Discussion:Calling all S Corp SEHI deduction experts!

My client is a 2%+ shareholder/employee in an S-corp. His company provides a health plan and splits the premiums 60/40. The 60% paid by the S corp. is reported as income on the W-2 and in Box 14. The 40% paid by the sh is also reported as income, but only appears on the year-end paystub as a post-tax deduction, and is excluded from Box 14.

It is clear that the 60% reported in Box 14 should be deducted as SEHI on 1040 Line 29 (2010), but unclear (to me) if the 40% paid by the employee can also be deducted... since it is technically still reported as income and is for a plan established by the S corp? It seems like that portion of the employee income would still be considered a "guaranteed payment" to the sh subsequently used for health premiums. Some posts seem to indicate that Notice 2008-1 alludes to this scenario, but I tend to relate that more to insurance NOT established by the S corp but paid for (externally) by the shareholder and then reimbursed by the S corp.

If the full amount IS deductible, then shouldn't the company be including the full portion for 2% shareholders in Box 14?

A plan providing medical care coverage for the 2-percent shareholder-employee in an S corporation is established by the S corporation if: (1) the S corporation makes the premium payments for the accident and health insurance policy covering the 2-percent shareholder employee (and his or her spouse or dependents, if applicable) in the current taxable year; or (2) the 2-percent shareholder makes the premium payments and furnishes proof of premium payment to the S corporation and then the S corporation reimburses the 2-percent shareholder-employee for the premium payments in the current taxable year. If the accident and health insurance premiums are not paid or reimbursed by the S corporation and included in the 2-percent shareholder-employee’s gross income, a plan providing medical care coverage for the 2-percent shareholder-employee is not established by the S corporation and the 2-percent shareholder-employee in an S corporation is not allowed the deduction under § 162(l).

(Key word "MAKE")

Who "made" the premium payments - That is, who physically wrote the checks to the insurance company - corp or shareholder? Corp did. This rule you reference is designed to weed out those shareholders who don't physically run (make) the premium payments through the corp (and there were many of us that did this prior to Notice 2008-1). I.E. Shareholder has a personal medical insurance policy, he doesn't physically run the premium payments through his S-corp. Instead, shareholder "makes" all premium payments personally and takes the deduction directly on his 1040. This won't work for the exact reason you cite (among others).

How do you come to that conclusion?

Also, 2% S-corp shareholders can't participate in a 125 plan.

Is 100% of the insurance premium paid, to the insurance company, by the corporation? Is 40% of that amount withheld from the shareholder/employee's paycheck? Is that withholding of 40% of the premium "after tax"? Knowing these facts will help us. The answer to all these questions is yes, isn't it...

Answer to all above is YES.

As for comments on the 125 plan, the S Corp does have a 125 plan setup for regular employees (and < 2% SH). It is 60/40 for ALL employees under the plan. The difference for 2%+ SH is that the 40% deducted on the paycheck is POST TAX and the 60% portion is reported in Box 1, 3, 5 and 14 of the W-2 (although I think the Box 3/5 inclusion is incorrect in this case). I am unsure if the 60% portion still comes through a 125 plan for the 2% SH, but I don't think this is allowed.

Thanks for all comments... I'm not sure if I'm any closer to a definitive answer though!! :)

As an FYI - You wind up with the exact same result under the above method as you would under the standard method (with the standard method being "corp makes payment and simply puts it on the guy's W2"). And when I say "same result," I'm talking on the corp's end (wage deduction) and on the shareholder's end (W2).

When you say the health plan is 60/40 for other employees, do you meen that 60% is a pure employer contribution and the 40% can be paid by the other employees through a §125 salary reduction agreement; or, do you meen that 60% is eligible for §125 salary reduction and 40% is required to be an after-tax deduction for all employees? If if is the earlier, becuase all amounts are pre-tax for the other employees, I believe that by the having 100% "company paid" insurance for the >2% SH is not discriminatory and can all be excluded from Soc Sec & Medicare wages. However, if it is the latter, then only 60% of the >2% SH health insurance would be able to excluded from Soc Sec & Medicare wages, otherwise you would have a discriminatory plan.

Thanks to all for the input. I will include 100% of the premiums as an SEHI deduction on my client's 1040. I will also be amending his 2008 and 2009 returns to do the same.

Furthermore, I will recommend the following to the S Corp: 1. Re-investigate their reporting of health premiums as income in Box 3 and 5 for 2% SH. 2. Include in Box 14 the amount for post-tax, payroll-deducted health premiums for 2% SH (this would be the 40% -- they already include the 60%).

Agree?

Section 106 provides an exclusion from the gross income of an employee for employer-provided coverage under an accident and health plan. A 2-percent shareholder is not an employee for purposes of §106. Treas. Reg. §1.106-1; section 1372(a). Accordingly, the premiums are not excludible from the 2-percent shareholder-employee’s gross income under §106.

It also states In order for the 2-pecent [sic] shareholder-employee to deduct the amount of the accident and health insurance premiums, the S corporation must report the accident and health insurance premiums paid or reimbursed as wages on the 2-percent shareholder-employee’s Form W-2

I think the 60-40% percent issue is moot in light of the above. This statement seems to indicate that 100% of the premiums are income to the 2% shareholder, included in wages subject to withholding, no matter who pays what.

How about the statement in Notice 2008-1 that allows the "S" shareholder to pay the premiums personally, and then be reimbursed by "S" to shareholder.

This reimbursement presumably creates a pre-tax situation for this shareholder........kinda like what a 125 plan does. You pay the expense, then get reimbursed from the plan with pre-tax dollars.

1. 100% of the premiums are reported as income to the SH.

2. The S Corp "makes" 100% of the premium payments (on behalf of the SH) to the insurance company.

These key points should allow for a 100% SEHI deduction of premiums for the SH (assuming no other rules are broken, like other insurance eligibility, etc.).

Next question... What can the S Corp claim as an expense? Currently they only claim the 60% in order to be in-line with regular employees. However, if we assume that the 60/40 makes no difference to the SH based on the 2 points above, then couldn't you also assume they make no difference to the S Corp? 100% is a guaranteed payment (fringe) to the SH, therefore an expense to the S Corp? Since this S Corp already deducts FICA for the 2% SH (satisfying the requirement of class separation), then it seems like this would be a no brainer.

TaxLes: The entire amount of the 2% SH's insurance is wage expense to the Corp. Likewise, it is wage income to the SH and then above the line deduction for the SH. Given this, the actual expense ends up being the wage expense on the S-Corp return. The wage income and SEHI deduction is just an in-and-out on the SH's return.

On the other hand, the 60% *is* a fringe benefit, and it's artificially included in the W-2 as taxable compensation as Notice 2008-1 tells us to do. But the difference is that the shareholder gets to *keep* the value of the 60% - it's the value (the cost?) of the health insurance coverage provided by and paid for by the corporation: there's no withholding for the 60%.

It seems to me that the 40% that's "paid to" the shareholder as compensation is *certainly* deductible by the corporation as compensation. It's not an insurance premium, not yet, not until it's been withheld by the corporation and then paid out - by the corporation - as part of the 100% of the premium that the corporation pays to the insurance company.

The 40% withholding isn't an insurance premium, and it's not the value of an insurance coverage. It's an amount *equal to* 40% of the cost of the guys insurance. It's maybe easier to see if the salary weren't withheld from, and the shareholder/employee wrote a check to the corporation for 40% of the premium. See how the 40% withholding isn't really a premium, it's just cash going in a circle...?

I think Notice 2008-1 doesn't address this.

What's the result for the SEHI deduction if the shareholder *doesn't* have the 40% withheld after tax, but writes a personal check to his employer for the 40% instead of the withholding? That, I believe, is where we are. Where that gets us to, I don't know.

Leaves the FICA and Medicare up in the air (which you seem less concerned with, right?) but I think it moves the 40% deduction to the shareholder's Form 1040 Page 1 Line 29 where you probably already had it even before this scintillating analysis...

DAJCPA, your last post gets to the "meat" of my original question of interpretation... who "makes" the payment. It is all SH money, but the S corp writes the check.

It would certainly make things more clear if the S Corp reduced the salary by the amount equal to the 40% and simply PAID 100% of the premiums and included them in Box 1, 3, 5, and 14. FICA would apply at that point, but as stated that is of lower concern for my client. Unfortuntately, that is not how they reported it, so I have 3 tax years to clean up in which the 40% portion is NOT included as an SEHI deduction. It was easily missed because Box 14 only included the 60%. The client actually recongized the fact that Box 14 only included the 60% and asked the question, "Why can't I get a deduction for the 40% I pay?"

But can I only call it the latter (a taxable benefit) if it is removed from the paystub completely? What makes it regular old wages? Just the fact that it is shown on the paystub? It is clearly marked as a Health premium withholding after tax. It seems that it should automatically be a taxable benefit because of the 2% SH status. Whether it is shown on a paystub or added to the W-2 shouldn't matter in the end, should it?

The bottom line is whether it is sufficient enough to "stretch" into a 100% SEHI deduction and withstand an audit... that is what I must decide. The more people that weigh in one way or the other certainly increases my confidence that it is within the realm of interpretation in my client's favor. :)

Thanks again for all the comments... This has turned out to be much more interesting that expected!

I still stand by the language of "paid or reimbursed" from Notice 2008-1.

Thanks again for the opinions and support.

Discrimination rules will not apply to 2% shareholders. Take a look at the June 18, 2010 thread and it makes more sense.

I'm never sure, as I mentioned in one of my posts above, whether or not health insurance plans discriminating in favor of >2% SH's make the discriminatory portion fall outside the exclusion provided by §3121(a)(2)(B)and subject to Soc Sec & Medicare. I'm not sure how to read the phrase "if the requirements for the exclusion under §3121(a)(2)(B) are satisfied" in Announcement 92-16. Yes, the employer portion (60% in this case) is paid under the plan for sure as it is dictated by the plan, but is the 40% considered paid under the plan since the 40% is only paid for the >2% SH? This has always puzzled me.

Hopefully this will work.

I agree with Harry in his earlier posts above - only the portion of medical insurance paid by the S Corp and added to the W-2 box 1 taxable wages (exempt from boxes 3 & 5 taxes) qualifies as an above the line deduction. Any portion of gross wages payroll deducted for the employee to pay a share of the insurance cost cannot be included in a 125 plan, does not reduce wages on the W-2 box 1, is fully taxable for boxes 3 & 5. This portion of insurance cost cannot be deducted above the line on page one of the 1040 for SEHI. It goes to Schedule A medical expenses.

I like how Harry put that last part - he is "screwed" on that portion of the insurance cost.

More good insight DAJCPA... The question I have is that if the 40% is NOT considered "paid under the plan," then does that exclude it from being deducted as SEHI, or does it simply make the >2% SH income subject to FICA?

KathiJud, thanks for your insight as well. Sounds like you are confident in your interpretation. I think where I (and others) have been struggling is in the fact that Notice 2008-1 states the following: "...premiums paid or furnished by an S corporation on behalf of its 2-percent shareholders...." The phrase "paid or furnished by...on behalf of..." has been interpreted as the S Corp writing the check to the insurance company. In my clients case, 100% of the premiums are Box 1 wages and 100% of the payments were MADE (checks written) by the S Corp. While 40% was shown as paystub wages reduced to pay a portion of the premiums, it doesn't seem to break the rules required for the plan to be established by the S Corp.

Would love to get consensus on this one before proceeding. :)

Because that [reimbursing a shareholder/employee for premiums paid by the employee/shareholder] has been found by Notice 2008-1 to show the existence of a "plan" of the corporation/employer and to establish the payment for the insurance under that plan. Which satisfies the requirements of IRC Section 162(l). I think that was the entire point of the IRS Notice.

This isn't "word games," this is reality. If I'm due a $10k gross paycheck in December and my employer takes all of it away from me (net pay of $0) because they have 'already paid me the $10k in the form of $10k worth of health insurance the employer paid throughout the year,' then I am being taxed on the value of the health insurance. I am walking away with net cash pay of $0 for December.

If I'm hearing KathiJud correctly, she's saying that the $10k Fringe Benefit is not included in my income as a fringe benefit, but rather, it's included as just regular wages (a/k/a an "agreed amount of gross pay") that I'm being taxed on. To this I say hogwash. I clearly have been taxed on the $10k, and I clearly went home with $0 net pay in December. This means I was not taxed on any cash I received, but on some intangible that has a quantifiable value.

2008-1 requires that any amount you want to be treated as eligible for the above the line deduction be paid as the expense of the corp for the shareholder's benefit with no reimbursement from agreed gross wages.

No it doesn't. 2008-1 is merely making it clear that the premium payment must be run through the corp in some way, shape or form, including reimbursement. In other words, if you're an S-corp shareholder and pay a personal premium, you can't take it as an S/E Health deduction on your 1040.

But I think that's exactly what you're saying...

Okay, I know what "should be" doesn't really amount to anything, so let me get back to something concrete. §535(6) explains the qualifications for "the plan" to be established under the S Corp. There are only 2 scenarios that qualify: premiums paid by the S Corp and reported as W-2 wages, or premiums reimbursed by the S Corp and reported as W-2 wages (or presumably a combination of the two). If you don't believe the 40% shown as a paystub wage deduction is "paid" or reimbursed by the S Corp, or that it hasn't been reported as wages, then how can you believe the plan is established under the S Corp given these 2 simple rules? And if the plan isn't established under the S Corp, then how can any of the premiums (even the 60% portion that you believe IS "paid" by the S Corp) be deducted as SEHI? Since no one here has suggested that the 60% isn't deductible, then this line of logic breaks down (or we are all wrong, and no deduction is allowed). Since I don't think that is true, I am compelled to believe that 100% of the premiums are PAID by the S Corp as defined in §535(6). As stated in Notice 2008-1, premiums paid or furnished by the S Corp on behalf of the SH are considered guaranteed payments (i.e. not wages) even though the paystub would suggest otherwise. This implies that 100% of the premiums are reported as income on SH W-2 Box 1. And with all conditions seemingly met, 100% of the premiums are allowable as an SEHI deduction, as they "should be" (darn, I did it again).

Feel free to pick this apart as you will. I'm not trying to play word games, just trying to understand the laws and apply them correctly.

Make as if we don't use the "after tax" withholding but use the shareholder's check, instead, to pay his 40% of the premium (by paying the employer, who then pays 100% of the premium...) and the whole thing works... But this is just *illustration* - the same result *should be* available *using* the after-tax withholding, as in the OP's scenario.

The W-2 should show 100% of the premium as an SEHI payment, eligible for deduction by the shareholder/employee on his page 1, albeit subject to the "earned income from the business" limitation.

[Added: I think I may have changed my position on this, but I'm not going to go back now and check. There's things to do involving grill, heat, meat, and sauce.]

Is there a requirement for a written plan covering the medical insurance of the shareholder? I don't see a written plan requirement, therefore if the S Corporation somehow includes the amount of SEHI in the W-2 that would indicate there is some type of a plan, i.e., oral.

The Section 125 plan administrator may have a problem in how the shareholder is included the Section 125 plan.

Heck, I know nothing about SEHI I am just wool-gathering again.

Notice 2008-1 had a purpose which was to clarify the S Corp had to pay for premiums in order to get the above the line deductions. They wanted to do away with the shareholder payment from their own funds for premiums and getting the deduction. Personal payments are to be documented and reimbursed by the corporation to get the favorable tax treatment.

When you keep this purpose in mind, how can you overlook the deduction from the shareholder's wages for premium costs which is in fact personal after tax payment of premiums?

Again I say, to fix this, fix the wage and check stub reporting to show this the correct way. Company pays 100% of premiums, adds to Box 1 of the W-2 wages, is subject to income tax withholding, exempt from social security and medicare taxes. Shareholder gets the above the line deduction.

Premiums flow to shareholder's return in three places:

Line 7 wages

SEHI deduction above the line of an equal amount to line 7 wage amount

Deduction for premiums treated as wages also included in S Corp pass through on K-1 for this owners %

It was done on an after-tax basis in this case.

Notice 2008-1 had a purpose which was to clarify the S Corp had to pay for premiums

One purpose of the notice was to clarify that the corp had to "make" the premium payments.

Kathi, if this was the key purpose of Notice 2008-1, then why didn't they give an example of an S Corp paying the premiums through a wage deduction and clearly state that it doesn't qualify for the deduction? It seems to me Notice 2008-1 addresses the case of 100% of premium payments made by the SH (outside of any wage deduction), and that it is these payments that must be documented and reimbursed in order for the plan to be considered established under the S Corp. In my client's case, there's no documentation of payment to provide and reimburse since it's all handled through the S Corp.

Kathi/Chris, both of you seem to have experience handling this issue (in opposite ways), but has either of you dealt with the IRS directly (or found any other supporting documentation) regarding your interpretations of Notice 2008-1?

1) S-shareholder cannot pay the insurance out of his own pocket and take an S/E Health deduction on his 1040 [IRS says this won't work because the premiums have not been run through the corp and as such, the corporation has not directly provided this fringe benefit to the shareholder under the corporation's health insurance program. And since the S-corp has not directly provided this fringe to the shareholder, said fringe was not directly included in the shareholder's income and was certainly not reflected on his W-2. Now, the shareholder would argue that it has been inlcuded in his income since this was truly a corporate obligation that the corporation never deducted, thereby increasing the Ordinary Income passed thru to the shareholder, or reducing the ordinary loss passed through to the shareholder. Under the new guidance, this shareholder argument falls flat].

2) S-corp cannot separately state the deduction on the shareholder's K-1, which the shareholder then claims directly on his 1040 as S/E health [taxpayers used to argue that this would work because the deduction, since not offset at the corporate level against Ordinary Income, means that the shareholder has included it in his income (by virtue of reporting higher ordinary income, or less of an ordinary loss). Again, under new guidance, this argument falls flat].

3) S-corp cannot deduct corporate-paid health insurance as an "ordinary (fringe benefit) deduction" on the 1120S, with the shareholder then reporting the amount on Line 21, Form 1040, as "other income" and then with the shareholder taking the S/E health deduction on the face of his 1040. Under new guidance, this taxpayer argument likewise falls flat since the health insurance was not directly included in the shareholder's income, as reported by the S-corp (i.e. on shareholder's W-2).

4) S-corp cannot treat the corporate-paid health insurance as a Shareholder Distribution, with the Shareholder then taking the S/E health deduction on his 1040. [Again, for the reasons cited above, this won't work any longer. But note that RR 91-26 disallows this treatment anyway, although the rationale in RR 91-26 is a bit flawed].

I won't go so far as to say that these are the types of arguments that the IRS is attempting to "combat" with Notice 2008-1. The IRS isn't really isn't opining on the logical or illogical nature of these taxpayer arguments. Rather, the IRS is raising its arms and saying, "Enough is enough. There's too many aruments here, be they logical or not. So let's try to come up with a single method of tackling this issue." This is the overall intent of Notice 2008-1. Given this intent, this is probably why we don't have any examples in the Notice that involve after-tax deductions on the part of the shareholder.

But under general tax principles, if an employee is hit with an after-tax deduction for something, this is prima facie evidence that the value of the underlying fringe benefit was indeed included on the Shareholder's W-2.

Also, I think I heard that this Notice was actually drafted by one of the Big CPA firms - as sort of a pro bono project - and submitted by the CPA firm to Treasury/IRS who studied it and (maybe) made changes, and then published it as their own, early in 2008, but retroactively effectively to .. whenever.

Does anybody else also remember this back story of the Notice?

Chris, thanks for the details. I think you have a better case for the wage deduction that I do. In your scenario, 100% of the payments are deducted at the end of the year and it seems to support that the S Corp IS providing this as a SH fringe benefit, and that they just choose to report it this way (so that is shows up on the paystub and not JUST the W-2). In my scenario, the S Corp is trying to say that they pay 60% and the SH pays 40% (just like regular employees), only without any pre-tax benefit since the >2% SH can't participate in the 125 plan.

So back to my question a couple posts ago, is there ANY benefit to the S Corp (or anyone else, besides the IRS) in reporting it this way? If the "fix" is to change the reporting for the >2% SH to reduce the wages and remove the wage deduction so that 100% of the premiums just show up on the W-2 (and not the paystub), then does ANYTHING change other than reporting? If the answer is no, then I still question why my client can't deduct the full amount of the premiums, even though the S Corp reported it this way.

Yes, the Notice clarified that the policy doesn't have to be in the name of the corp, and as such, a reimbursement to the shareholder (or a direct premium payment by the corp to the insurer) will work. But that was no big surprise to those of us who had already been running such premiums through the corp for numerous years prior to the issuance of Notice 2008-1.

The common thread of all 4 examples is that (1) premiums must be run through corp in order to get an S/E Health deduction [through a direct premium payment by the corp or through a reimbursement to the shareholder] and (2) the value of the fringe needs to show up on shareholder's W2 (which the S/H is required to properly report on his 1040). This is the real jist of the notice.

Prior to Notice 2008-1, we had RR 91-26, and its various provisions were interpreted in a wide variety of ways by taxpayers and practitioners. Notice 2008-1 merely clarified everything. For example, the idea that the fringe needed to be "included in the shareholder's income" was interpreted such that it could easily be done without showing it on the guy's W2. RR 91-26 also said the corp "may" deduct the amount as wages - some took the position that it could be deducted as a fringe, and therefore, no W2 reporting was required. And still others completely bypassed RR 91-26 and argued that they could take the deduction personally if they paid the premiums personally and did not run them through the corp. And there were even more arguments and ideas than this.

Ex 1: Policy in S/H's name; shareholder personally makes premium payments; no reimbursements from corp; No deduction allowed.

Ex 2: Policy is in corp's name; corp makes premium payments; Yes deduction allowed.

Ex 3: Policy is in S/H's name; corp makes premium payments direct to insurer; Yes deduction allowed.

Ex 4: Policy is in S/H's name; S/H makes premium payments and is reimbursed by corp; Yes decuction allowed.

I think what I'm looking for is this... if the S Corp changes reporting for the future to show 100% of the payments in the same place (something they would ONLY do for the >2% ), what is the impact to the S Corp? Furthermore, if this change in reporting results in no loss of benefit for the S Corp, then it would seem the past returns could be amended (pursuant to Notice 2008-1 Example 3) to include 100% of the premium as an SEHI deduction in spite of the 60/40 reporting.

What if you had a law firm with 8 shareholders (all more than 2%)? If the firm had a policy that 100% of health insurance would be covered for all employees and shareholders, most employees would sign up for this. So they require 40% to be paid by employees hoping that some will opt for their insurance through a spouse (and hopefully let a big company subsidize most of the cost). Ideally the firm's bottom line would be helped if the shareholders could also get insurance through a spouse. But if 100% is paid by the law firm for shareholders, some shareholders will opt for that. So maybe the firm says we will keep the 60-40 split just to encourage the shareholders to look elsewhere. At close to $20k per year for a family plan, we could be talking some decent money.

Thanks for the response. That is an interesting point. However, I was more curious about whether there was any reason they would show 60/40 for >2% SH from a *taxable* standpoint, particularly since they would have regular employees that they want to keep at 60/40. I'm suggesting no change in total compensation for the >2% SH electing to take the insurance, just a change in the way it is reported. Of course, this would effectively reduce the salary of the >2% SH, and if a >2% SH were to decline the insurance, then the S Corp would have to choose whether to increase their salary by 40%.

What I'm really trying to do is justify that if all the S Corp has to do is change the way they report premiums paid for >2% SH and there is no loss of tax benefit to the S Corp, then I can claim that prior years that show 60/40 for >2%SH were reported as such out of ignorance and not intent. This gives some level of backup for filing amended returns to deduct 100% of the premiums for previous tax years.

If, on the other hand, by changing the reporting (to show 100% of the premiums ONLY on the W-2) somehow changes how the S Corp can deduct, or if FICA comes into play because of discrimination, then this would prevent any justification for amending my client's past returns to take the full deduction.

Hopefully that made sense....

I guess this is what Kathi is saying, by having the shareholder withhold 40% from their pay it is in essence saying the S Corp is only willing to pay 60%. I think the only way I would amend is if you went back and filed corrected W2's and I do not know how you could justify that if the 40% was actually withheld from their pay.

Based on all the opinions above, it’s obviously a judgment call. I would discuss the issues with the client and let them know the issues and let them make the call knowing that he 40% could be denied as above the line.

KathiJud: if the Taxles's client tells the S-Corp to change the paystubs to show the 40% as taxable benefit and stop paying Soc Sec & Medicare on the 40% I assume that this would fix the issue? HOwever if I am the S-Corp I'm again going to ask the question: is the 40%, since it is discrimanatory (offered for SH's but not other employees), subject to SS & Medicare becuase I'm not sure if the requirements for the exclusion under §3121(a)(2)(B) are satisfied. Does anyone know for sure if the §3121(a)(2)(B) requirements are satified for the discrimanatory portion? If not, your right back in the same boat-- the fringe benefit is after-tax (for all taxes) and, therefore, the same as regular wages and, thus, not allowed for SEHI deduction.

Definitely not, since the plan would not be established under the business as described in Notice 2008-1. It must be PAID BY or REIMBURSED BY the S Corp. As Ckenefick explains, the PAID BY has been accepted (by many) to mean CHECKS WRITTEN BY and never states that this can't be through a wage reduction.

In the scenario I'm suggesting, there would be no change to the W-2 Box 1, so it wouldn't need to be corrected. Going forward, the S Corp would reduce wages by an amount equal to the 40% and then include that in the S Corp portion of the premium. The W-2 stays the same (except perhaps the amount shown in Box 14, which is optional), but the paystub changes so that it doesn't show up as wages first.

Your point about the reimbursement did make me think about something else. What if the S Corp pays the 60% (or 100%) IF (and only if) the SH participates in the group plan? Would the failure of the S Corp to reimburse a SH (who gets his own plan in his name) by the same amount that the S Corp "pays" for other SH in the group plan be a violation of the guidelines described in Notice 2008-1? It is my understanding that my client's S Corp doesn't pay or reimburse ANYTHING unless the SH (or even a regular employee) participates in the group plan.

Not speaking directly for Kathi, but her posts in the link provided by BerkshireCPA earlier in this discussion state that the S Corp paying for 100% of the >2% SH premiums does NOT constitute discrimination. Discrimination would come into play if the S Corp wanted to pay different amounts for regular employees based on other factors (compensation, job role, years of service, etc.).