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C corporations offer better tax treatment for fringe benefits than S corporations. But don't avoid an S corporation election simply because of fringe benefits.

S corporations may wind up with the same tax treatment as C corp owners, especially when it comes to health insurance. Just make sure you establish a formal plan that says you will pay health insurance premiums for a certain class of employees, such as management employees.

What's deductible, what's not

Here are the rules: C corporations can offer several tax-advantaged fringe benefits to their employees, including owner/employees. The corporation can write off the outlays while the employees can exclude them from taxable income.

The rules governing fringe benefits for S corporation employee/owners are not as favorable. Any S corporation employee/shareholder who owns (directly or indirectly) more than 2 percent of the company's stock faces limits on tax-free fringes.

What's allowed: An S corporation can deduct and exclude from the income of 2-percent-or-more employee/shareholders the following fringe benefits:

• Dependent care assistance.

• Education assistance programs.

• Qualified employee discounts, no-additional-cost services, working-condition fringe benefits, on-premises athletic facilities and fringe benefits that cost very little.

Offer such fringes if they're of value to you.

What's not allowed: An S corporation can deduct the following company-paid fringe benefits, but 2-percent-or-more employee/shareholders must pick up additional compensation for the benefit:

• Premiums for accident and health insurance coverage.

• The expense of meals and lodging furnished for the convenience of the S corporation employer.

• The cost of up to $50,000 of group-term life insurance coverage.

In addition, an S corporation typically must treat taxable fringe benefits paid on behalf of its 2-percent-or-more employee/shareholders as additional compensation. That means withholding payroll taxes.

Grab health-premium tax breaks

Even with those unfavorable rules, your S corporation can secure additional tax savings on payments made under a health insurance plan.

Even though such health insurance premium payments are treated as compensation to 2-percent-or-more S cor-
poration employee/shareholders, that compensation isn't subject to employment taxes.

So even though health insurance paid by your S corporation is taxable income for you, those payments are not subject to Social Security, Medicare or unemployment taxes.

Also, a 2-percent-or-more employee/ shareholder is treated just like a self-employed person when it comes to health insurance.

So S corporation owners are eligible for an above-the-line deduction for any health insurance premiums the corporation pays.

Starting in 2003, you can deduct 100 percent of the amount paid for medical insurance for an employee/shareholder and dependents.

A case study

Suppose you and your brother Bob each own 50 percent of an S corporation. During 2004, the corporation pays health insurance premiums totaling $5,000 for Bob as well as $7,500 in premiums for you and your family.

A written agreement exists between the corporation and the owners (you and Bob) covering those payments.

In this example, treat health insurance premiums as wages. Include the $5,000 for premium expenses as wages on Bob's Form W-2, and the $7,500 appears on your Form W-2.

But because the premiums are paid under a plan for a class of employees, those wages are not subject to payroll taxes. Also, you and Bob write off $7,500 and $5,000, respectively, on your personal tax returns as an adjustment to income.

Those above-the-line deductions reduce your adjusted gross income. In effect, the S corporation deducts the health insurance premiums, but they do not increase your personal tax obligation.

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