Key Takeaways

  • S corporations offer fringe benefits, but 2-percent shareholders are subject to different tax rules than regular employees.
  • Some benefits are fully taxable to these shareholders, such as health insurance and group-term life insurance premiums.
  • Others, like de minimis perks or on-site meals, may be excluded from income even for 2-percent shareholders.
  • IRS reporting and compliance are crucial for proper treatment of fringe benefits, especially when they are treated as compensation.
  • Benefits such as HSAs, FSAs, and dependent care assistance plans are generally not available to 2-percent shareholders under the same favorable tax treatment.
  • Reasonable compensation requirements also impact benefit planning for shareholder-employees.

S corp fringe benefits refer to additional benefits that supplement the salaries of employees in an S corporation. Unlike a regular corporation, which is subject to double taxation, an S corporation (S corp) allows its income, loss, deductions, and credits to flow through to its shareholders' personal tax returns. In this type of corporation, certain types of fringe benefits are taxable, while others are nontaxable.

Fringe Benefits in an S Corporation

Fringe benefits are usually excluded from the taxable income of an employee in an S corporation. Nonetheless, shareholders who own over 2 percent of the corporation's stock get special treatment. Instead of being taxed at the corporate level, an S corporation passes its income through to its shareholders. As such, it is subject to taxation rules that are different from those that apply to other types of business entity.

Additional Benefit Limitations for 2-Percent Shareholders

In addition to being taxed on many common benefits, 2-percent shareholders are excluded from several popular tax-advantaged plans. These include:

  • Health Savings Accounts (HSAs): Contributions made by the S corp to an HSA on behalf of a 2-percent shareholder are treated as taxable income.
  • Flexible Spending Arrangements (FSAs): 2-percent shareholders cannot participate in FSAs on a pre-tax basis.
  • Dependent Care Assistance Programs: Similar to FSAs, these benefits are not excluded from income for 2-percent shareholders.
  • Section 125 Cafeteria Plans: These plans, which allow employees to pay for benefits like insurance premiums pre-tax, are not available to 2-percent shareholders.

Employers must carefully distinguish between employee types when administering these benefits. Improper inclusion can lead to adverse tax consequences and disallowed deductions.

What Are 2-Percent Shareholders?

Designated as owners of an S corporation, 2-percent shareholders are not allowed to participate in Section 125 plans. They are regarded as partners and required to comply with additional taxation and reporting requirements. The additional regulations are applicable to shareholders with 2 or more percent of the outstanding stock of the company or 2 percent of the voting rights at any point within the tax year. 

Stock ownership is subject to family attribution rules, meaning a shareholder's parents, grandparents, spouse, children, and grandchildren are considered indirect owners of the same amount of stock.

Which Fringe Benefits Are Taxable?

Two-percent shareholders in an S corporation are required to pay taxes on the following fringe benefits:

  • Premiums for group-term life insurance coverage worth up to $50,000.
  • Premiums for health, accident, disability, and long-term care insurance.
  • Meals and lodging provided for the employer's convenience.
  • Reimbursements of transportation and moving expenses.
  • Adoption assistance programs.
  • Employee achievement awards with monetary values.

Third-party payroll service providers will usually report taxable fringe benefits on W-2 forms on behalf of the shareholders.

Which Fringe Benefits Are Nontaxable?

There are certain kinds of fringe benefits that are nontaxable, even for 2-percent shareholders. They include:

  • Cellphones used for business purposes
  • On-site meals for employees
  • Employee discounts
  • Use of company-owned vehicles for business purposes
  • Retirement planning assistance from an employer-sponsored program
  • Use of a health club provided by the employer
  • De minimis benefits such as company parties and holiday gifts.

Structuring Benefits to Minimize Tax Burden

Although many fringe benefits are taxable for S corp owners with more than 2 percent ownership, strategic planning can help reduce tax liability:

  • Reimbursements under Accountable Plans: If properly documented, reimbursements for business expenses are not considered taxable income.
  • Use of Company-Owned Vehicles: When used strictly for business, the value is not taxable, but mixed-use must be appropriately accounted for.
  • Business Cellphones: When used primarily for business and substantiated with documentation, cellphone benefits remain tax-exempt.

Employers should establish formal policies and maintain clear documentation to support these tax treatments.

Reporting Taxable Fringe Benefits

As an S corporation owner, you must report taxable fringe benefits as normal income on your individual tax return. The company may report those fringe benefits on Form 1120S as deductible salaries and wages. If you are working as an officer in an S corporation, you are required to report your fringe benefits as officer compensation.

The fringe benefits you provide for your employees are subject to federal withholding, state withholding, Federal Insurance Contribution Act (FICA) taxes, and Federal Unemployment Tax Act (FUTA) taxes. Premiums for health and accident insurance are an exception. Since they are not regarded as wages, these fringe benefits are only subject to federal and state withholding.

Importance of Reasonable Compensation

S corporations are required by the IRS to pay shareholder-employees a “reasonable salary” before distributing profits. Fringe benefits, when added to a low salary, may trigger scrutiny if the total compensation appears below market standards.

If fringe benefits are used to substitute for wages, the IRS may reclassify distributions as wages, subjecting them to payroll taxes and penalties. To avoid issues, shareholder compensation should align with industry norms based on roles, responsibilities, and experience.

Understanding Work-Related Fringe Benefits

Work-related fringe benefits refer to benefits that are not included in the income of an employee under Section 132. Such benefits are also called statutory fringe benefits or Section 132 fringe benefits. Two-percent shareholders of an S corporation can provide all work-related fringe benefits on a tax-favored basis, except for eligible transportation fringe benefits and reimbursements of moving expenses.

Qualified employee discounts and no-additional-cost services must be provided without discrimination. Qualified employee discounts are only excluded from income if they are discounts on products or services within the corporation's line of business where the employee works. For instance, if an S corp produces electrical components and runs a retail department store, an employee working in the department store does not qualify for tax-exempt discounts on electrical components.

Fringe Benefits Treated as Compensation

Revenue Ruling 91-26 and IRS Announcement 92-16 provide a partial clarification of the treatment of fringe benefit while directly addressing only premiums on health and accident insurance. 

Revenue Ruling 91-26 states premiums on health and accident insurance paid on behalf of 2-percent shareholders must be reported as compensation paid to them. As such, the premiums will not be deducted on IRS Form 1120S. According to IRS Announcement 92-16, if the deemed wages are paid in accordance with a plan under Section 3121(a), they are not subject to self-employment and FUTA taxes.

Frequently Asked Questions

1. What are 2-percent shareholders in an S corporation? They are individuals who own more than 2% of the company’s stock or voting power and are subject to special fringe benefit tax rules.

2. Can S corp owners deduct health insurance premiums? Yes, but for 2-percent shareholders, the premiums are reported as taxable income and then deducted on their personal return under IRC §162(l).

3. Are retirement benefits tax-free for S corp owners? Retirement plan contributions (like SEP IRAs or 401(k)s) are allowed, but the tax treatment varies depending on the plan and the shareholder’s compensation.

4. Can S corp owners use a cafeteria plan to receive pre-tax benefits? No, 2-percent shareholders are specifically excluded from participating in Section 125 cafeteria plans.

5. Do S corporation benefits need to be reported on a W-2? Yes. Taxable fringe benefits must be included in the shareholder’s W-2 as wages, even if they are later deducted on a personal return.

If you need help with S corp fringe benefits, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.