Tax Savings with Health Insurance

By Jason Watson, CPA
Posted Monday, October 23, 2023

When your S corporation pays for your self-employed health insurance (SEHI) and dental / vision premiums, 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 are 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.

To make things even stranger, a lot of taxpaying citizens are accustomed to health insurance either being 100% provided by their employer or a payroll deduction in some fashion. This works well for employees since the payroll deduction is usually pre-tax and therefore the tax benefit is immediate However, for the employee turned S Corp owner, this can be a small derailment during the transition.

To recap- 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!

Another way to view your self-employment health insurance is that it is costing you about 60 cents on the dollar. 15 cents in less payroll taxes and another 25 cents in income tax savings. This might not make you feel better given the massive cost of health insurance, but here it is just the same.

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

Big Alert: If you have access to health insurance through your spouse, you generally cannot do two things. You cannot get your own health insurance coverage and have it be a tax deduction for the business. You also cannot consider the additional premium paid by your spouse as a reimbursement and therefore deduction for the business (typically this is already tax-advantaged since it deducted pre-tax by your spouse on their paycheck).

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.