8802 / How are accident or health benefits taxed for stockholder-employees of a closely-held C corporation?

An employer’s accident or health plan must be established for employees in order to provide tax-free coverage and benefits.¹ The same is true with respect to amounts received under a state’s sickness and disability fund under IRC Section 105(e)(2).

If a plan covers only stockholder-employees, the IRS can challenge tax benefits claimed under the plan on the ground that the plan is not for employees. The challenge for the closely-held C corporation is in establishing that the stockholder-employees are covered as employees, rather than in their capacity as stockholders. If this cannot be established, then premiums or benefits are likely to be treated as dividends. The result is that the premiums will be nondeductible by the corporation and the premiums or benefits will be includable in the gross incomes of covered stockholder-employees.²

Courts have found, however, that the tax benefits of employer-provided health insurance are available in a plan that covers only stockholder-employees. This is the case only if the plan covers a class of employees that can be segregated rationally from other employees, if any non-stockholder employees exist, on a criterion other than their being stockholders.³

The Bogene, Smith, Seidel, and Epstein cases, which were decided in favor of the taxpayers, all involved plans that covered only active and compensated officers of the corporation who also were stockholders. In Smith and Seidel, the officer-shareholders also were the only employees, though in Bogene and Epstein the corporations also employed other employees who were not shareholders and who were not covered by the plans.

The plan in American Foundry, where the plan was found to not be a plan for employees, covered only two of five active officers of a family corporation.⁴

The plan in Sturgill covered four officer-stockholders of a family corporation. Two of the four were not active or compensated as officer-employees and the plan was held not to be one for employees.⁵

The plan in Leidy covered only the president, who was the sole stockholder, and the vice president, who was no longer active in the company.

In American Foundry and in Sturgill, courts allowed the corporations to deduct reimbursement payments to the active officers as reasonable compensation, even though the payments were not excludable by shareholder-employees under IRC Section 105.