The Rigid Rules of Flex Plans

S-corp shareholders don't qualify for tax-free accounts to cover medical expenses

Q: My husband and I just started a computer consulting company -- an S corporation -- and the two of us are the only employees. I'm wondering: Can we set up a medical flex plan that would allow us to set aside tax-free money to be used for medical and dental expenses?

A: . Medical flex plans, also known as a flexible savings accounts, were established under Section 125 of the Internal Revenue Code to allow changes in the way certain types of expenditures are taxed. In accordance with IRS Code 125, expenditures such as medical, dental, vision, and dependent-care expenses not covered by insurance may be paid with pre-tax dollars, resulting in a reduction in your federal taxes and, in most cases, your state taxes. Generally, all employees are eligible to participate in these plans. Therefore, in order for you, as a 2%-or-more shareholder, to be eligible to participate, you must be considered an employee.

Shareholders of S corps are subject to special rules with respect to fringe benefits, including flexible spending accounts. Under Section 1372 of the Internal Revenue Code, a 2% shareholder of an S corp is treated as a partner in a partnership for fringe-benefit purposes. Therefore, S corps must look to the partnership rules in determining the treatment of fringe benefits to a 2% shareholder. Proposed regulation 1.125-1 confirms that the term "employee" does not include self-employed individuals. Since a 2% shareholder of an S corp is treated as a partner of a partnership for fringe-benefit purposes and not an employee, S-corp shareholders are also excluded from participation in a flexible spending account.

In addition, family members defined in Internal Revenue Code 318(A)(1) -- spouses, children, grandchildren, and parents -- also would be treated as 2% shareholders and precluded from the benefit of a Section 125 flexible savings account.

Robert J. Traphagen, CPA

Traphagen & Traphagen

Oradell, N.J.

Editor's note: While the information in Tax Adviser represents the opinion of an expert, it is not legally binding.

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