New Shareholders in s Corp

[Dan]

I have a cafeteria plan client that uses a fiscal plan year. As of 1/1/09, several employees were given ownership in the S-corporation so they are no longer eligible to defer. My question is what happens to the pre-tax deferrals that these new owners did not use prior to 1/1/09? Can they continue to submit claims for reimbursement or do they lose their remaining balances? Thanks for any help.

[J Simmons]

What happens under your cafeteria plan when other employees lose their eligibility for the cafeteria plan mid-year?

[LRDG]

As of 01/01/09 revised IRS Sec. 125 regs, there are no official regulations addressing this particular change in status from eligible employee to ineligible S corp owner-employee.

These individuals no longer meet Employee Status requirements of Sec. 125. They are owner employees, and as such no longer meet eligibility requirements as of the date of their change in status to S corp owner-employees.

Their salary reductions should be discontinued on a date that coincides with the effective date of the status change.

There are or should be rules in the plan document that address the treatment of FSA balances for mid-year termination of employment and other status changes that do comply with IRS regs.

I would follow the existing termination of employment rules as they are in your plan doc as a reasonable precedence or template for handling mid year loss of eligibility the result of status change to S corp owner employee status.

IRS may be more conservative, could require forfeiture of FSA balances retroactive to the beginning of the plan year for this class of owner employees. However, that would not follow the example that exists for other mid-year termination and change in status regs.

It seems only reasonable to allow reimbursements through the end of the plan year for reimbursement of funds accumulated in the FSA at the time when they were eligible participants.

Amend the plan document to coincide with the decision made for these employees.

This is at least the second time in the past couple of months this question has come up. It might be time to address this issue with IRS via a private letter ruling.

edited to add: There are issues in the S owner employee change in status that do not exist in other mid year election changes or changes in status. Cobra is a question of particular interest not addressed for this class of employees. While I can use reasonable judgment, it is no substitute for an official IRS ruling. For instance, for a plan that allows termination of employment participants to fund their FSA from the last paycheck pre tax via Cobra, should it be an option for change in status owner employees, or can that option be denied? What about other Cobra options? What to do with those who terminate with claims that exceede available MFSA balances, or more importantly would IRS treat them differently than non-S corp owners terminating employment with claims that exceede available balances?

WWIRSD?

[GBurns]

I did not think that ineligibility was caused by just being a shareholder but rather is triggered by being a 2% (or more) shareholder.

What is the shareholding % of each of these persons ?

[Dan]

The new shareholders are all more than 2% owners. They have stopped deferring as of 1/1/09.

[GBurns]

I have never thought about this before, so never looked it up.

How is the shareholding % calculated ? Authorized shares or issued shares or what ?

Edit: How is it supposed to be calculated, in general ? The question is not directed at Dan, but to the general audience.

[LRDG]

GBurns, you're right, my apologies for not being more specific. It would apply to those who are 'more than 2%' owners of the S corporation.

The following from BenefitsLink, (it appears dated):

"Further, it appears that persons who own more than 2 percent of the shares of an S corporation are not considered "employees." (An S corporation is a corporation that has elected to be treated as an "S" corporation for income tax purposes, pursuant to subchapter S of the normal income tax provisions in the Code.) See Code section 1372, which states that for purposes of the "fringe benefits" portions of the Code an S corporation is treated as a partnership and a more than 2 percent shareholder of the S corporaiton is treated as a partner of such partnership."

Here is the URL: http://benefitslink.com/modperl/qa.cgi?db=qa_125&id=6

It looks dated, the full text posted March 31, 1997, although there's not necesserily a more recent revision. I'll search in event there is, appreciate anyone with revisions or info would also post the text and/or a link.