax Issues
      • State Tax Issues and Nexus
    • Chap 6 - S Corporation Election

      • Formation (Election) of an S-Corp
      • Electing S-Corp Filing Status, Retroactive for 2022
      • Another Option, Dormant S Corp
      • Missing Payroll, Now What
      • Mid-Year Payroll
      • Nuts and Bolts of the S Corp Election
      • Ineffective S Corp Elections
      • S Corp Equity Section
      • Terminating S Corp Election
      • Distributed Assets
      • 5 Year Rule
      • Life Cycle of an S Corporation
    • Chap 7 - Section 199A Deduction Analysis

      • Section 199A S Corp Considerations
      • Calculating the Qualified Business Income Deduction
      • Section 199A Defining Terms
      • Specified Service Trade or Business (SSTB) Definitions
      • Trade or Business of Performing Services as an Employee
      • Services or Property Provided to an SSTB
      • Section 199A Deduction Decision Tree
      • Section 199A Reasonable Compensation
      • Section 199A Pass-Thru Salary Optimization
      • Cost of Increasing Shareholder Salary
      • Section 199A Rental Property Deduction
      • Negative Qualified Business Income
      • Qualified Property Anti-Abuse
      • Aggregation of Multiple Businesses
      • Section 199A W-2 Safe Harbors
      • Additional Section 199A Reporting on K-1
      • Section 199A Frequently Asked Questions
    • Chap 8 - Section 199A Examples and Comparisons

      • S Corp Section 199A Deduction Examples
      • Section 199A Side by Side Comparisons
      • Section 199A Basic Comparisons
      • Section 199A Health Insurance Comparison
      • Section 199A 200k Comparison
      • Section 199A 250k Comparison
      • Section 199A Specified Service Business Comparison Part 1
      • Section 199A Specified Service Business Comparison Part 2
      • Section 199A Phaseout
      • Section 199A Recap
      • Section 199A Actual Tax Returns Comparison
    • Chap 9 - Reasonable Shareholder Salary

      • IRS S Corp Stats
      • Reasonable S Corp Salary Theory
      • IRS Revenue Rulings and Fact Sheet 2008-25
      • Tax Court Cases for Reasonable Salary
      • Risk Analysis to Reasonable Shareholder Salary
      • Reasonable Salary Labor Data
      • Assembled Workforce or Developed Process Effect
      • RCReports
      • W-2 Converted to 1099 Reasonable Salary
      • S Corp Salary Starting Point
      • Multiple Shareholders Payroll Split
      • Additional S Corp Salary Considerations
      • Reasonable Salary Recap
    • Chap 10 - Operating Your S Corp

      • Chapter 10 Introduction
      • Costs of Operating an S Corp
      • New S Corp Puppy, What Do I Do Now
      • Accounting Method
      • 1099-NEC Issued to Your SSN
      • Take Money Out of the S Corp
      • Processing S Corp Payroll
      • Taking Shareholder Distributions
      • Reclassify Shareholder Distributions
      • Accountable Plan Expense Reimbursements
      • Accountable Plan Requirements
      • Shareholder Distributions as Reimbursements
      • S Corp Tax Return Preparation
      • Distributions in Excess of Basis
      • Minimize Tax or Maximize Value (Economic Benefit)
      • Tracking Fringe Benefits
      • Other Tricks of the Trade with S Corps
      • Adding Your Spouse to Payroll
      • Chap 10 - Comingling of Money
    • Chap 11 - Tax Deductions, Fringe Benefits

      • Chapter 11 Introduction
      • Four Basics to Warm Up To
      • Section 199A Deductions – Pass Through Tax Breaks
      • 185 Business Deductions You Cannot Take
      • Depreciation
      • Small Business Tax Deductions Themes
      • Value of a Business Tax Deduction
      • Deductions the IRS Cannot Stand
      • Automobiles and LLCs, S Corps
      • Business Owned Automobile
      • Section 179 and Bonus Depreciation
      • You Own the Automobile, Get Reimbursed By The Mile
      • You Own the Automobile, Take Mileage Deduction
      • You Own the Automobile, Lease Back to Your Company
      • Automobile Decision Tree
      • Home Office Deduction
      • Tax-Free Rental of Your Home
      • Tax Home
      • Business Travel Deduction
      • Deducting Business Meals
      • Sutter Rule
      • Cohan Rule
      • Capital Leases versus Operating Leases
      • Putting Your Kids on the Payroll
      • Educational Assistance with an S-Corp - Section 127
      • Summary of Small Business Tax Deductions
      • Comingling of Money
      • Reducing Taxes
    • Chap 12 - Retirement Planning

      • Retirement Planning Within Your Small Business
      • Self Employed Retirement Plan Basics
      • Retirement Questions to Ask
      • Tax Savings and Tax Deferrals
      • Using a 401k in Your Small Business Retirement Options
      • The Owners-Only 401k Plan
      • Having Staff with a Solo 401k Plan
      • Self-Directed 401k Plans
      • Traditional 401k (A Company Sponsored Plan)
      • 401k Plan Safe Harbor Provision
      • 401k Plans with Roth Option (Roth 401k)
      • Two 401k Plans
      • Rolling Old 401k Plans or IRAs into Your Small Business 401k Plan
      • 401k Loans and Life Insurance
      • 401k Plans and Roth IRA Conversions
      • Turbo Charged 401k Plans
      • SIMPLE 401k
      • SEP IRA
      • SEP IRA, Roth IRAs and the Roth Conversion
      • Controlled Groups
      • Owner Only 401k Plans in MMLLC Environment
      • Non-Qualified Deferred Compensation Plan
      • Exotic Stuff
      • Expatriates or Expat Tax Deferral Planning
      • Small Business Retirement Planning Recap
      • Personal Defined Benefit Plan
    • Epilogue

      • WCG Fee Structure
      • More About WCG
      • Consultative Approach
      • Core Competencies
      • No BS
      • Expectations of Our Clients
      • Final Words
      • Tax Consultation Business Advising, S Corp Consult
    • Chap xx - Health Care

      • Disclosure and Updates
      • Gaming the HSA System
      • Health Care Summary
      • Health Savings Accounts (HSAs)
      • Long-Term Care
      • Multiple Employees
      • One Person Show or Husband-Wife Team, S Corporation
      • Section 105 Health Reimbursement Arrangement (HRA)
      • Section 125 Cafeteria Plans and Flex Spending (FSA)
      • Sole Proprietors and Single Member LLCs
    • Chap yy - Business Valuations, Sale, Exit Planning

      • Business Valuation Techniques
      • Buy-Sell Agreements
      • Deal Structure
      • Debt Service
      • Exit Plans, Succession
      • Purchase Price Allocation
    • Chap zz - Other S Corp Thoughts

      • 1099 Income as Other Income, No Self-Employment (SE) Taxes
      • Audit Rates and Risks with an S-Corp
      • Recap of S-Corps
      • Rental Losses with an S-Corp
      • Rentals Owned by an LLC Fallacy
      • W-2 or 1099-MISC That Is The Question
  • Expat and Expatriate KB

    • Expat FAQs

      • Are there any downsides to claiming the foreign earned income exclusion?
      • Are there exceptions to the bona fide residence or physical presence tests?
      • As an ExPat, do I need to file a State tax return?
      • Can I deduct mortgage interest paid on my foreign home?
      • Do I have to pass the same test each year?
      • Does voting through an absentee ballot mess up my bona fide foreign residency?
      • How do fluctuating currency values affect my taxes?
      • How do I handle my foreign rental property?
      • How do I qualify for the foreign earned income exclusion?
      • How do moving expenses affect my exclusion?
      • How do partial years work with the foreign earned income exclusion?
      • How do tax treaties affect my ExPat situation?
      • How does the foreign housing exclusion or deduction work?
      • If I am a self-employed ExPat, what taxes am I responsible for?
      • If I don't qualify for the housing deduction, can I still deduct expenses?
      • May I still make contributions to my IRA as an ExPat?
      • What amount can I deduct for foreign earned income exclusion?
      • What happens if my host country has a form of social security?
      • What is a tax home or abode, and how do they relate to each other?
      • What is considered foreign earned income?
      • What is foreign earned income exclusion?
      • What is the bona fide residence test?
      • What is the difference between foreign tax credit and deduction?
      • What is the physical presence test?
  • Rental Property KB

    • Rentals FAQs

      • Can I claim my residence as a rental, sell it for a loss and deduct the loss?
      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • Can I deduct the taxes associated with public improvements?
      • Can I rent out half a duplex or a room in my house?
      • Do I need receipts for my rental expenses?
      • Do rental properties offer good tax sheltering?
      • How are repairs and improvements different?
      • How do I handle my foreign rental property?
      • How do passive loss limitations affect me?
      • I purchased a rental property last year. What closing costs can I deduct?
      • If I don't have any rental income can I still claim a loss?
      • If I move back into my rental, how does that work?
      • If my employer provides a cell phone, is that income?
      • Is depreciating my rental a good thing?
      • My rental sale was a huge loss. What can I do?
      • Rentals Owned by an LLC Fallacy
      • What are tax issues with an LLC owning a rental property?
      • What are the exceptions to rental activities?
      • What are the rules on a home office deduction?
      • What is active participation versus material participation?
      • What is considered rental income?
      • What rental property expenses can I deduct?
    • Real Estate Pros

      • Are rental activities always passive activities?
      • Are there downsides to the real estate professional designation?
      • Are there specific material participation tests for real estate professionals?
      • Do I need to group my rental activities together?
      • How do I record the hours spent as a real estate professional?
      • If I meet the 750-hour test, do I also meet the 500-hour material participation test?
      • What activities count and don't count?
      • What are some of the IRS tricks to deny my real estate professional designation?
      • What are some of the tax court cases for real estate professionals?
      • What are the general tests for material participation?
      • What is active participation versus material participation?
      • What is the definition of real estate professional?
      • Why designate myself as a real estate professional?
  • Other Tax Information KB

    • Audits

      • Can I ignore an IRS notice or claim I never received it?
      • How can I pay my taxes or my notice of deficiency?
      • How can I prepare for my face to face or interview field audit?
      • How do I appeal the collections of unpaid taxes?
      • How does a joint return get handled during an audit?
      • How does bankruptcy affect my unpaid taxes?
      • How much is interest and penalty on taxes owed?
      • How should I respond to an IRS notice or letter?
      • What are my chances of being audited?
      • What are some of the types of IRS notices and letters?
      • What can the IRS do if I don't pay my taxes- what is the collections process?
      • What causes or triggers an IRS audit?
      • What if I cannot pay my taxes?
      • What IRS publications deal with audits?
      • What is the appeals process?
      • What is the period of limitations for an audit?
      • What types of audits could I face?
      • Who can be with me at my IRS audit or conference?
    • Charitable Contributions

      • Are there ways to earmark money for an individual?
      • Do I need receipts for my donations?
      • Does deducting charitable contributions cause an audit?
      • How do I determine the value of my donation?
      • What are some of the donations I can deduct?
      • What are some other charitable deductions?
      • What are the limits of my donations?
      • Who qualifies as a charity?
      • Why give to charities?
    • Education, Tuition Deductions

      • Are Educational Savings Accounts Worth It
      • Are There Tax Breaks for Going to College
      • Are There Tax Savings When My Employer Pays for My Education
      • Can I deduct the cost of sports, games or hobbies while in college?
      • IRAs and Savings Bonds To Help With Higher Education Costs
      • What College Expenses Can I Deduct From My Income
      • What constitutes a full-time student for tax purposes?
    • Homes and Real Estate FAQs

      • Can I deduct the loss on my primary residence?
      • Can I deduct the taxes associated with public improvements?
      • Can I exclude the gain on my home sale?
      • How does a Federal Disaster affect my casualty loss?
      • My home was destroyed- what deduction can I take? How do casualty losses work?
      • The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
      • What are the rules on a home office deduction?
      • What is Cancellation of Debt? Is it taxable income?
    • Medical, Health Insurance

      • What are qualified medical expenses?
      • Why can't I deduct health insurance premiums?
    • Mortgages, Bad Debts

      • Can I deduct a bad debt on my tax return?
      • Can I deduct the loss on my primary residence?
      • Is cancellation of debt always taxable?
      • The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
      • What is Cancellation of Debt? Is it taxable income?
    • Recordkeeping

      • Are there specific records I need to keep?
      • Do I need receipts for my expenses?
      • How does proper recordkeeping affect my audit results?
      • How long do I have to keep records?
      • How should I maintain my tax records?
      • What are the requirements for mileage records?
      • Why should I keep tax records?
    • General Tax Questions

      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • If my employer provides a cell phone, is that income?
      • Tax Brackets Misconceptions- Should I earn more money?
      • What is the marriage penalty and how does it affect our tax returns?
  • Small Business KB

    • Small Biz FAQs

      • Hobby Versus Business

        • 3 out of 5 Test
        • Hobby Versus Business Testing
        • Philosophy of Business Losses
        • Private Track Coach Deducts Business Losses for Eight Years, Court Says OK
        • WCG (formerly Watson CPA Group) Philosophy on Hobby Losses
      • Independent Contractors

        • Behavioral Control
        • Colorado's Criteria for Contractor Status
        • Employee or Independent Contractor
        • Employee or Independent Contractor Status
        • Financial Control
        • IRS Determination, Form SS-8
        • Misclassified Workers Can File Social Security Tax Form
        • Salespeople As Contractors
        • Sample Response to CO Unemployment Claim
        • Statutory Employee and NonEmployees
        • Tax Court's Checklist
        • Type of Relationship
      • LLC and S-Corps (superseded)

        • As a one-person show, should I still form an LLC? An S-Corp?
        • Automobiles and LLCs, S Corps (superseded)
        • Can I call my 1099 other income which avoids employment taxes?
        • Determining the S-Corp Payroll Amount
        • Estimated Tax Payments, Withholdings Issues for an S-Corp
        • How do I convert my LLC to an S-Corp?
        • How does an LLC or S-Corp's income affect my taxes?
        • If the S-Corp taxation is what I ultimately want, should I form an LLC or C-Corp?
        • Is there a way to avoid Self-Employment tax?
        • Should I convert my LLC to an S-Corp (Sub-S Election)?
        • Should I form an LLC with my spouse?
        • The S-Corp Grind, Operational Hassles
        • The Zero Dollar Paycheck
        • What are the operational hassles of an S-Corp LLC?
        • What is an Accountable Plan?
        • The Money Trail for S-Corp Elections
        • 185 Reasons NOT to S-Corp, Downsides to S-Corp Election
      • Can I call my 1099 other income which avoids employment taxes?
      • Can I deduct country club dues as a business expense?
      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • Health Care Expenses, Premiums, HRAs, HSAs - Section 105
      • Hobby Versus Business Article
      • How can I avoid or reduce Self-Employment (SE) taxes?
      • If I am a self-employed ExPat, what taxes am I responsible for?
      • If my employer provides a cell phone, is that income?
      • LLCs and S-Corps
      • Retirement Planning within an S-Corp
      • S-Corp Hard Money Facts, Net Savings
      • Turn Your Vacation Into a Tax Write Off
      • What are tax issues with an LLC owning a rental property?
      • What are the rules on a home office deduction?
      • What business or corporate expenses can I deduct?
      • What do I do with a 1099-K?
      • What is the difference between a hobby and a business?
      • What is the difference between an LLC, S-Corp and a C-Corp?
      • Why can't I deduct health insurance premiums?
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Tax Savings with Health Insurance

Created OnJuly 11, 2021
UpdatedOctober 16, 2021
byJason Watson, CPA
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By Jason Watson, CPA
Posted Sunday, July 11, 2021

When your S corporation pays for your self-employed health insurance (SEHI), including coverage for your family, that amount is added to Box 1 Wages on your W-2. So, your income is artificially increased by the annual amount of premiums. However, there are two huge concepts you need to love and embrace.

First, Box 3 Social Security Wages and Box 5 Medicare Wages do not get increased by the amount of premiums paid. Here is a silly looking, but illustrative W-2.

Box 1 Wages 50,000 Box 2 Federal Tax Withholdings 21,735
Box 3 Social Security Wages 40,000 Box 4 SS Withholdings 2,480
Box 5 Medicare Wages 40,000 Box 6 Medicare Withholdings 580
Box 16 State Wages 50,000 Box 17 State Tax Withholdings 4,347

Don’t get tweaked on the Federal and State tax withholdings. We’ll explain that in a later chapter.

Spoiler alert: When WCG processes shareholder payroll, we increase income tax withholdings to help budget for the K-1 income that is combined with your W-2 income on your individual tax return). This allows you to land on tax neutrality as a household without needing separate estimated tax payments. Beauty!

Back to the W-2. Your focus should be on Box 3 and Box 5- these are the boxes that we want to reduce to the best of our abilities and with reasonableness.

Subsequently Box 4 and Box 6 is the calculation of the Social Security and Medicare taxes based on the amounts in Box 3 and Box 5. As you can see, your compensation is $50,000 but only $40,000 is being used to compute Social Security and Medicare taxes. Why is this? Some taxable fringe benefits, such as health care benefits (self-employed health insurance premiums and HSA contributions), are only added to Box 1 Wages, and not Box 3 or Box 5. Boom!

Explained another way; if we all decide that $50,000 is reasonable shareholder salary, and your self-employed health insurance premiums are $10,000, then only $40,000 is ran through payroll. But, the $40,000 and the $10,000 are combined to reflect total shareholder salary.

How does this translate to the corporate tax return? Line 7 of Form 1120S is “Compensation of officers” and the $50,000 in Box 1 above would be entered there (we’ll chat about the effects of solo 401k plan deferrals in a bit). Line 21 of Form 1120S is “Ordinary business income.” Line 7 as compared to Line 21 is one of the ways the IRS will consider a challenge of your S corporation with respect to reasonable shareholder salary (the IRS also looks at your K-1, specifically Box 16 Code D, as compared to your W-2, both connected by your Social Security Number).

Got it? Good. Next concept.

The second concept is that self-employed health insurance (SEHI) premiums are effectively deducted on Line 7 of Form 1120S as Officer Compensation. Therefore, the salary paid to the shareholders plus health insurance directly reduces Line 21 on Form 1120S which is your taxable ordinary income generated by the S corporation.

However, your W-2 shows $50,000 in taxable wages and this will appear on Line 1 of page 1 on your Form 1040. Hmmm… how does that work? We know what you are thinking- you are paying income taxes on the full $50,000 since the W-2 shows $50,000 but you were paid $40,000… where is the tax savings? This concern would be true except that you are considered self-employed as a greater than 2% shareholder, and therefore the health insurance premiums are deducted on Line 16 on Schedule 1 of your Form 1040 as an adjustment to income. This is a dollar for dollar reduction in your gross income to arrive at your adjusted gross income (AGI) on Line 8b.

Just to reiterate- the deduction and subsequent tax benefit of self-employed health insurance (SEHI) is done on the S corporation tax return. The deduction appears on your individual tax return, but it is a net zero as we’ve illustrated above (we accountants call this an in and out… income comes in, but is adjusted out for a net zero effect).

Said in another way; salary and health insurance end up as Officer Compensation and are deducted together on the S Corp tax return. This amount appears again on your individual tax return, but you get a “reduction” for the health insurance component. Deduction on business return. Net zero on individual tax return.

If this doesn’t resonate quite yet, don’t worry. However, we have seen this screwed up several times when clients run their own payroll and / or prepare their own individual tax returns. Be aware and know that you should have a Line 16 entry on Schedule 1 of your Form 1040 if you are paying self-employed health insurance premiums. Period.

So, we have an artificial increase in salary by the amount of SEHI and our reasonable shareholder salary testing is improved, but Social Security and Medicare taxes are computed on a lessor amount. Winner winner chicken dinner!

There are more examples of this stuff in a later chapter dedicated to reasonable shareholder salary. Also, the handling of self-employed health insurance in this manner is encouraged by the IRS as outlined in Fact Sheet 2008-25.

Here is the blurb if you can’t get enough-

The health and accident insurance premiums paid on behalf of the greater than 2 percent S corporation shareholder-employee are deductible by the S corporation as fringe benefits and are reportable as wages for income tax withholding purposes on the shareholder-employee’s Form W-2. They are not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes. Therefore, this additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder, but would not be included in Boxes 3 or 5 of Form W-2.

A 2-percent shareholder-employee is eligible for an AGI deduction for amounts paid during the year for medical care premiums if the medical care coverage is established by the S corporation.   Previously, “established by the S corporation” meant that the medical care coverage had to be in the name of the S corporation.

In Notice 2008-1, the IRS stated that if the medical coverage plan is in the name of the 2percent shareholder and not in the name of the S corporation, a medical care plan can be considered to be established by the S corporation if: the S corporation either paid or reimbursed the 2percent shareholder for the premiums and reported the premium payment or reimbursement as wages on the 2percent shareholder’s Form W-2.

Payments of the health and accident insurance premiums on behalf of the shareholder may be further identified in Box 14 (Other) of the Form W-2. Schedule K-1 (Form 1120S) and Form 1099 should not be used as an alternative to the Form W-2 to report this additional compensation.

That was IRS Fact Sheet 2008-25 which can be downloaded here-

wcginc.com/8247

Moving on… Here is a summary of the savings assuming a 40% salary and a $10,000 annual health insurance premium.

40% Reasonable Salary, With Health Insurance

The following table highlights the significant savings when factoring self-employed health insurance into the reasonable salary calculations.

Income Total
SE Tax
Salary Total
Payroll Tax
Delta Delta%
30,000 4,239 2,000 306 3,933 13.1%
50,000 7,065 10,000 1,530 5,535 11.1%
75,000 10,597 20,000 3,060 7,537 10.0%
100,000 14,130 30,000 4,590 9,540 9.5%
150,000 18,711 50,000 7,650 11,061 7.4%
200,000 20,050 70,000 10,710 9,340 4.7%
300,000 22,972 110,000 16,830 6,142 2.0%
500,000 29,991 190,000 20,204 9,787 2.0%

35% Reasonable Salary, Without Health Insurance

As mentioned, the previous illustrations are based on a reasonable salary that was 40% of the net ordinary business income after expenses and deductions. If your reasonable S Corp salary is less than this, your savings increase. For grins, the table below shows the results and subsequent savings using a 35% reasonable salary figure. Check out the $150,000 figure! $10k in savings.

Income Total
SE Tax
Salary Total
Payroll Tax
Delta Delta%
30,000 4,239 10,500 1,607 2,632 8.8%
50,000 7,065 17,500 2,678 4,387 8.8%
75,000 10,597 26,250 4,016 6,581 8.8%
100,000 14,130 35,000 5,355 8,775 8.8%
150,000 18,711 52,500 8,033 10,679 7.1%
200,000 20,050 70,000 10,710 9,340 4.7%
300,000 22,972 105,000 16,065 6,907 2.3%
500,000 29,991 175,000 19,769 10,222 2.0%

The salary calculation part of running an S Corp is one of the biggest challenges, but it also allows for most wiggle room for argument if necessary. Our chapter on S Corp salary will touch on the various tools we use to determine a reasonable shareholder salary including-

  • IRS Revenue Ruling 74-44
  • IRS Fact Sheet 2008-25
  • Tax Court Cases
  • Bureau of Labor Statistics / Risk Management Association Data
  • RCReports
  • Rules of Thumb (Biz Valuation, 1/3 1/3 1/3)

Here is some initial food for thought from a 2013 Tax Court case-

Sean McAlary Ltd. Inc. v. Commissioner, TC Summary Opinion 2013-62– the IRS hired a valuation expert to determine that a real estate agent should have been paid $100,755 salary out of his S Corp’s net income of $231,454. Not bad. He still took home over $130,000 in K-1 income and avoided some self-employment taxes. The valuation expert had used Bureau of Labor Statistics data to determine the average salary for real estate agents in the taxpayer’s zip code.

Here is the entire Tax Court summary opinion-

wcginc.com/8244

Please don’t be that guy who extrapolates or basically twists the previous Tax Court case into something else. BLS data is only one aspect of determining a reasonable salary. As mentioned, there is more on the salary stuff in a later chapter and pinning your entire argument on BLS data might leave money on the table.

Until then, consider the following summary which outlines the savings using various net ordinary business income after expenses and deductions, and reasonable shareholder salaries paid (including one with self-employed health insurance)-

Net Biz Income 40% Salary
No Health Ins.
40% Salary
$10k Health Ins.
35% Salary
No Health Ins.
30,000 2,403 3,933 2,632
50,000 4,005 5,535 4,387
75,000 6,007 7,537 6,581
100,000 8,010 9,540 8,775
150,000 9,531 11,061 10,679
200,000 7,810 9,340 9,340
300,000 4,798 6,142 6,907
500,000 9,497 9,787 10,222

Good stuff!

Why are we belaboring the heck out of this? In other words, does payroll really need to be dialed in this tightly? Consider that paying a salary which is $10,000 too high will cost you $1,530 in unnecessary payroll taxes. Read that again. If you paid yourself $100,000 when a reasonable salary could have been $80,000, you paid $3,060 too much in payroll taxes. What would you rather spend $3,060 on? Lots!

So, payroll calculations need to be just a bit tighter than bar napkin quality and just a hair below NASA precision.

Jason Watson, CPA, is a Senior Partner of WCG, Inc., a boutique yet progressive tax and
consultation firm located in Colorado and South Dakota serving clients worldwide.


Jason Watson CPA LinkedIn     Jason Watson CPA Email

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