Discussion:PEO and the S-Corporation

"Our company understands that the premiums paid by an S Corp are normally included in the employee’s gross income for a plan the S Corp sponsors & provides. As you are aware, in this normal situation, the S Corp would not include a deduction for health insurance premiums paid on behalf of greater than 2% shareholders on line 18 of their Form 1120S tax return. Rather, they would include such amounts on the shareholders’ W-2 and take a compensation deduction on either line 7 or 8 of Form 1120S. On the shareholders’ individual Form 1040 tax returns, the shareholders would have W-2 compensation income that would be reported on line 7 and then be able to take a self-employed health insurance deduction on line 29.

The situation changes in the PEO relationship. We sponsor & provide the plan to eligible worksite employees. The client in turn pays an all-inclusive fee for a variety of human resource services. The client simply doesn’t pay health insurance premiums to us for the greater than 2% shareholders. The full amount of the PEO service fees should be deductible on the Form 1120S. While we don’t see our clients’ tax returns, we believe that it’s a pretty common practice to take that deduction on line 19 of the 1120S. The deduction of the PEO services fees would flow through to the shareholders’ Form 1040 as reduced net income of the S corp. On Form 1040, the shareholders would not have an amount for health insurance premiums added to their W-2 and they would not have a self-employed health insurance deduction.

Our position is consistent & based on Internal Revenue Bulletin, 2008-1 & we believe W-2 reporting is not appropriate. We also believe our position is tax neutral to the client and shareholder. In addition, it’s our understanding that the health plan policy must be established by the S Corp or shareholder for a self-employed insurance deduction to be taken (per IRS Publication 535, page 18). Because the health plan is sponsored by Administaff and health insurance premiums are paid by Administaff rather than the S corp, we believe that even if we were to include the value of the premiums in the shareholder’s income, the shareholder’s ability to take a self-employed insurance deduction could be in jeopardy.

Since the reporting of amounts on both Form 1120S and Form 1040 are subject to the specific facts and circumstances surrounding the PEO relationship, the client should discuss this matter with their tax advisor."

My question is: Do you think the PEO's position is a valid position? Seems like the s/h is missing out on a deduction.

In some cases, reporting the shareholder's medical insurance as a benefit does not result in the same tax consequences as reporting the premiums on the W2. Case in point -- EIC. As far as I know, there is no adjustment to earned income for EIC purposes for any medical insurance that might be included. (If I'm wrong on that, please let me know.) Granted this probably does not apply to a whole lot of taxpayers, but it might allow someone to get the EIC when they are technically not supposed to.

Riley2...thanks for your help, although I'm like Natalie and don't see which code section under 414(n)(3)(C) is the one you are referring to. I did see sec 106, Contributions by Employer to Accident and Health Plans listed. But the only plans this section referred to were Archer MSA, Contribtions to Flexible Spending Arrangements and HSAs. These are not the health plans my client has.

So not sure that 414 applies. Did I miss something?

Thank you so much for the feedback! You are awesome.

Why is this significant?

Internal Revenue Code § 106 basically says that 106 benefits provided to employees (as defined elsewhere) are excludible from gross income. Unfortunately, an employee of an S corporation is not really an employee at all if he and his family own more than 2% of the stock in the S corporation. Thus, an S corporation shareholder is taxable on Sec. 106 benefits provided by the leasing company. This means that the premiums should be included in box 1 of the W-2.

That was easy.

Now, for the difficult part. Internal Revenue Code § 162(l) limits the SE health insurance deduction to the amount of the shareholder’s FICA/Medicare wages from the S corporation. In this case, the shareholder’s FICA/Medicare wages from the S corporation are zero, forcing the shareholder to deduct his health insurance premiums on Schedule A.