The differences in the federal income taxation of employee benefit plans relate to whether the individual covered under the plan is considered to be self-employed. Employees who have no ownership in the entity are all treated the same. Individuals considered self-employed are, in many instances, subject to different tax rules.
An individual is self-employed if he or she is a sole proprietor, partner, or 2 percent or more shareholder of an S corporation or of an LLC taxed as an S corporation. Shareholders of a C corporation or of an LLC taxed as a C corporation are not treated as self-employed, regardless of the amount of their ownership.
Here are some ways sole proprietors, partnerships, S corporations and LLCs taxed as S corporations may incur extra federal income tax liability from employee retirement and benefit plans.
* Contributions to qualified retirement plans are not deductible to the extent that they create a net operating loss.
* Group term life insurance premiums paid for self-employed individuals are not deductible by the entity and are included in gross federal taxable income of the self-employed individual. The self-employed individual is not entitled to take a portion of this expense as a business deduction or a personal itemized deduction.
* Employer-provided disability insurance for self-employed individuals is not deductible. If disability occurs, however, the self-employed individual pays no income tax on the proceeds.
* Self-employed individuals cannot participate in cafeteria plans and qualified transportation fringe benefit plans.
The taxability and deductibility of employee benefit plans should generally not be the deciding factor in selecting a form of entity, but business owners should understand that these factors may affect both their business and their personal bottom lines in significant ways. Paul M. Yenerall is a lawyer with Eckert Seamans Cherin & Mellott. Contact him at www.escm.com.