On December 13, 2007, the Internal Revenue Service issued Notice 2008-1 providing rules under which a 2% shareholder-employee in an S corporation is entitled to an income tax deduction for accident and health insurance premiums that are paid or reimbursed by the S corporation and included in the 2% shareholder-employee's gross income.

While many employees are eligible to exclude contributions made by an employer for accident and health insurance premium payments or reimbursements from gross income, 2% percent shareholder-employees of S corporations are not considered employees for this purpose. Because of this classification, the Internal Revenue Code has required the inclusion of such contributions or reimbursements made by an S corporation in the gross income of a 2% shareholder-employee.

Special rules promulgated under Notice 2008-1, however, provide that if certain requirements are met, a deduction may now be taken. The requirements include the following:

• The 2% shareholder-employee's earned income from the S corporation must exceed the amount of the premiums for the accident and health insurance policies covering the shareholder-employee;
• The 2% shareholder-employee may not be eligible to participate in any subsidized health plan maintained by the S corporation or the employer of his or her spouse;
• The shareholder-employee must report the premium payments or reimbursements received from the S corporation as gross income on the Form 1040, U.S. Individual Tax Return;
• The S corporation must establish a plan. A plan providing medical care is considered "established" by the S corporation if the S corporation makes insurance premium payments on behalf of the 2% shareholder-employee or reimburses the 2% shareholder-employee for insurance premium payments in the current taxable year; and
• The S corporation must report the accident and health insurance premium payments or reimbursements as wages on the 2% shareholder-employee's Form W-2 in that same year.

For the purposes of the special rules outlined in Notice 2008-1, a 2% shareholder-employee is defined as any person who either owns (or is considered as owning) on any day during the taxable year more than 2% of the outstanding stock of the S corporation or more than 2% of the total combined voting power of all stock of the S corporation.

An Internal Revenue Service representative has confirmed to us that the special rules are effective immediately. Two percent shareholder-employees of S corporations should review the Notice carefully to determine whether they satisfy the requirements and are therefore qualified to claim the deduction under section 162(l) of the Internal Revenue Code.

Steven J. Friedman is Chair of Littler Mendelson's Benefits Practice Group and a Shareholder in the New York office. Andrea Jackson, Senior Consultant, Employee Benefits and Legal Compliance, in Littler Mendelson's Dallas office, co-authored this article. If you would like further information, please contact your Littler attorney at 1.888.Littler, info@littler.com, Mr. Friedman at sfriedman@littler.com, or Ms. Jackson at ajackson@littler.com.