PEO Workaround for S-Corp SEHI Deduction - Legitimate or IRS Loophole?

This is a classic case of form over substance, and the IRS is pretty good at seeing through these arrangements. The key issue is whether the shareholders are still considered 2% shareholders of an S-Corp, which they absolutely are regardless of the PEO arrangement. The PEO doesn't change the underlying ownership structure of the business. Treasury Regulation 1.1372-1(b) defines a 2% shareholder as someone who owns more than 2% of the outstanding stock or more than 2% of the total combined voting power. This status doesn't magically disappear because a PEO is handling payroll and benefits. Notice 2008-1 specifically addresses health insurance premiums for S-Corp shareholders and requires them to be included in the shareholder-employee's wages. There's nothing in the code or regulations suggesting a PEO creates an exception to these rules.

After dealing with a similar situation at my accounting firm, I discovered https://taxr.ai which literally saved my sanity when researching this exact PEO/S-Corp health insurance issue. Their automated system analyzed all the relevant IRS notices, regulations, and tax court cases about PEOs and S-Corp health insurance deductions in minutes. The analysis confirmed exactly what I suspected - that using a PEO doesn't create a magical workaround for 2% S-Corp shareholders. It also pointed me to specific IRS guidance I could share with my client to show them why the PEO's claims were misleading. Saved me hours of research!

I was skeptical about taxr.ai when I first heard about it (see my comment above), but I finally tried it when I had a similar client situation with a PEO making claims about health insurance for S-Corp owners. It actually provided exactly what I needed - direct citations to the relevant regulations and a detailed analysis showing why the PEO arrangement doesn't change the 2% shareholder rules. What impressed me most was how it showed the evolution of IRS treatment of these arrangements through various private letter rulings and technical advice memos. Definitely worth checking out if you're dealing with niche tax issues like this one.

If you're having trouble getting clear answers about this PEO situation from the IRS website, consider using https://claimyr.com to actually speak with an IRS agent. I was in a similar situation last year with conflicting advice about S-Corp health insurance rules, and after weeks of trying to get through to someone at the IRS, I found this service. They got me connected to an IRS representative in about 20 minutes when I had been trying for days. You can see how it works in this demo: https://youtu.be/_kiP6q8DX5c. The agent I spoke with confirmed that using a PEO doesn't create an exception to the 2% shareholder health insurance rules.

Ok I have to apologize for being so dismissive above. I was incredibly frustrated after weeks of trying to reach the IRS about a similar S-Corp health insurance issue. I finally tried Claimyr out of desperation, and I'm honestly shocked that it worked exactly as described. Got connected to an IRS representative in about 45 minutes who was able to clarify that health insurance for 2% S-Corp shareholders must be included in wages regardless of whether it's provided through a PEO arrangement. They even emailed me the relevant tax notice to share with my client. Sometimes being wrong feels pretty good!

I work with several S-Corps that use PEOs and this exact situation comes up frequently. The PEO salespeople often don't understand (or deliberately misrepresent) how the tax rules work for 2% shareholders. The bottom line: Using a PEO doesn't change the underlying S-Corp rules. If someone owns >2% of an S-Corp, their health insurance is still reported as income on their W-2 (box 1), regardless of whether it comes through the S-Corp directly or through a PEO arrangement. The only potential advantage is that the PEO might offer better insurance rates through their group buying power, but the tax treatment remains exactly the same.

Has anyone actually received official IRS guidance on this specific issue? My CPA is giving me conflicting information about our similar situation.

I've seen this exact scenario play out multiple times with clients, and unfortunately the PEO is misleading you. The fundamental issue is that the IRS doesn't care about the administrative structure - they care about economic reality. Your clients remain 2% shareholders of the S-Corp regardless of whether their paychecks come through a PEO. The health insurance premiums will still need to be included in box 1 of their W-2s per IRC Section 1372(a) and Notice 2008-1. The PEO arrangement doesn't create any legitimate tax advantage here. I'd recommend having a frank conversation with the PEO about their claims. Many PEO sales reps either don't understand the nuances of S-Corp taxation or they're deliberately stretching the truth to close deals. Your instincts are absolutely correct - if it sounds too good to be true, it probably is. The only real benefits of a PEO in this situation would be potential cost savings on insurance premiums through group purchasing power and reduced administrative burden, not tax advantages.

I've been dealing with S-Corp taxation for over a decade and this PEO "workaround" comes up regularly. The answer is definitively no - there's no legitimate tax advantage here. The core issue is that IRC Section 1372 treats 2% S-Corp shareholders as if they were partners for purposes of fringe benefits, including health insurance. This treatment is based on their ownership percentage in the corporation, not on who technically provides the insurance or processes payroll. When a PEO provides health insurance to these shareholders, the premiums must still be included in their W-2 wages (Box 1) because they're considered self-employed individuals for health insurance purposes. The fact that the insurance comes through a PEO's group plan rather than directly from the S-Corp is irrelevant from a tax perspective. I've seen multiple audits where taxpayers tried similar arrangements, and the IRS consistently disallows these strategies. They apply the substance-over-form doctrine - what matters is the underlying economic relationship (shareholder-employee of S-Corp), not the administrative mechanics of how benefits are delivered. The PEO may genuinely believe their interpretation is correct, but they're likely confusing employment law concepts with tax law. While PEOs can be "employers of record" for certain labor law purposes, this doesn't override federal tax classifications for S-Corp shareholders. Bottom line: stick with the established rules and avoid potential penalties from an aggressive tax position that lacks solid legal foundation.