Key Considerations for S Corporations in Year-end Payroll Reporting

Fringe Benefits

By Lauren Foley, MSA

As Dec. 31 approaches, an important consideration for employers is proper payroll reporting. W-2s must be sent to employees by Jan. 31, resulting in a very short window in which to ensure that final payroll is correct for tax reporting. In addition to compensation, employers must be sure that benefits are properly reported, including fringe benefits.

Fringe benefits are considered compensation and included in employee wages, unless they qualify for exclusion (i.e., are nontaxable and omitted from employee wages). However, if the recipient is a ‘2% shareholder’ (i.e., an owner and employee) of an S corporation, fringe benefits that otherwise qualify for exclusion are included in wages.

What Are Fringe Benefits?

A fringe benefit is a form of pay, including cash, amounts paid on behalf of an employee (e.g., health and life insurance, retirement and health accounts), or in-kind (e.g., property, meals, company cars), in addition to stated pay for the performance of services.

The Internal Revenue Code provides that fringe benefits are taxable, excluded, or partially taxable, depending on the type of benefit. If a fringe benefit is excluded or partially taxable, it must be ‘qualified,’ i.e. meet strict requirements to qualify for this preferential tax treatment. Even if excluded or partially taxable by employees, employers may deduct the cost of fringe benefits.

Lauren Foley

“The Internal Revenue Code provides that fringe benefits are taxable, excluded, or partially taxable, depending on the type of benefit. If a fringe benefit is excluded or partially taxable, it must be ‘qualified,’ i.e. meet strict requirements to qualify for this preferential tax treatment.”

What Are S Corporations?

Qualifying corporations that make S elections under the Internal Revenue Code are not separately taxed, as regular (C) corporations are. S corp status allows corporations to avoid double taxation by passing income, losses, and deductions to its shareholders, who report these items directly on their tax returns. Often, S corp shareholders are also employees.

Fringe Benefits and S Corp 2% Shareholder Employees

Due to the overlap between owner and employee status, special rules apply to S corp shareholder employee fringe benefit taxation and reporting. These rules apply to shareholders owning 2% or more of S corp stock (2% shareholders). Even if excludable by regular employees, 2% shareholder benefits are generally taxable and must be reported on the shareholder’s W-2. The following benefits are treated differently for 2% shareholders:

• Health insurance premiums are taxable and included on 2% shareholder employee W-2s. Regular employees’ W-2 wage does not include the employer paid portion of their health insurance.

• Retirement plan contributions are subject to self-employed contribution rules for 2% shareholder employees. These rules allow contribution of 25% of net earnings from self-employment. Retirement plan contributions for regular employees are non-taxable if they are within limits.

• Dependent care assistance from an employer is tax-free up to $5,000 for regular employees, while all dependent care benefits are taxable to 2% shareholder employees.

• Group term life insurance is entirely taxable to 2% shareholder employees, while life insurance is tax-free up to $50,000 coverage for employees.

• Health savings accounts are tax-free to regular employees but taxable to 2% shareholder employees.

• Unlike regular employees, 2% shareholder employees cannot participate in flexible spending accounts.

In addition, family members of 2% shareholders (e.g., spouse, children, parents) are also treated as 2% shareholders for fringe benefit purposes. That means any benefits they receive must follow the same tax and reporting rules as the ones given to the actual shareholder.

“Many S corporations are unaware of these rules and may face IRS adjustment if fringe benefits are not properly reported. If fringe benefits are omitted from W-2 reporting, the IRS may disallow related deductions, resulting in increased taxable income and potential penalties.”

Compliance and Planning

Many S corporations are unaware of these rules and may face IRS adjustment if fringe benefits are not properly reported. If fringe benefits are omitted from W-2 reporting, the IRS may disallow related deductions, resulting in increased taxable income and potential penalties.

If you are an S corp, planning to start an S corp, or a 2% shareholder employee, it’s important to review all the shareholders’ ownership percentages to determine the correct tax treatment of shareholder employee fringe benefits. The S corp should decide which benefits to offer and clearly communicate this information to its payroll provider, especially regarding shareholder benefits. Be sure to consult your CPA or refer to the IRS website for fringe benefit guidance.

Lauren Foley, is a senior associate at the Holyoke-based accounting firm Meyers Brothers Kalicka, P.C. This material is generic in nature. Before relying on the material in any important matter, users should note date of publication and carefully evaluate its accuracy, currency, completeness, and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances.