Oh my gosh. It’s crazy, right? Complicated old rules and then fuzzy new rules from the Affordable Care act make it really hard for S corporation shareholders to know how to handle the payroll accounting for health insurance.
In this lengthy post, then, I’m going to review the old rules which still impact how we need to handle stuff. And then I’m going to shine a light on the current, partially-constructed new rules.
Note: Because I think this information will probably be most useful to tax practitioners that serve small businesses, I’m going to heavily link to primary source authorities. If you’re a small business owner, you can probably ignore these links.
Old Rule #1: 2% S corporation shareholders get the self-employed health insurance deduction
The first old rule to know: 2% S corporation shareholders do get to take a self-employed health insurance deduction as long as they handle the payroll accounting right.
In the case of S corporations, more specific rules are contained in Notice 2008-1. This notice explains that health insurance premiums paid by an S corporation are treated the same way as partnership guaranteed payments for income tax purposes. In addition, for payroll tax purposes, the premiums can be exempt as long as they meet the requirements for exclusion in IRC § 3121(a)(2)(B).
Putting this all together, it means that generally speaking, when a 2% shareholder-employee of an S corporation receives their W-2, then—assuming for simplicity that the shareholder-employee’s only compensation is salary and health insurance—box 1 should include both the salary and health insurance, boxes 3 and 5 should include just the salary, and box 14 should indicate the amount of the shareholder-employee’s health insurance.
Then, when the shareholder-employee goes to file their tax return, line 7 (wages, salaries, tips, etc.) should include the compensation from box 1 of the W-2, and line 29 (self-employed health insurance deduction) should include the health insurance from box 14 of the W-2. The net effect on line 37 (adjusted gross income) is that the health insurance ultimately becomes exempt from income tax in addition to payroll tax. Note, however, that this beneficial tax treatment all hinges on the S corporation carefully following the rules described in Notice 2008-1.
Old Rule #2: Certain employee health plans can’t discriminate
And here’s another old pre-Affordable Care Act rule to know about: certain health plans can’t discriminate. Unfortunately, this rule requires a bit of gritty detail to understand. So let me walk you through the details. (Sorry, this will take a few paragraphs.)
Two types of employee health insurance benefits have been historically subject to non-discrimination: plans described under IRC § 105(h), and plans described under IRC §125.
IRC § 105(h) has barred self-insured group health plans from discriminating in favor of their highly-compensated employees (often referred to as “highly-compensated individuals,” or HCIs).
There are two nondiscrimination tests under IRC § 105(h) that an employer must meet: the eligibility test, to ensure that enough non-HCIs are eligible for the group health plan, and the benefits test, to make sure that HCIs are not receiving superior benefits from the plan.
So what is a “highly-compensated individual”? HCIs include the following employees:
- The highest-paid 25% of all non-excludable employees
- The five highest-paid officers
- The more-than-10% shareholders
The following are “excludable employees”:
- Employees who have not completed three years of service
- Employees under age 25
- Part-time or seasonal employees
- Non-resident aliens with no U.S. source income.
To pass the eligibility test, an employer must meet either the 70% test, the 70/80% test, or the nondiscriminatory classification test. The 70% test is probably the easiest to administer, but the hardest to pass, while the nondiscriminatory classification test is probably the easiest to pass, but the most complicated to administer.
The 70% test is simple: The plan benefits 70% or more of all non-excludable employees. The 70/80% test is slightly more nuanced: 70% or more of all non-excludable employees are eligible to benefit under the plan, and of those employees, 80% actually do benefit.
The nondiscriminatory classification test is simple enough in concept: the plan must benefit a classification of employees that is both “reasonable” and “nondiscriminatory.” The complexity, of course, comes from trying to concretely answer the question, “what do ‘reasonable’ and ‘nondiscriminatory’ mean?”
According to the regulations, a “reasonable” classification is one that is based on objective business criteria. Examples in the regulations include job categories (e.g. full-time vs. part-time), nature of compensation (hourly vs. salaried), and geographic location.
A “nondiscriminatory” classification is one that meets either the “safe harbor percentage test” from IRC § 410(b)(1)(B) or a facts and circumstances test. Note that the safe harbor percentage test will require several specific calculations to determine; it’s not something for an employer to “guesstimate.”
As I said before, the nondiscriminatory classification test is probably the most complicated test to administer, but the easiest test for a business to pass. If a small business wants to use this test to pass the eligibility test, it will need to hire a tax advisor who has thoroughly read the relevant Treasury regulations to figure out what counts as “reasonable” and “nondiscriminatory” (see Treas. Reg. 1.105-11). Otherwise, the business will need to defer to one of the simpler, but more restrictive, tests.
The benefits test says a plan must provide to non-HCIs all the same benefits that it provides to HCIs. In order to meet the benefits test, it’s not good enough for a plan to simply be nondiscriminatory on its face; the plan also has to be nondiscriminatory in its operation.
Some examples of a plan that would be “discriminatory on its face” include a plan that charges non-HCIs higher premiums or deductibles than HCIs, a plan that provides non-HCIs with access to fewer benefits than HCIs, or a plan that imposes a longer waiting period on non-HCIs than on HCIs.
“Nondiscriminatory in operation” is a facts and circumstances test. An example of a plan that is discriminatory in operation: an employer’s plan covers a benefit when an HCI needs that benefit, then the employer amends the plan to exclude the benefit once the HCI no longer needs that benefit.
For self-insured plans, the penalty for violating the discrimination rules has historically been that HCIs have to include the value of the “excess benefits” they receive as taxable income.
Types of Plans Covered
I mentioned earlier that these old rules only applied to “self-insured plans.” Let’s take a little bit of time to talk more in detail about what that means. The definition of a self-insured plan in the statute is as follows:
The term “self-insured medical reimbursement plan” means a plan of an employer to reimburse employees for expenses referred to in subsection (b) for which reimbursement is not provided under a policy of accident and health insurance.
That reference to subsection (b) just means that the plan pays for “medical care” as the term is defined in IRC § 213(d). “Medical care” therefore means amounts paid:
(A) for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body,
(B) for transportation primarily for and essential to medical care referred to in subparagraph (A),
(C) for qualified long-term care services (as defined in section 7702B(c)), or
(D) for insurance (including amounts paid as premiums under part B of title XVIII of the Social Security Act, relating to supplementary medical insurance for the aged) covering medical care referred to in subparagraphs (A) and (B) or for any qualified long-term care insurance contract (as defined in section 7702B(b)).
In the case of a qualified long-term care insurance contract (as defined in section 7702B(b)), only eligible long-term care premiums (as defined in paragraph (10)) shall be taken into account under subparagraph (D).
The relevant regulations (Treas. Reg. 1.105-11) get into the definition of a self-insured plan in further detail:
(i) Definition. A self-insured medical reimbursement plan is a separate written plan for the benefit of employees which provides for reimbursement of employee medical expenses referred to in section 105(b). A plan or arrangement is self-insured unless reimbursement is provided under an individual or group policy of accident or health insurance issued by a licensed insurance company or under an arrangement in the nature of a prepaid health care plan that is regulated under federal or state law in a manner similar to the regulation of insurance companies. Thus, for example, a plan of a health maintenance organization, established under the Health Maintenance Organization Act of 1973, would qualify as a prepaid health care plan. In addition, this section applies to a self-insured medical reimbursement plan, determined in accordance with the rules of this section, maintained by an employee organization described in section 501(c)(9).
(ii) Shifting of risk. A plan underwritten by a policy of insurance or a prepaid health care plan that does not involve the shifting of risk to an unrelated third party is considered self-insured for purposes of this section. Accordingly, a cost-plus policy or a policy which in effect merely provides administrative or bookkeeping services is considered self-insured for purposes of this section. However, a plan is not considered self-insured merely because one factor the insurer uses in determining the premium is the employer’s prior claims experience.
So to put it briefly, a self-insured plan is any employer-based health plan in which the risk has not been shifted to an insurance company. Therefore, the following types of arrangements would pretty clearly qualify as self-insured health plans and thus have always needed to follow the nondiscrimination rules of § 105(h):
- Administrative services only (ASO) plans
- Cost-plus arrangements
- Medical expense reimbursement plans, such as a health FSA, provided through a § 125 cafeteria plan
- Health reimbursement accounts (HRAs) for out-of-pocket medical expenses or expenses not covered by an employee’s insurance policy
It’s worth noting that the last category of plan I mentioned, HRAs, has been a common type of benefit for small businesses to offer.
It’s also worth briefly mentioning that there are also employee health care non-discrimination rules that predate the ACA in IRC § 125 (on cafeteria plans). However, I won’t spend much time discussing those rules here. This is a post about health insurance for 2% S corporation shareholder-employees, and such shareholders are, in fact, ineligible to even participate in § 125 plans (along with partners in a partnership and other self-employed individuals).
New ACA Rule #1: No EPPs or non-integrated HRAs or FSAs
This blog covered this new rule in depth in a prior article. But the short version of that post is that most premium reimbursement plans are no longer legal due to the Affordable Care Act’s market reforms, as the IRS explained in Notice 2013-54 and Notice 2015-17.
Effect on 2% S corporation shareholders
In response to questions about how the new rules against EPPs affected 2% S corporation shareholder-employees, the IRS said this in Notice 2015-17:
The Departments are contemplating publication of additional guidance on the application of the market reforms to a 2-percent shareholder-employee healthcare arrangement. Until such guidance is issued, and in any event through the end of 2015, the excise tax under Code § 4980D will not be asserted for any failure to satisfy the market reforms by a 2-percent shareholder-employee healthcare arrangement. Further, unless and until additional guidance provides otherwise, an S corporation with a 2-percent shareholder-employee healthcare arrangement will not be required to file IRS Form 8928 (regarding failures to satisfy requirements for group health plans under chapter 100 of the Code, including the market reforms) solely as a result of having a 2-percent shareholder-employee healthcare arrangement. [emphasis added]
Note that the IRS has also stated that it will not impose penalties on S corporation group health plans in the following two clear-cut situations:
- The S corporation provides medical benefits under a health plan that satisfies the ACA market reform requirements (for example, a group health plan that does not provide for reimbursement of individual policy premiums); or
- No more than one active employee participates in the employer payment plan under which the S corporation reimburses the cost of individual policy premiums.
New ACA Rule #2: No discrimination in favor of highly-compensated employees
The Affordable Care Act expanded non-discrimination rules to cover all employer health plans, not just self-insured ones. The new § 2716 of the Public Health Service (PHS) Act says:
Rules similar to the rules contained in paragraphs (3), (4) and (8) of section 105(h) of such Code shall apply.
As described above, IRC § 105(h) existed before ACA and contains rules that prohibit self-insured health plans from discriminating in favor of highly-compensated employees. And again, if an employer subject to § 105(h) violates the rules, then the highly-compensated employees who disproportionately benefit from the plan don’t get the income tax benefits generally applicable to employee group health plans.
However, if an employer subject to the new § 2716 violates the rules, it will be subject to a $100 per day per affected employee penalty. Brutal.
Since “similar to” is such a wishy-washy concept, employers and tax professionals on top of the issue made public comments requesting clearer guidance on what the new rules are. IRS Notice 2011-1 responded by essentially saying, you’re right employers, it’s not fair or practicable to ask you to follow a new set of rules when it’s not even clear what the rules are.
The notice further said that the IRS, the Treasury, the Department of Labor and the Department of Health and Human Services have all agreed that they won’t begin enforcing the rules until they establish some clear regulations. Finally, the notice also assured employers that there will be time between when the new regulations are published and when they are enforced to give employers the ability to get up to speed on the new rules.
Notice 2011-1 noted that many public commenters have submitted interesting ideas for what the new regulations could include. One idea was that “coverage” provided to a ‘highly compensated individual’ (as defined in § 105(h)(5)) on an after-tax basis should be disregarded in applying § 2716.”
But it’s important to note that currently, no regulations on § 2716 have been finalized, and I think we can all agree that the phrase “similar to,” on its own, is frustratingly uncertain, as is the fact that it’s already 2016 and we still have no idea when final regulations on this topic will be published.
Three Final Comments
This blog post is now exceedingly long, but let me share three final quick comments to try and tie this together a bit.
First a comment related to the delayed regulations: The IRS issued Notice 2008-1 because it realized many one-man-band S corporations couldn’t qualify for group health coverage under state insurance laws. On the surface, then, the rationale behind the old S corporation health insurance rules doesn’t seem to conflict too badly with the new market reform rules, since the market reforms only apply to plans that affect two or more people. I find it plausible that the future S-corporation-specific regulations will simply say, hey, Notice 2008-1’s provisions allowing individual premium reimbursement plans now only apply to one-employee S corps under the new market reforms, and if your S corporation has two or more employees, we’re going to make you find group health insurance because we don’t think there’s any reason why you can’t. (But of course, that’s simply me speculating.)
A second comment: The IRS noted in Notice 2015-17 that part of its reasoning for offering temporary relief was that the SHOP exchanges weren’t quite working as well as they needed to yet. Quoting from the notice:
The SHOP Marketplace addresses many of the concerns of small employers. However, because the market is still transitioning and the transition by eligible employers to SHOP Marketplace coverage or other alternatives will take time to implement, this guidance provides that the excise tax under Code § 4980D will not be asserted for any failure to satisfy the market reforms by employer payment plans that pay, or reimburse employees for individual health policy premiums or Medicare part B or Part D premiums (1) for 2014 for employers that are not ALEs for 2014, and (2) for January 1 through June 30, 2015 for employers that are not ALEs for 2015. After June 30, 2015, such employers may be liable for the Code § 4980D excise tax.
Were all of the state SHOP exchanges up and running, the IRS’ point in that first sentence would be quite valid. However, as we’ve covered previously on this blog, in 2017 most counties in Washington State won’t have access to SHOP at all. It’s unclear what affect this might have on IRS regulations on employer health plans going forward.
And a third and final comment: Once the federal government publishes final regulations to clarify § 2716, it might be worthwhile for employers to take the time to determine whether their employee health benefit plans are subject to IRC § 105(h) or § 2716. This is because § 105(h) plans will likely come with much more lenient penalties for noncompliance (loss of income tax-preferred status) compared to those for § 2716 plans ($100 per affected employee per day penalty).
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