Who Is Not Eligible for a Section 125 Plan?

Section 125 plans, often called “cafeteria plans,” allow employees to pay for certain benefits with pre-tax dollars. These plans allow individuals to reduce their taxable income by deducting qualified benefit expenses, such as health insurance premiums, directly from their paychecks. While offering tax advantages, not everyone is eligible to participate in a Section 125 plan, as specific criteria apply.

The Common Law Employee Standard

Eligibility for a Section 125 plan is limited to “common law employees.” The IRS uses a set of common law rules to determine if a worker is an employee or an independent contractor. These rules examine the relationship between the worker and the business across three main categories: behavioral control, financial control, and the type of relationship.

Behavioral control assesses whether the business has the right to direct or control what work is accomplished and how it is done, including instructions, training, and the methods used. Financial control evaluates the business aspects of the worker’s job, such as how the worker is paid, whether expenses are reimbursed, and who provides tools and supplies. The type of relationship considers factors like written contracts, whether employee benefits are provided, and the permanency of the relationship.

Individuals who do not meet this common law employee standard, such as independent contractors, are ineligible to participate in a Section 125 plan. Independent contractors typically control how and when their work is performed, bear their own business expenses, and offer their services to the general public.

Specific Exclusions for Business Owners

Beyond the common law employee standard, certain business owners are specifically excluded from Section 125 plan participation due to their tax classification. For instance, sole proprietors are considered self-employed individuals, not employees of their own business, for Section 125 plan purposes. This means they cannot utilize a Section 125 plan to pay for their health insurance or other qualified benefits on a pre-tax basis.

Similarly, partners in a partnership are treated as self-employed individuals rather than employees of the partnership. Consequently, they are not eligible to participate in a Section 125 plan offered by their partnership. While they may still be able to deduct certain benefits on their individual tax returns, they cannot do so through the pre-tax mechanism of a cafeteria plan.

An exclusion applies to more-than-2% shareholders of an S-corporation. Although these individuals can be employees of their S-corporation, the IRS, under Internal Revenue Code Section 1372, treats them as partners for fringe benefit purposes, including Section 125 plans. This means that while the S-corporation can sponsor a Section 125 plan for its common law employees, a shareholder owning more than 2% of the S-corporation’s stock cannot receive benefits through the plan on a pre-tax basis.