August, 2003 Tax Newsletter

S Corporation's Treatment of Employee-shareholder Fringe Benefits
 

In considering whether a corporation should elect S status as opposed to being taxed as a regular ("C") corporation, often an important factor is the treatment of fringe benefits.  Fringe benefits are employment-related benefits provided to an employee in addition to regular compensation.  They must be included in taxable income unless specifically excepted under a provision of the Internal Revenue Code.

Obviously, a tax-free fringe benefit is a great way to compensate employees. The employee receives a  benefit free from income tax, while the employer can generally deduct the cost of the benefit.  Moreover, tax-free fringe benefits are also free from payroll taxes.

Fringe Benefits for C Corporation Employees

C corporations can offer a number of tax-advantaged fringe benefits to their employees (who, in closely held businesses, are frequently also the owners). The corporation can deduct the benefits; the employees can exclude them from taxable income.   What a deal!!

Fringe Benefits for S Corporation Employees

Ah, here's the rub.  The rules governing fringe benefits for S corporation employees (including owners) are not as favorable as those applicable to C corporations.   For employee fringe-benefit purposes, the Tax Code provides that S corporations are treated as partnerships; any S shareholder owning (directly or indirectly) more than 2% of the stock on any day during the tax year is treated as a partner.

The Code neither defines "employee fringe benefits"  nor does is always parallel the partnership rules. However, the following benefits are available on a tax-advantaged basis (i.e., deductible by the S corporation and excludible from the income of 2% employee-shareholders), because such benefits are available to partners:

1. Dependent care assistance

2. Educational assistance programs

3. Qualified employee discounts, no additional-cost services, working-condition fringe benefits, on-premises athletic facilities and de minimis fringe benefits

Conversely, the following fringe benefits provided to 2% employee-shareholders are treated as additional employee compensation:

1. The cost of accident and health insurance plans, including uninsured medical expense reimbursement plans.

2. The expense of meals and lodging furnished for the employer's business needs

3. The cost of up to $50,000 of group-term life insurance coverage

4. Cafeteria plans.

A 1991 Revenue Ruling held that an S corporation must treat taxable fringe benefits paid on behalf of its 2% employee-shareholders as additional compensation subject to Federal tax withholding (and, generally, subject to employment taxes). However, payments made under a plan providing accident and health coverage (including payments of insurance premiums) and treated as compensation to a 2% employee-shareholder are not subject to employment taxes, because such payments are not deemed wages for that purpose.  However, the additional compensation is subject to Federal income tax withholding.

That Ruling specifically provides that a 2% employee- shareholder may be eligible for an above-the-line deduction for the accident and health insurance premiums the corporation paid.  For 2003, that deduction is 100% of the amount paid for medical insurance for the employee-shareholder and his or her spouse and dependents, and is reported as an adjustment to income.  However, the deduction is not available for calendar months in which the shareholder or spouse is eligible to participate in another employer-subsidized health insurance plan, nor can it exceed the taxpayer's earned income (including Social Security wages from the S corporation)

If providing tax-free fringe benefits is important to your corporation, it is very important to weigh the pros and cons of electing S status versus being taxed as a C corporation.  I can assist you in making the prudent decision.