What Are the Limits on Fringe Benefits for Pass-Through Entity Owners?

S corporations, partnerships and limited liability companies (LLCs) that are treated as partnerships for tax purposes qualify for “pass-through” taxation. In other words, these businesses aren’t subject to entity-level tax; instead, income, gains and losses pass through to the owners’ individual tax returns. This tax treatment generally offers an advantage over businesses operated as C corporations.

But there’s a catch: The tax rules for fringe benefits provided to owners of pass-through entities are generally unfavorable compared to the rules for C corporation shareholder-employees.

Tax treatment of common fringe benefits

Most fringe benefits provided to regular employees are “tax-favored.” That is, they’re tax-free to the recipient and deductible by the employer. Examples of tax-favored benefits include:

• Health insurance coverage,
• Contributions to Health Savings Accounts (HSAs), 
• Disability insurance coverage,
• Up to $50,000 of group-term life insurance coverage, 
• Qualified moving expense reimbursements, 
• Qualified adoption assistance programs, and  
• Qualified transportation fringe benefits (such as public transit passes, van-pooling and parking allowances).

Unfortunately, none of these fringe benefits are tax-favored when they’re provided for S corporation shareholder-employees who own more than 2% of the company’s stock, partners, or LLC members treated as partners for tax purposes. For these individuals, these fringe benefits are taxable. For S corporation owner-employees, the value (normally the cost) of the fringe benefit is added to the owner’s wages.

However, S corporation shareholder-employees who own more than 2% of the company’s stock, partners, and LLC members treated as partners for tax purposes can generally deduct health insurance premiums paid by the pass-through entity and HSA contributions made by the pass-through entity on their personal returns.    

Universally tax-favored fringe benefits

Some fringe benefits are tax-favored, regardless of whether they’re provided for regular employees or for S corporation shareholder-employees who own more than 2% of the company’s stock, partners, or LLC members treated as partners for tax purposes. That means the pass-through entity can deduct the cost of providing the benefits, and the recipients don’t owe federal income tax on the benefits, assuming the basic qualification rules for tax-favored treatment are met. These universally tax-favored fringe benefits include:

Qualified educational assistance. Up to $5,250 annually of qualified educational assistance can generally be provided tax-free to employees and pass-through entity owners. However, tax-favored treatment isn’t allowed if more than 5% of benefits are provided to owners (including their spouses and dependents) who own more than 5%. 

Qualified dependent care assistance. Up to $5,000 annually of qualified dependent care assistance can generally be provided tax-free to employees and pass-through entity owners. However, tax-favored treatment isn’t allowed if more than 25% of benefits are provided to owners (including their spouses and dependents) who own more than 5%.

Working condition fringe benefits. Examples include reimbursements for job-related education and cell phones given out primarily for noncompensatory business reasons.

De minimis fringe benefits. These benefits are so small that accounting for them would be unreasonable or impractical. A common example is occasional meal reimbursements when working outside normal business hours.

Fringe benefits that aren’t listed in this article — such as free airfare for a personal vacation or season tickets to sporting events — are generally taxable whether provided to an employee or an owner of a pass-through entity. The pass-through entity can generally deduct the cost.

Moving target

When your business is set up as a pass-through entity, the tax code limits tax-favored fringe benefits for owners. The rules are complicated — and they could change under congressional tax reform efforts. Your tax advisor is atop the latest developments and can help you navigate the rules.

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