Who Is Ineligible to Participate in a Section 125 Plan?

A Section 125 plan, often called a cafeteria plan, allows employees to choose between receiving taxable cash compensation or non-taxable qualified benefits. This arrangement enables employees to pay for certain benefits, such as health insurance premiums, with pre-tax dollars, thereby reducing their taxable income. While these plans offer significant tax advantages for both employees and employers, specific Internal Revenue Code (IRC) regulations determine who is eligible to participate. Not all individuals associated with a business can enroll in a Section 125 plan, as eligibility is primarily tied to an employer-employee relationship.

Individuals with Self-Employment Income

Individuals considered self-employed for tax purposes are ineligible to participate in a Section 125 plan. This category includes sole proprietors, partners in a partnership, and members of a Limited Liability Company (LLC) if the LLC is taxed as a sole proprietorship or partnership. Section 125 plans are designed for common-law employees; self-employed individuals are not considered employees of their own unincorporated businesses under the tax code. For example, a sole proprietor files business income and expenses on Schedule C (Form 1040), distinguishing their income from traditional W-2 wages. Similarly, partners receive a Schedule K-1 (Form 1065) reflecting their share of partnership income, treated as self-employment income rather than wages.

While a sole proprietorship or partnership can establish a Section 125 plan for its common-law employees, the owners themselves cannot participate on a pre-tax basis. Benefits paid to a self-employed individual through such a plan would be considered taxable income. The tax benefits of a Section 125 plan, such as reduced federal income, Social Security, and Medicare taxes, are intended for an employee’s salary reduction, which does not apply to self-employment income.

Shareholders of S-Corporations

Shareholders who own more than 2% of an S-corporation are also ineligible to participate in a Section 125 plan on a pre-tax basis. A “2% shareholder” is defined as someone who directly or indirectly owns more than 2% of the outstanding stock of the S-corporation, or stock possessing more than 2% of the total combined voting power of all stock. This rule extends to family members of such shareholders, including spouses, children, parents, and grandparents, due to attribution rules.

For fringe benefit purposes, 2% S-corporation shareholders are treated similarly to partners in a partnership, not as common-law employees. While an S-corporation can establish a Section 125 plan for its other employees, the 2% shareholders cannot use the plan to receive benefits tax-free. For instance, if an S-corporation pays health insurance premiums on behalf of a 2% shareholder, these amounts are included in the shareholder’s W-2 wages and are subject to income tax withholding.

These amounts are exempt from Social Security and Medicare (FICA) taxes if the premiums are paid under a plan covering a class of employees. Although 2% shareholders cannot participate in a Section 125 plan, they may still deduct health insurance premiums on their personal federal income tax returns through the self-employed health insurance deduction. Allowing an ineligible 2% shareholder to participate in a Section 125 plan can jeopardize the plan’s tax-qualified status for all participants, potentially making all benefits taxable.

Non-Employees and Other Associated Individuals

Beyond self-employed individuals and 2% S-corporation shareholders, other groups are ineligible for direct participation in a Section 125 plan because they do not meet the definition of a common-law employee. The Internal Revenue Service (IRS) defines a common-law employee as someone whose employer has the right to control what work is done and how it is done. This control extends to details like work hours, methods, and the provision of tools or equipment.

Independent contractors, who control their own work methods and are often engaged for specific projects, are not considered common-law employees. Consequently, independent contractors, often classified as 1099 workers, cannot participate in Section 125 plans. Including non-employees like independent contractors in a Section 125 plan can lead to tax qualification issues for the entire plan.

Retirees and former employees are ineligible for direct participation, although a Section 125 plan may extend benefits to them if the plan design permits and it does not primarily exist for them. Non-employee directors, who serve on a corporation’s board but do not otherwise provide employee services, are also excluded. While spouses and dependents cannot enroll in a Section 125 plan themselves, they can receive qualified benefits, such as health coverage, through the participation of an eligible employee.