Cafeteria Plans in S-Corps

[ERISA1]

I've got an S-Corp as a client. They want to adopt a "premium only" cafeteria plan. I understand that 2%+ shareholders are treated the same as sole proprietors and partners (i.e., they can't benefit from tax-free treatment for medical insurance, and a cafeteria plan won't help to make the cost of coverage tax-free).

I've heard it said, however, that if the spouse of an owner is a legitimate employee, then the spouse can buy coverage tax-free through a cafeteria plan, because the spouse is not an owner-employee.

This seems too easy. Shouldn't the spouse be treated as an owner, as a result of the attribution of ownership rules under code section 318? (e.g., spouses are always treated as key employees as a result of 318.)

RIA's research service seems to confirm my reading. Has anyone heard of this back door approach? Have you seen any thing published by IRS that would support this approach?

[Lisa Hand]

Might want to look at IRC section 318 - constructive ownership of stock. Spouses, children, grandparents and parents of greater than 2% shareholders of S corp owners may not participate due to the ownership attribution rules.

[Lisa Hand]

The exception for sole proprietor is clearly defined as along as the employee/spouse is a bona-fide employee. However, it is not as clearly defined from the IRS for partner's spouses, and of course they would not be eligible if they were also a partner.

[Guest Robin Sproles]

I agree – I think IRC Sec, 318 attribution rules would cause an 2%+ S Corp. shareholder’s spouse to be treated as an owner-employee and, thus, ineligible for cafeteria plan participation. However, these attribution rules do not apply to sole proprietors or partners.

In Ltr. Rul. 9409006, the IRS ruled that a sole proprietor’s husband was not an owner-employee and, since he was a bona fide employee of his wife’s business, he could receive reimbursements under the business’s medical reimbursement plan that were tax free to him and fully deductible by the business.

It would seem the same reasoning would apply to cafeteria plan participation -- a sole proprietor’s or partner’s spouse would not be treated as an owner-employee and, therefore, should be able to participate in the cafeteria plan. Maybe that's what you've heard?