One Ugly Rule for Owners of S Corporations Deducting Health Insurance

An ugly rule applies to how S corporation owners deduct the cost of health insurance that a corporation puts on its W-2s.

The words that make this an ugly rule are “earned income,” and this is unusual because you generally think of earned income as a good thing.

But for the S corporation owner who hopes to deduct his or her health insurance as a self-employed health insurance deduction on Schedule 1 of the owner’s personal Form 1040, the term “earned income” can create ugly results (hence the “ugly rule”).

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Applying the Ugly Rule

As you likely know from our prior articles, the S corporation deducts as W-2 wages the cost of health insurance it pays or reimburses to the more-than-2-percent shareholder.

On the shareholder’s W-2, the cost of the health insurance adds to the wage amount in box 1 of the W-2 but not to the wages reported in box 3 or box 5.2

The Form 1040 instructions (which are incorrect, or misleading at best) for how the more-than-2-percent\ shareholder deducts the health insurance premiums state:

You can deduct the premiums only if the S corporation reports the premiums paid or reimbursed as wages in box 1 of your Form W-2 . . . and you also report the premium payments or reimbursements as wages on Form 1040 or 1040-SR, line 1a.

If you quit reading the Form 1040 instructions at this point, which could be a logical stopping point, you could easily conclude that box 1 wages control the deduction.

But no, that would be wrong. It would be too logical!

On the next page of the instructions, you find a footnote in the “Self-Employed Health Insurance Deduction Worksheet” that states:

If you were a more-than-2-percent shareholder in the S corporation under which the insurance plan is established, earned income is your Medicare wages (box 5 of Form W-2) from that corporation.

What happened? The ugly rule makes Medicare wages the “earned income.”

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Key point. If you operate your business as an S corporation and want your full self-employed health insurance deduction, you need S corporation Medicare wages in box 5 equal to or greater than what the S corporation paid or reimbursed you for your health insurance.

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Takeaways

The tax code definition of the box 5 Medicare wages as earned income for the more-than-2-percent S corporation shareholder creates trouble for the shareholder who has little or no Medicare wages in box 5 of his or her W-2.

And this problem can exist when someone starts a new S corporation and does not take a salary the first year, but does have the corporation pick up the tab for the shareholder’s health insurance.

If you operate your business as an S corporation and want your full self-employed health insurance deduction, you need S corporation Medicare wages in box 5 equal to or greater than what the S corporation paid or reimbursed you for your health insurance.

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