Subchapter or S corporations are corporations that pass corporate income, losses, deductions, and credits along to their shareholders for federal tax purposes. Each shareholder of an S corporation reports the income and losses on his or her personal tax return.  The tax on this income is assessed at the shareholder’s individual income tax rate.

The Internal Revenue Code includes corporate officers within the definition of “employee” for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding.  Courts have consistently held that when corporate officers receive payments for more than minor services performed for the corporation their compensation should be considered wages subject to federal employment taxes, not as distributions or loans to shareholders.  The fact that the employee is also a shareholder does not change that requirement.  The compensation of S corporate officers should always be treated as wages.  This is also stated in the instructions to Form 1120S.

The amount of compensation to the shareholder/employee assigned as wages cannot exceed the amount received by him or her either directly or indirectly from the corporation.  If the shareholder/employee receives or is entitled to receive cash or property, then a reasonable salary amount must be determined.  There are no specific guidelines for this.  Factors used in determining the amount of compensation to a shareholder/employee can include:  his or her duties, responsibilities and qualifications; the time he or she spent on the business; wages of non-shareholder employees or comparable wages for similar services; a legal agreement or the use of any other formula for calculation.

If an S corporation shareholder/employee owns more than 2 percent of the corporation, and the corporation pays his or her health and accident insurance premiums, these premiums are deductible by the S corporation as benefits and are reportable as wages on the shareholder/employee’s Form W-2. They are not subject to Social Security, FICA or FUTA taxes. Therefore, this additional amount is included in Box 1 (Wages) of the W-2 but not in Boxes 3 or 5 of that form.  This shareholder/employee is eligible for an AGI deduction for amounts paid during the year for medical care premiums if the medical care coverage is established by the S corporation.  This means that the medical care coverage must be in the name of the S corporation or that the S corporation either paid or reimbursed this shareholder for the premiums and reported that amount as wages on his or her W-2.

Payments made by the S corporation of the shareholder/employee’s health and accident insurance premiums may be further identified in Box 14 (Other) of the Form W-2.  Neither a Schedule K-1 (Form 1120S) nor a Form 1099 should be used as an alternative to the Form W-2 to report this additional compensation.

Additional information can be found at www.irs.gov in article FS-2008-25 titled “Wage Compensation for S Corporation Officers,”and Form 1120S (U.S. Income Tax Return for an S Corporation).

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