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S Corps and Section 125 Cafeteria Plans w/ FSA


Guest jca123
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Guest jca123

My father, mother, sister and I all work for our family business (S-Corp) along with several other employees. A year ago we instituted a Section 125 Premium Only Plan so that everyone could have their health insurance deducted pre-tax. At that time we were told that my father and mother could not participate however nothing was said about my sister or I. We are now planning on adding a Health FSA to the POP plan and were just informed by the person preparing the documents that since my sister and I are family members we can't participate in either program.

I had orginally thought that you had to be a 2% or greater shareholder and since I am not, thought I was eligble. We were informed that family members who work for S-corps are automatically excluded from these types of benefits because S-corps are "pass through" corporations. I could understand this if I was still a dependant but I have my own family now.

After digging and talking to several accountants it appears that my sister and I can participate however our net gain will only be the savings of 7.65% due to the Social security we won't have to pay. The company will also save the same in matching funds.

My questions are:

1) Am I correct in my thinking up to this point?

2) Is there a way my sister and I can participate in these programs and actually receive the full benefit?

Thanks in advance!

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Take a look at the two attached Coordinated Issue Papers issued by the IRS that bear on this topic.

I do not agree that you and your sister can participate in a Health FSA. Cafeteria plans, including health flex accounts, are only for employees and former employees.

Prop Treas Reg 1.125-1, Q&A-4 provides "The term 'employees' does not ... include self-employed individuals described in section 401© of the Code."

IRC sec 401© specifies that partners of a partnership are self-employed.

IRC sec 1372(a) provides that an S corporation shall be treated as a partnership, and IRC sec 1372(b) makes any 2-percent shareholder of the S corporation 'a partner' of such partnership.

IRC sec 1372(b) defines '2-percent shareholder' to be "any person who owns (or is considered as owning within the meaning of section 318) on any day during the taxable year of the S corporation more than 2 percent of the outstanding stock of such corporation or stock possessing more than 2 percent of the total combined voting power of all stock of such corporation".

IRC sec 318(a)(1)(A)(ii) attributes to children the stock held by their parents.

Thus, if either of your parents have more than 2% of the S corporation stock, and are thereby wired as a 'partner' ineligible for a Health FSA (and cafeteria plan, generally), then you and your sister too are wired as ineligible 'partners'.

If the S corp pays health premiums for 2% shareholder/employees, the S corp withholds for income taxes on the amount it so pays. If the S corp does this as part of a plan for its employees (and their dependents) generally or for a class of its employees (and their dependents), then it does not pay FICA on the amount of health premiums paid for 2% shareholder/employees. IRS Announcement 92-16, I.R.B. 1992-5, 2-3-92.

The S corp tax deducts the amount so paid but correspondingly includes it in the taxable income reported to the 2% shareholder/employee. The S corp shareholder/employee may then tax deduct health insurance premiums, on his or her own Form 1040. (This tax deduction is not available for any calendar month that the shareholder/employee is eligible to participate in any subsidized health plan maintained by ANY employer of the shareholder/employee or spouse. IRC sec 162(l)(2)(B).)

Rather than seek to participate in employer-reimbursement health plans, you and your sister could bulk up on health insurance--extensive coverage, low deductibles, low co-pays, low co-insurance, as well as auxillary health insurance like supplemental health, dental, vision, cancer, etc. The premiums are higher because the out of pocket to you is lower. You then get to deduct the premiums. Had some of those premium dollars saved by having less coverage been paid out of pocket by you, you might not receive any tax benefit. That becauase you may only deduct the out of pocket to the extent it, along with the premiums you pay, exceed 7.5% of your adjusted gross income--and then only if you itemize on Schedule A to your Forms 1040. So from a tax perspective for you and your sister, deemed S corp shareholders/employees, paying premiums for health insurance is likely better than facing health expenses out-of-pocket.

John Simmons

johnsimmonslaw@gmail.com

Note to Readers: For you, I'm a stranger posting on a bulletin board. Posts here should not be given the same weight as personalized advice from a professional who knows or can learn all the facts of your situation.

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Guest Guest99

Thanks for your quick response. I will have to read and re-read those documents before it sinks in but if I understand you correctly, my sister and I can't participate at all. This is a disappointment since I feel like we are regular employees like everyone else. We all are responsbile for paying 100% of our health insurance and it would have really helped out to have the insurance deducted pre-tax and to be able to participate in the Health FSA.

Would you please elaborate a little bit more on what our options are and the benefits we may recieve? You had mentioned paying out of pocket for a different insurance policy (individual policy?) however to me that doesn't add up since we would most likely not receive the same policy benefits as when we belong to a group policy.

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John:

Thanks for providing those 2 documents.

Reading through them gave me an idea I want to bounce off of you, and others.

Let's say, that the employer has a $5,000 deductible plan, and is considering raising the deductible to $15,000.

He guarantees that the employees who incur expenses between $5,000 and $15,000 will be paid.

However, their salaries will be adjusted to account for any medical expenditures the employer pays between $5,000 and $15,000 of expenses.

Is this discriminatory?

Don Levit

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jca123:

The opportunities for planning into a given situation are nearly endless, and I would think you'd be best served by having an in-person or telephone conversation with a qualified benefits professional and the health insurance professional--who may be the same person.

John Simmons

johnsimmonslaw@gmail.com

Note to Readers: For you, I'm a stranger posting on a bulletin board. Posts here should not be given the same weight as personalized advice from a professional who knows or can learn all the facts of your situation.

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Don,

The arrangement you describe would involve ER reimbursement and so IRC 105h and its nondiscrimination requirement are implicated.

Because there is no mention of excluding any EEs, nor any having a lesser max amount of reimbursement for some EEs (assuming there would be eligibility rules that would, in essence, exclude those earning less than $10,000 for the year), there should be no discrimination.

I think there would be problems with this arrangement, however, for the EE. That's because this would have the same effect as a $10,000 per EE medical expense reimbursement plan, where the amount an EE doesn't use is paid as additional compensation. This would make the amounts paid in reimbursement for medical expenses taxable income for the EE just as would extra, bonus pay of the unused part of the $10,000.

In Rev Rul 2002-41, it is explained:

Section 105(b) states that except in the case of amounts attributable to (and not in excess of) deductions allowed under §213 (relating to medical expenses) for any prior taxable year, gross income does not include amounts referred to in subsection (a) if such amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by the taxpayer for the medical care (as defined in §213(d)) of the taxpayer or the taxpayer's spouse or dependents (as defined in §152 ).

Section 1.105-2 provides that only amounts that are paid specifically to reimburse the taxpayer for expenses incurred by the taxpayer for the prescribed medical care are excludable from gross income. Thus, §105(b) does not apply to amounts that the taxpayer would be entitled to receive irrespective of whether or not the taxpayer incurs expenses for medical care.

Under the arrangement posited, the EE would be entitled to the entire $10,000 irrespective of whether or not the EE incurs expenses for medical care. It would all be paid as extra pay, bonus if the EE has no qualifying medical care expenses. So that entire $10,000 is taxable to the EE, regardles of how much in medical care expenses the EE might have.

John Simmons

johnsimmonslaw@gmail.com

Note to Readers: For you, I'm a stranger posting on a bulletin board. Posts here should not be given the same weight as personalized advice from a professional who knows or can learn all the facts of your situation.

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John:

Thanks for your reply.

Let's revise my idea, based on the taxable implications.

Everything remains the same, except for the employer reimbursements between $5,000 and $15,000 of medical expenses.

Assume the employer adds to each employees' salary 20 cents for every dollar of benefits not used.

Each employee, then, has the opportunity of making an extra $2,000 if they use no benefits between $5,000 and $15,000.

The employer does have exposure for each employee of $10,000, before the insurance kicks in.

However, if only 10% of the employees reach the $15,000 level, the employer may still come out ahead for enlarging the deductible, and saving premiums (even after reimbursing those employees who do not use the full benefits, before the insurance kicks in).

Don Levit

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Hi, Don,

I think in that situation each EE would be taxable on $2,000, since the EE will receive at least that much through extra pay or medical expense reimbursement. The other $8,000 is dependent on the EE incurring medical expenses, and so that ought not be taxable.

Given what I suspect you are trying to accomplish with the arrangement, this would seem to be a pretty good tweak.

John Simmons

johnsimmonslaw@gmail.com

Note to Readers: For you, I'm a stranger posting on a bulletin board. Posts here should not be given the same weight as personalized advice from a professional who knows or can learn all the facts of your situation.

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  • 2 weeks later...
Guest jca123

The following statement comes from the IRS Headliner Volume 41 dated Feb 12, 2003 titled "S Corp Shareolder-Employees- Reporting Health and Accident Insurance Premiums.

"The cost of these health and accident insurance premiums paid on behalf of the greater than 2% S corporation shareholder-employee (hereafter referred to as "shareholder") is deductible by the S corporation and reportable as additional compensation to the shareholder.

This additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement issued to the shareholder. If these payments are made under a "plan" for the S corporation employees and their dependants, the amount would only be subject to income tax withholding, and would not be included in Boxes 3 or 5 of form W-2 wages for social security of Medicare, nor would it be subject to the FUTA tax. Form K-1 (1120s) and Form 1099 should not be used as an alternative to the Form W-2 to report this additional compensation.

The payments of the health accident insurance premiums on behalf of the shareholder may be further identified in Box 14 (other) of the form W-2"

Does this in any way help my cuase?

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No, that doesn't address health FSAs--but it does describe how you ought to be handling the tax reporting of health insurance premiums.

John Simmons

johnsimmonslaw@gmail.com

Note to Readers: For you, I'm a stranger posting on a bulletin board. Posts here should not be given the same weight as personalized advice from a professional who knows or can learn all the facts of your situation.

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Aren't the salary reductions under section 125 for the FSA regarded or treated as premiums by the Treas Regs.?

George D. Burns

Cost Reduction Strategies

Burns and Associates, Inc

www.costreductionstrategies.com(under construction)

www.employeebenefitsstrategies.com(under construction)

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The problem is that flex accounts are only tax free by virtue of IRC § 125. IRC § 125 is only for EEs. An 'EE' that also owns or is deemed to own more than 2% of the stock of the S Corp ER is not an 'EE' for IRC § 125 purposes. See my first post above in this thread.

If the S Corp pays the health insurance premiums for an 'EE' who owns or is deemed to own more than 2% of the stock of the S Corp ER pursuant to a plan not subject to IRC § 125 (i.e., a plan that does not give EEs a choice between a taxable benefit like cash and an otherwise tax-free benefit), it is tax-free.

John Simmons

johnsimmonslaw@gmail.com

Note to Readers: For you, I'm a stranger posting on a bulletin board. Posts here should not be given the same weight as personalized advice from a professional who knows or can learn all the facts of your situation.

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If an S Corp pays the health insurance premium for a 2% or more shareholder it is not tax free to the employee but is reported as income to that person. As far as I can recall it has always been that way.

http://www.irs.gov/businesses/small/articl...=107451,00.html

http://www.irs.gov/businesses/small/articl...=157049,00.html

Does anyone know if the Ruling requested by the AICPA on IRS Headliner Volume 163 above, was issued?

George D. Burns

Cost Reduction Strategies

Burns and Associates, Inc

www.costreductionstrategies.com(under construction)

www.employeebenefitsstrategies.com(under construction)

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It is so reported as taxable income to the S corp shareholder/EE, but then the shareholder/EE gets a deduction (Line 29 on Form 1040; see pages 29-30 of the Instructions). The S Corp deducts it as employee compensation. So tax free--though subject to FICA/FUTA/SUTA.

John Simmons

johnsimmonslaw@gmail.com

Note to Readers: For you, I'm a stranger posting on a bulletin board. Posts here should not be given the same weight as personalized advice from a professional who knows or can learn all the facts of your situation.

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That is a most fascinating definition of tax- free.

George D. Burns

Cost Reduction Strategies

Burns and Associates, Inc

www.costreductionstrategies.com(under construction)

www.employeebenefitsstrategies.com(under construction)

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