The Internal Revenue Service has come out with an interpretation that could affect the ability of some S corporation shareholder-employees to deduct health insurance premiums.

The guidance, given in IRS Notice 2008-1, affects taxation of health insurance premiums for S corporation employees who own 2% or more of the corporation’s stock, IRS officials write in the notice.

Section 1372(a) of the Internal Revenue Code says the IRS will treat S corporations as partnerships for the purposes of applying benefits tax rules.

Any “2-percent shareholders” of an S corporation will be treated as partners, officials write in the new notice.

If an S corporation meets a variety of conditions, it can deduct the cost of benefits for 2-percent shareholder-employees from its own taxable income, officials write.

Section 106 of the Internal Revenue Code normally lets employees exclude health insurance premiums from taxable income.

The 2-percent shareholders themselves are not employees for purposes of Section 106 and cannot simply exclude health insurance premiums from their taxable income, officials warn.

The 2-percent shareholder-employees may be able to deduct health insurance premiums paid by S corporations if:

- The amount of the deduction is less than the income the 2-percent shareholder-employee earns from the trade or business associated with the health plan.

- The 2-percent shareholder-employee is not eligible to participate in any other subsidized health plan maintained by the shareholder-employee’s employer or the shareholder-employee’s spouse.

- The S corporation makes the premium payments for the health coverage in the current taxable year or reimburses the 2-percent shareholder-employee for the coverage in the current taxable year.

- The S corporation reports the health premiums paid or reimbursed as wages.

- The 2-percent shareholder-employee includes the premium payments or reimbursements from the S corporation in taxable income.

“If the accident and health insurance premiums are not paid or reimbursed by the S corporation and included in the 2-percent shareholder-employee’s gross income, a plan providing medical care coverage for the 2-percent shareholder-employee is not established by the S corporation and the 2-percent shareholder-employee in an S corporation is not allowed the deduction,” officials warn.

Taxpayers who have been eligible for the deduction and did not take it can file amended tax returns to claim the deduction, officials write.

A copy of the notice is available