Income inclusion for self-insured medical plan benefits paid to S shareholders.

Effective for tax years beginning Jan. 1, 1991, Rev. Rul. 91-26 provided guidance for reporting requirements for accident and health insurance premiums paid by S corporations on behalf of its 2% shareholders. In its ruling, the IRS stated that, under Sec. 1372, these premiums paid on behalf of the 2% shareholder/employees as consideration for services rendered will be treated like guaranteed payments from a partnership under Sec. 707(c). As such, the premium are deductible in full by the corporation and includible in the shareholder's gross income. The shareholder then deducts a portion of this amount from gross income on his personal tax return to arrive at adjusted gross income (AGI). The rest is a Schedule A itemized deduction subject to the 71/2% of AGI floor.

An issue arises for S corporations with self-insured medical reimbursement plans that include shareholders. For fringe benefit purposes, an S shareholder is not an employee. Thus, benefits paid to or on behalf of a 2% S shareholder may not be excluded from that individual's income. The question arises as to what amount should be includible in the shareholder's gross income-the total dollar amount of claims paid during the year or some other factor or equivalency (such as a COBRA amount). Rev. Rul. 91-26 spoke strictly of health insurance "premiums" and did not specifically address the reporting requirements for the amounts paid through self-insured plans.

Sec. 105(e) provides that amounts received by employees under a self-insured medical reimbursement plan are treated as amounts received through accident or health insurance and thus excluded from gross income. Self-employed individuals, however, are not treated as employees for Sec. 105 purposes. If excluded health and accident benefits are treated as if received through health insurance, by analogy and reference to Rev. Rul. 91-26, the amount includible in income of a 2% S shareholder could be considered the health insurance premium equivalent or "COBRA amount." The Service, however, appears to be taking a different approach by considering the full benefit paid by the employer as taxable income to the shareholder. There are, however, no published rulings or opinions on this subject to date.

One way to avoid this issue altogether would be to continue the self-insured medical plan for all employees and to purchase traditional accident and health insurance coverage for the 2% shareholders. There would be no question as to the amount to include in the shareholder's income; it would be the amount of health insurance premiums paid by the S corporation on behalf of the individual shareholders. In any event, S corporations implementing self-insured medical plans must act carefully and be aware of the potential tax implications.