As pass-through entities, S corporations (S corps) enjoy many tax benefits. The business pays less for Social Security and Medicare tax and doesn’t pay corporate income tax. Profits are split between shareholders who are taxed on their gains. The shareholders are then able to make certain deductions on their taxes. Because of this arrangement, shareholders are ineligible to take part in some of the tax advantages associated with health reimbursement arrangements (HRAs).
A common question for health benefit providers is whether S corp shareholders are able to participate in a tax-free health benefit. Greater than 2 percent shareholders of an S corporation are considered self-employed, and therefore aren’t eligible to participate in an HRA or pretax deductions for group health insurance. That said, an S corp is still eligible to offer an HRA.
HRA for non-owner employees of an S corp.
An HRA can still be valuable for an S corp. HRAs are a viable option as a non-owner employee health benefit and can save the business owners money, time, and hassle. Traditional group insurance coverage is the go-to for many businesses, but the high costs can be prohibitive. With an HRA, owners can offer non-owner employees tax-free allowances that fit within the company’s budget. This allows employees to choose their own individual insurance policy rather than being bound to one option.
Can HRAs work for other business owners?
In order to participate in an HRA, an individual must be an employee of the company or the dependent of an employee. Depending on how the business files, an owner might be an eligible employee. Let’s look at the other filing statuses besides S corp and how they affect HRA eligibility.
- C corp: A C corporation exists as a separate entity from the owner. Owners are considered employees of the corporation. This means they are eligible to participate in an HRA benefit. This eligibility includes the C corp owner’s dependents. Reimbursements made through the HRA to the owner and dependents are entirely tax-free.
- Sole prop: A sole proprietorship is an unincorporated business. The business is owned by a single individual. In this case, there is no distinction between the business and owner, meaning the owner isn't an employee. Because of this, sole proprietors aren’t eligible to participate in an HRA directly.
However, if the owner is married to a W-2 employee of the business, they’d be eligible to participate in the HRA through their spouse. All reimbursements would be tax-free to both the sole proprietorship and the owner’s spouse.
- LLC: Like an S corp, an LLC partnership is a pass-through entity. The partners are directly taxed on profits individually, while the business is not subject to income tax. Partners are considered self-employed as opposed to employees of the company. This makes them ineligible to participate in a reimbursement benefit directly.
Partners can participate in the benefit if they’re the spouse of a W-2 employee of the business, so long as the partner’s spouse isn’t also a partner of the business.
Option for S corp owners—Deducting insurance premiums
While S corp owners don’t have access to the same tax-free health insurance as non-owner employees, they’re still able to maximize their tax savings in regard to their health insurance premiums. Unlike their employees, S corp owners can take a personal income tax deduction on health insurance premiums paid through business.
To qualify for deductions, S corp owners’ health insurance policies must be established by the business and not by the S corp owner directly.
For an S corp owner’s policy to be considered established by the business, the business must ultimately pay for premiums. This means the business must either pay for the premiums directly or by reimbursing the S corp owner for payment. If the S corp owner pays the policy premiums on their own without being reimbursed by the business, the owner is not qualified to take a tax deduction.
When the business pays for the premium, they must next include the premiums as gross wages in the S corp owner’s Form W-2. When these criteria are met, the shareholder can deduct their premiums on Form 1040.
In addition to health insurance policies, shareholders of an S corp can use this approach to deduct premiums for vision, dental, accident, and long-term care policies.
While HRAs aren’t available to S corp owners, they can help the business save money and empower employees to choose their own health care. The owner can also deduct the cost of their premiums on their personal taxes. S corps can enjoy the best of both worlds by avoiding income tax, providing a tax-free benefit, and allowing owners to receive personal tax deductions for health care.