An ugly rule applies to how S corporation owners deduct the cost of health insurance that a corporation puts on its W-2s.
The words that make this an ugly rule are “earned income,” and this is unusual because you generally think of earned
income as a good thing.
But for the S corporation owner who hopes to deduct his or her health insurance as a self-employed health insurance
deduction on Schedule 1 of the owner’s personal Form 1040, the term “earned income” can create ugly results (hence
the “ugly rule”).

Applying the Ugly Rule
As you likely know from our prior articles, the S corporation deducts as W-2 wages the cost of health insurance it pays or
reimburses to the more-than-2-percent shareholder.
1
On the shareholder’s W-2, the cost of the health insurance adds to the wage amount in box 1 of the W-2 but not to the
wages reported in box 3 or box 5.2
The Form 1040 instructions (which are incorrect, or misleading at best) for how the more-than-2-percent shareholder
deducts the health insurance premiums state:3
You can deduct the premiums only if the S corporation reports the premiums paid or reimbursed as wages in box 1 of
your Form W-2 . . . and you also report the premium payments or reimbursements as wages on Form 1040 or 1040-SR,
line 1a.
If you quit reading the Form 1040 instructions at this point, which could be a logical stopping point, you could easily
conclude that box 1 wages control the deduction.
But no, that would be wrong. It would be too logical!
On the next page of the instructions, you find a footnote in the “Self-Employed Health Insurance Deduction Worksheet”
that states:
If you were a more-than-2-percent shareholder in the S corporation under which the insurance plan is established,
earned
income is your Medicare wages (box 5 of Form W-2) from that corporation.
What happened? The ugly rule makes Medicare wages the “earned income.”4

Example 1. Ted is the sole owner of his S corporation. The corporation reimburses Ted
$18,000 for his family health insurance plan, putting the $18,000 as wages in box 1 of the
W-2 and $0 in box 5 for Medicare wages.
The $18,000 is Ted’s sole compensation from the S corporation for the year.
Ted’s Form 1040 tax deduction for his self-employed health insurance is zero.
Why zero? His earned income for the health insurance deduction is zero—equal to his
Medicare wages.
Key point. This problem can exist when someone starts a new S corporation and does
not take a salary the first year, but does have the corporation pick up the tab for the
shareholder’s health insurance.

Example 2. Janet is the sole owner of her S corporation. The corporation pays her a
salary of $107,000 and reimburses her $22,000 for her individually purchased family
health insurance.
The S corporation puts $129,000 ($107,000 + $22,000) in box 1 as wages and $107,000
in box 5 as wages subject to Medicare taxes.
Janet’s Form 1040 tax deduction for her self-employed health insurance is $22,000.
Why $22,000? Her earned income of $107,000 exceeds the $22,000 of insurance costs.
Reasonable compensation. Janet’s reasonable compensation is $129,000 (wages plus
the cost of the health insurance).

Key point. If you operate your business as an S corporation and want your full self-employed health insurance
deduction, you need S corporation Medicare wages in box 5 equal to or greater than what the S corporation paid or
reimbursed you for your health insurance

Example 3. Ken’s S corporation suffered a downturn in business, which created a
$180,000 loss for the year. Because the business had a bad year, Ken did not take a
salary, but the S corporation reimbursed his health insurance.
Too bad for Ken! He gets zero as a self-employed health insurance deduction, and
depending on his circumstances, he could pay taxes on the dollar amount of the health
insurance that landed in box 1 of his Form 1040.

Example 4. Ava’s S corporation had $790,000 in net income, paid Ava $80,000 in salary,
and paid $20,000 for her family health insurance.
The S corporation reports on Ava’s K-1 $690,000 of net income ($790,000 – $80,000 –
$20,000). Her W-2 shows $100,000 as wages in box 1 and $80,000 in box 5.
Because Ava’s box 5 wages of $80,000 are greater than the $20,000 of health insurance,
Ava deducts her $20,000 of health insurance as a self-employed health deduction on line
17 of Schedule 1 of her Form 1040.
Reasonable compensation. Ava’s reasonable compensation is $100,000.

Takeaways
The tax code definition of box 5 Medicare wages as earned income for the more-than-2-percent S corporation
shareholder creates trouble for the shareholder who has little or no Medicare wages in box 5 of his or her W-2.
And this problem can exist when someone starts a new S corporation and does not take a salary the first year, but does
have the corporation pick up the tab for the shareholder’s health insurance.
If you operate your business as an S corporation and want your full self-employed health insurance deduction, you need
S corporation Medicare wages in box 5 equal to or greater than what the S corporation paid or reimbursed you for your
health insurance.