When you are the main owner of your company and pay for your own medical and dental insurance with S Corp funds, the IRS requires that the premiums you pay be included in your compensation (read: your W-2). What’s fun about that? This means that your reported income appears higher due to the inclusion of these premiums, which would typically mean paying more taxes, right? Not necessarily—just hear me out.
- Impact on Social Security and Medicare Wages: Health care premiums show up only in Box 1 of your W-2 (which shows wages). However, they do not go in Boxes 3 (Social Security Wages) and 5 (Medicare Wages) on your W-2. For example, if your total compensation is $100,000 and you have $10,000 in health insurance premiums, your W-2 will show $110,000 in Box 1. However, Boxes 3 and 5 will only display $100,000. This means that Social Security and Medicare taxes are calculated based on $100,000 rather than on the inflated $110,000. Social Security and Medicare taxes (roughly 15%) won’t be imposed on these $10,000 of health care insurance premiums, so you won’t pay $1,500 in additional taxes on this amount. Of course, as a business owner, you would get to deduct half of $1,500, but it's always better not to have the expense in the first place rather than to have the expense and then deduct it.
- Reporting Medical Deduction on Tax Forms: On the S Corporation tax return (Form 1120S), you will deduct this medical expense, which is now on your W-2 as part of the compensation of officers deduction. This deduction will include the $110,000 from Box 1 of your W-2, as we talked about earlier (and not Boxes 3 and 5 that trigger additional tax liability). This officer compensation deduction will reduce the net income of your S Corporation, which is beneficial since the IRS often focuses on the difference between officer compensation and net income in their attempt to determine reasonable compensation amounts. For your personal tax return (Form 1040), the W-2 shows $110,000 in taxable wages. But then you get to deduct $10,000 of health insurance premiums separately on Schedule 1 of your Form 1040. This deduction is a dollar-for-dollar reduction in your gross income, which lowers your adjusted gross income (AGI). Essentially, while your W-2 shows an inflated salary due to the premiums, the deduction on your individual tax return offsets this amount, resulting in no net impact on your AGI. In other words, the health insurance premiums are reported twice ( as income and as a deduction), but the overall tax impact remains balanced, resulting in a net zero effect.
- If deductions net each other, where is the tax benefit? The tax benefit lies in the Medicare and Social Security taxes that you did not pay on that additional $10,000. Also, the salary appears artificially higher because of the medical premiums, which helps with reasonable shareholder salary calculations. Meanwhile, Social Security and Medicare taxes are based on a lower amount. It’s a good outcome!
- Important Considerations: If you have health insurance coverage through your spouse, you generally cannot claim a tax deduction for your own health insurance premiums through the S Corporation. Additionally, you cannot consider the premiums paid by your spouse as a reimbursement or deduction for the business, as these premiums are typically already tax-advantaged through their payroll deductions.
To recap, while self employed health insurance premiums cause an artificial increase in your reported salary, they help improve the testing of reasonable shareholder salaries. Social Security and Medicare taxes are computed on a lower amount, resulting in tax savings.