S corporations, partnerships and limited liability companies (LLCs) that are treated as partnerships for tax purposes qualify for “pass-through” taxation. In other words, these businesses aren’t subject to entity-level tax; instead, income, gains and losses pass through to the owners’ individual tax returns. Currently, this tax treatment generally offers an advantage over businesses operated as C corporations.
But there’s a catch: The tax rules for fringe benefits provided to owners of pass-through entities are generally unfavorable compared to the rules for C corporation shareholder-employees.
Tax treatment of common fringe benefits
Most fringe benefits provided to regular employees are “tax-favored.” That is, they’re tax-free to the recipient and deductible by the employer. Examples of tax-favored benefits for the 2017 tax year include:
- Health insurance coverage,
- Contributions to Health Savings Accounts (HSAs),
- Disability insurance coverage,
- Up to $50,000 of group term life insurance coverage,
- Qualified moving expense reimbursements,
- Qualified adoption assistance programs, and
- Qualified transportation fringe benefits (such as public transit passes, van-pooling and parking allowances).
Unfortunately, none of these fringe benefits are tax-favored when they’re provided for S corporation shareholder-employees who own more than 2% of the company’s stock, partners, or LLC members treated as partners for tax purposes. For these individuals, these fringe benefits are taxable. For S corporation owner-employees, the value (normally the cost) of the fringe benefit is added to the owner’s wages.
However, S corporation shareholder-employees who own more than 2% of the company’s stock, partners, and LLC members treated as partners for tax purposes can generally deduct health insurance premiums paid by the pass-through entity and HSA contributions made by the pass-through entity on their personal returns as an above the line deduction.
Universally tax-favored fringe benefits
Some fringe benefits are tax-favored for the 2017 tax year, regardless of whether they’re provided for regular employees or for S corporation shareholder-employees who own more than 2% of the company’s stock, partners, or LLC members treated as partners for tax purposes. That means the pass-through entity can deduct the cost of providing the benefits, and the recipients don’t owe federal income tax on the benefits, assuming the basic qualification rules for tax-favored treatment are met. For 2017, these universally tax-favored fringe benefits include:
Qualified educational assistance. Up to $5,250 annually of qualified educational assistance can generally be provided tax-free to employees and pass-through entity owners. However, tax-favored treatment isn’t allowed if more than 5% of benefits are provided to owners (including their spouses and dependents) who own more than 5%.
Qualified dependent care assistance. Up to $5,000 annually of qualified dependent care assistance can generally be provided tax-free to employees and pass-through entity owners. However, tax-favored treatment isn’t allowed if more than 25% of benefits are provided to owners (including their spouses and dependents) who own more than 5%.
Working condition fringe benefits. Examples include reimbursements for job-related education and cell phones given out primarily for noncompensatory business reasons.
De minimis fringe benefits. These benefits are so small that accounting for them would be unreasonable or impractical. A common example is occasional meal reimbursements when working outside normal business hours.
Fringe benefits that aren’t listed in this article — such as free airfare for a personal vacation or season tickets to sporting events — are generally taxable whether provided to an employee or an owner of a pass-through entity. The pass-through entity can generally deduct the cost.
Moving target
When your business is set up as a pass-through entity, the tax code limits tax-favored fringe benefits for owners. The rules are complicated — and some of these benefits maybe changing for tax years starting in 2018 under congressional tax reform efforts. Our tax department is atop the latest developments and can help you navigate the rules.
