Before we begin, let me say that the key reason to incorporate or form an LLC is to limit the liability of the owners and shield personal finances from that of the business. But inevitably, questions about incorporating typically boil down to a single topic…taxes.
Whether it’s reducing self-employment taxes or looking to avoid that ‘double taxation’ whammy, business owners ponder which legal structure is right for their business and financial situation. In a previous article, I discussed the issue of double taxation and the S Corporation’s pass-through tax treatment.
But there are other tax implications involved when picking a business structure. And here I’d like to focus on how business deductions and employee benefits are affected by your legal structure:
A C Corporation can deduct 100% of the health insurance it pays for its employees, including those employees who are shareholders. The corporation can also fully deduct the costs of any medical reimbursement plan. And employees of a C Corporation are not taxed on the health benefits they receive.
With the S Corporation (and LLC that has elected pass-through tax treatment), it’s a different story. In an S Corporation, 2% or greater shareholders are not considered employees. Note: The term 2% shareholder refers to someone who directly or indirectly owns more than 2% of the corporation’s stock or owns stock with more than 2% of the voting power, at any time during the year. The health insurance of a 2% shareholder isn’t deductible by the corporation unless it’s included on the shareholder-employee’s W2. This means that these shareholders will need to pay taxes on their medical benefits ? however, they may be entitled to deduct those medial expenses on their personal tax returns.
If you find yourself in this situation, please take the time to make sure you’ve set up your policy and reimbursements correctly. For example, the healthcare policy can be in the name of the S Corporation and the S Corporation can pay the premiums and report the premium amounts as W2 wages. Or, if the policy is in your own name (and you pay the premiums yourself), the S Corporation must reimburse you and report the premium amount on the W2 wages.
In addition, be aware that you’ll need to make the same coverage benefits (this holds true for retirement plans and other benefits as well) to all employees within the same classification. You can offer different plans to different classes of employees (i.e. full-time workers, part-time workers, salaried workers, hourly workers), but you must treat everyone within the same classification consistently.
Both C Corporations and S Corporations can offer retirement plans to employees, including shareholder employees. Examples include: SEP plans (where the Corp can make large contributions to employee IRAs), Simple IRAs (with low employee contributions and employer matching contributions), and 401K (with higher contribution limits). However, be aware that in the S Corporation, shareholder employees receive retirement plan benefits based on earned W2 income, and not their shares of the corporation profit (in the form of dividends).