Partners Can't Participate in a Firm's HSA Program? Not Exactly True!

Partners aren't shut out of a Health Savings program. Not by any stretch. But they have to play by a slightly different set of contribution rules.

Certain business owners face a different set of rules when they participate in a company-sponsored Health Savings Account program. These owners include

• partners in a partnership,
• members of a Limited Liability Company (CCL), and
• owners of 2% or more of the shares issued by a Subchapter S corporation. (Note: the 2% threshold in federal tax law preserves employee status for workers who receive profit-sharing incentives in the form of very small ownership positions in the entity.)

They can treat their employees as any other business entity treats its, but these owners face certain restrictions on how they fund their Health Savings Accounts.

Restriction: Employer Contributions

Partnerships, LLCs, and Subchapter S corporations can make employer contributions into their employees' Health Savings Accounts. But those same owners can't receive a tax-free contribution from the entity. Instead, any money that the business contributes to their accounts is taxable income to them.

When the business deposits $1,000 into all enrollees' Health Savings Accounts, the business deducts the contributions as a business expense, like other compensation (including wages and other benefits). Non-owners receive the funds tax-free. Owners can receive the same contribution, but that amount is included in their taxable income.

Owners can then deduct the entity's contribution on their personal income-tax return. They receive most (but not all - see below) of the tax benefits that their employees enjoy when they participate in the Health Savings Account program.

Restriction: Pre-Tax Payroll Deductions

Eligible employees, regardless of business structure, can contribute to their Health Savings Accounts via pre-tax payroll deductions if their employer adopts a Cafeteria Plan. Those contributions flow into the Health Savings Account before federal payroll and income taxes and state income taxes (except in California and New Jersey -the two states that don't allow a deduction from state income levies) are applied.

In contract, federal tax law bars owners from enjoying the benefits of a Cafeteria Plan. They can make after-tax contributions - even setting up after-tax payroll deductions so that they fund their account systematically as many employees do - and then deduct that amount on their personal income tax return. They gain most (but again, not quite all) of the tax benefits that their employees enjoy.

The Net Loss to Owners

Partners, LLC members, and Subchapter S corporations suffer two losses because of their status as entity owners.

First, they can't avoid federal payroll taxes. Those levies amount to 7.65% (the employee and entity each pay this much) on the first $137,000 (2022 figure, indexed annually for inflation) of taxable income. Income above that level is taxed at only 1.45% (the Medicare tax after the 6.2% Social Security tax ceiling is met). On a $7,300 contribution (the maximum for a family contract when the account owner is under age 55), the Medicare tax amounts to only $105.85 (each, the owner and entity).

As a silver lining, if they end up paying any of the 6.2% Social Security payroll tax (because their taxable income is less than $137,000 in 2022), they report a higher income for purposes of calculating their Social Security benefit

Second, they receive their tax break a little later than employees. An employee who contributes $1,000 during the first quarter of the calendar year can do so through pre-tax payroll, before income taxes are applied. In contrast, an owner who makes the same $1,000 deposit does so with after-tax funds and must wait a year to receive the tax deduction on her personal income tax return.

Otherwise, a Level Playing Field

The distinction between owners and employee and the different tax treatment applies to contributions only. Once a Health Savings Account owner has funded her account, the distinction between business owner and employee isn't relevant under the tax code. Owners and employees are subject to the same annual contribution limits. Owners and employees can invest their balances and enjoy tax deferral on the growth of their balances. Owners and employees can withdraw funds tax-free for the same qualified expenses. Neither owners nor employees face a deadline to reimburse qualified expenses tax-free.

This equal treatment after contributions are deposited is important. Owners can't participate in a Health FSA, nor can they receive tax-free reimbursements from a Health Reimbursement Arrangement, or HRA. Both programs are employer-sponsored and exclude owners from participation. In contrast, Health Savings Accounts are personal accounts, even when the business offers the program and deposits funds into eligible participating employees' accounts. That's why owners can fund a Health Savings Account - albeit with some slightly different rules under the federal tax code - and not participate in other programs.

The C-Corporation Advantage

Owners of a C Corporation are classified as employees under the federal tax code. They don't own the entity. Rather, they own stock in the business. They are considered employees of the C Corporation. Therefore, they can take advantage of all the benefits of the Cafeteria Plan.

It may seem unfair to think that titans like Jeff Bezos or Mark Zuckerberg - both business owners whose personal fortunes are in the tens or hundreds of billions of dollars - can receive favorable tax treatment on their Health Savings Accounts (if they participate), whereas a plumber, attorney, certified public accountant, or owner of a tree service can't. But those small-business owners have the option to organize their entities as a C Corporation to enjoy the tax breaks that partners, LLC members, and greater-than-2%-shareholders of a Subchapter S corporation don't. They choose to establish their business under a structure in which they're direct owners presumably because the overall tax advantages and cost are less than adopting the C Corporation structure.

The Bottom Line

Health Savings Accounts provide partners, LLC members, and certain owners of a Subchapter S corporation to enjoy the benefits of a Health Savings Account program on terms that are similar - though not identical, and not quite as beneficial - as their employees. It's an opportunity that the same owners aren't afforded under federal tax law when their business offers other tax-advantaged medical reimbursement accounts.

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