This is a question I am receiving more frequently, and it seems fitting to address it in a blog post. There are also quite a few articles on this topic, but nearly all of them leave out important points and background information.
The question is usually posed by a business taxpayer treated as an S Corporation, and the client is typically the sole shareholder or owns the company entirely with the spouse. For purposes of this post, shareholder such as for a corporation has the same meaning as the member of an LLC. IRS regulation also applies to shareholders owning more than 2% of the S Corporation.
S Corporation shareholders are required to be paid a “reasonable salary” when providing services to the S Corporation. If you are the sole shareholder and have no employees, then you most likely fit under the requirement of taking a “reasonable salary.” We’re not going to address salary requirements here, but it is an element of the question.
Only employees are eligible for Health Reimbursement Arrangements (HRA). Thus, an S Corporation shareholder who is not receiving wages as an employee will not qualify. In most small businesses, the shareholder is also an employee.
At this point, we should acknowledge that tax regulation on health-related topics for S Corporations is not well defined. The tax professional community has been left hanging since 2015, so the science and technicalities of health care arrangements for an S Corporation are quite complex.
An HRA, more specifically, the Qualified Small Employer HRA (QSEHRA), must be coordinated with an Affordable Care Act compliant health insurance policy. A small employer is one with fewer than 50 full-time equivalent employees. The policy need not be provided by the same employer. For example, the employee may obtain coverage through the Marketplace and participate in a QSEHRA through an employer which does not offer health insurance. (Note: The presence of an HRA will render the employee ineligible for Premium Tax Credits through the Marketplace, and the HRA must be reported on Form 1095-C.)
To this point, it would seem that an S Corporation shareholder who is also an employee would qualify for the QSEHRA. Unfortunately, current IRS regulations do not permit the shareholder/employee and family members from participating in a QSEHRA. However, a QSEHRA can be offered to non-shareholder employees, so long as they are not family members of the shareholder. This rule is unique to S Corporations. Sole proprietors and C Corporations can implement a QSEHRA for anyone who is an employee, even if the employee is the sole proprietor’s spouse or the majority shareholder in the C Corporation.
Here, then, we must differentiate the two types of HRAs. We just discussed the QSEHRA. A different type of HRA is the self-insured plan. First, some brief background.
When the Affordable Care Act was first enacted, the law deemed any type of health reimbursement arrangement, even if it was just to reimburse out of pocket expenses or premiums, as an offer of coverage. Any offer of coverage must comply with ACA requirements, which include minimum essential coverage and coverage for preexisting conditions, among others. Initially, the HRA was all but eliminated under the guise of it being an offer of coverage, or rather, a substitute for health insurance coverage. Because the offer of coverage did not meet ACA requirements, the HRA was essentially deleted.
Although the HRA was brought back in the form of the QSEHRA, an alternative to traditional health insurance is to self insure. Applicable large employers (50+ employees) can adopt a self-insured plan so long as it otherwise meets ACA requirements.
Things get more sticky with small employers. Self-insured plans and HRAs are deemed to be offers of coverage. (The QSEHRA is exempt because it requires the employee be covered under an ACA-compliant insurance policy.) The ACA imposed daily penalties for offers of coverage which did not comply with ACA requirements. Not only does this mean small employers have a number of pitfalls to avoid, the penalties made it cost-prohibitive to offer anything unless the small employer offered a traditional group health insurance plan, which is also cost-prohibitive. Coincidentally, S Corporations were hit the hardest by the ACA.
In 2015, the IRS issued a notice relaxing these penalties for small employers, and particularly for S Corporations, until further guidance was provided, which has not happened yet.
Thus, premium reimbursement arrangements and self-insured plans for shareholder/employees is once again permissible without penalty even if they are not ACA compliant. However, anything offered for the shareholder/employee cannot discriminate against non-shareholder employees. Thus, before you construct an arrangement, you must be sure it is not discriminatory and that your business has the financial capability to include all qualifying employees in the plan.
Still, these arrangements only offer payroll tax benefits for an S Corporation. There is no income tax benefit to the shareholder. The reason for this is that any type of health care coverage or expense reimbursement arrangement is considered a fringe benefit. S Corporation shareholders are treated as partners under partnership taxation rules, and those rules require fringe benefits to be included in wages.
Thus, while the S Corporation can deduct amounts paid under a reimbursement arrangement, the shareholder must include the amount on box 1 of the W-2. There is only an offsetting self-employed health insurance premium deduction available when the S Corporation reimburses premiums for a “qualified health plan.” This terms limits premiums to insurance policies which are state regulated, and the IRS includes Medicare premiums for retirees.
Expense reimbursement arrangements and self-insured plans for shareholder/employees are not premiums because they are not state regulated plans. As medical-related expenses, however, they are excluded from wages for payroll tax (FICA/FUTA) purposes.
Thus, the primary benefit of a self-insured plan for the shareholder/employee will be a reduction in payroll taxes.
It’s been a long post, so we’ll end it here. Contact us if you have questions or would like to discuss these topics for your business.