Who Is Not Eligible for a Section 125 Plan? Rules for 2026

Reviewed by a licensed benefits professional. Last reviewed: September 23, 2026.

People who are not eligible for a Section 125 plan are self-employed owners, more-than-2% S corporation shareholders and their family members, and independent contractors. Everyone else on your W-2 payroll can be eligible, as long as your written plan document lets them in.

I get this question on almost every first call with a business owner. The owner wants the tax break for the staff, and then asks, "Can I get it too?" The honest answer depends on how your company is taxed, not on your job title. This guide covers who is in, who is out, what the IRS requires before you start, and what it all means in dollars.

Want to see what the plan saves for the people who do qualify? Run your numbers first.

Who Is Not Eligible for Section 125 Plan Coverage?

Section 125 of the Internal Revenue Code says every participant in a cafeteria plan must be an employee. Sole proprietors, partners, LLC members taxed as partners, more-than-2% S corporation shareholders, their family members who work for the S corporation, board members who only serve as directors, and 1099 contractors are not employees for this purpose, so they cannot participate.

A Section 125 plan, also called a cafeteria plan, is a written employer plan that lets employees pay for certain benefits with pre-tax pay. The rule that only employees can participate comes straight from the statute. Internal Revenue Code Section 125(d)(1)(A) defines a cafeteria plan as a written plan under which "all participants are employees."

The IRS then spells out who is not an employee in Proposed Treasury Regulation 1.125-1(g). The IRS lets employers rely on these proposed regulations. Here is the full list of people who cannot participate:

The S corporation line surprises owners the most. A married couple that owns a 100% S corporation cannot participate, and neither can their adult son on payroll, because Section 318 treats the son as owning what his parents own. We cover that case in detail in our guide to Section 125 rules for S corp shareholders.

Contractors are the other common mistake. A 1099 worker is not on your payroll, so there is no paycheck to take a pre-tax deduction from. If you are unsure whether your workers are employees or contractors, read our breakdown of whether 1099 contractors can get Section 125 benefits before you draft the plan.

What Companies Qualify for Section 125 Plans?

Any employer with at least one W-2 employee can sponsor a Section 125 plan. That includes C corporations, S corporations, LLCs, partnerships, sole proprietorships, nonprofits, and churches. There is no minimum company size and no minimum payroll. The business only needs employees who are not in one of the excluded owner groups.

The key word is sponsor. A sole proprietor can sponsor a plan for employees even though the sole proprietor cannot join it, according to Proposed Treasury Regulation 1.125-1(g)(2). The same is true for partnerships and S corporations.

Here is how the entity type changes who benefits:

There is also one benefit a Section 125 plan cannot pay for, no matter who the employee is. Internal Revenue Code Section 125(f)(3) bars pre-tax payment of individual marketplace health plans bought on HealthCare.gov or a state exchange. The plan can pay for group health, dental, and vision premiums, health FSAs, dependent care FSAs, and HSA contributions.

Can Employees Be Excluded From a Section 125 Plan?

Yes. An employer can limit eligibility by job class or years of service, as long as the rules do not favor highly compensated employees. Internal Revenue Code Section 125(g)(3) allows a service waiting period of up to 3 years, and employees who meet it must be able to join by the first day of the next plan year.

In practice, most small employers use a much shorter wait. A 30, 60, or 90 day waiting period that matches the group health plan is common. You can also limit the plan to full-time employees, or exclude union employees whose benefits were bargained in good faith under Section 125(g)(1).

What you cannot do is write rules that let owners and managers in while keeping hourly staff out. That fails the eligibility test, and the penalty lands on the people you were trying to help. Under Section 125(b), highly compensated participants lose their tax-free treatment when the plan discriminates. For 2026, a highly compensated employee is anyone who earned more than $160,000 in the prior year or owns more than 5% of the company, according to IRS Notice 2025-67.

Key employees face a second limit. Under Section 125(b)(2), if key employees receive more than 25% of all the plan's qualified benefits, key employees lose the tax break. IRS Notice 2025-67 sets the 2026 key employee officer threshold at $235,000. Our guide to Section 125 nondiscrimination testing walks through all three tests with worked numbers.

What Are the Section 125 Requirements?

A Section 125 plan must meet four requirements: a written plan document adopted before the plan year starts, participation limited to employees, elections made before the period they cover, and benefits limited to cash or qualified benefits. The plan must also pass nondiscrimination testing each year.

What Are the Section 125 Plan Document Requirements?

The Section 125 plan document must describe every benefit offered, who is eligible, how and when employees make elections, the maximum pre-tax amount, how the plan is funded, and the plan year. Proposed Treasury Regulation 1.125-1(c) lists these elements.

The plan document is the single most important requirement. Proposed Treasury Regulation 1.125-1(c)(6) says that if there is no written plan, or the written plan fails these rules, the arrangement is not a cafeteria plan. Every pre-tax deduction then becomes taxable wages, retroactively, for every employee.

A compliant plan document covers these items:

1. A specific description of each benefit and how long it lasts.
2. The eligibility rules, including any waiting period.
3. The election procedures, including when elections are made and when they become irrevocable.
4. How employees pay for benefits, which is usually salary reduction.
5. The maximum amount of employer contributions and employee salary reductions.
6. The plan year.
7. Any FSA rules, such as the uniform coverage rule and a carryover or grace period.

A premium-only plan, the simplest Section 125 plan, still needs a written document. Many employers also need a wrap document and summary plan description for their health coverage under ERISA. Our guide to wrap plan documents and SPD requirements explains when that applies.

What Are the Section 125 Filing Requirements?

A Section 125 plan by itself has no annual IRS filing. IRS Notice 2002-24 suspended the old Form 5500 Schedule F requirement for cafeteria plans. However, a health FSA or group health plan inside the cafeteria plan may still need its own Form 5500 if it covers 100 or more participants at the start of the plan year.

Payroll reporting is where the real filing work happens. Pre-tax Section 125 deductions come out of Box 1, Box 3, and Box 5 wages on each employee's Form W-2. HSA contributions made through the plan go in Box 12 with code W, and dependent care FSA amounts go in Box 10, according to the 2026 IRS General Instructions for Forms W-2 and W-3.

How Much Does Eligibility Change the Savings? A Worked Example

Eligibility decides who gets the tax savings. Here is a real-world style example with round numbers, using a Florida S corporation with 12 people on payroll and 2 contractors.

• The owner holds 100% of the S corporation stock and draws a W-2 salary.
• The owner's spouse works in the office on W-2 payroll.
• 10 staff members are W-2 employees with no ownership.
• 2 bookkeeping and IT contractors are paid on a 1099.

Only the 10 staff members can participate. The owner is a more-than-2% shareholder. The spouse is treated as one under Section 318 attribution. The contractors are not employees.

Each of the 10 staff members pays $400 a month toward group health premiums. The math, using the 7.65% FICA rate from IRS Publication 15 and the 2026 12% federal bracket from IRS Revenue Procedure 2025-32:

Florida has no state income tax, so these numbers include only federal income tax and FICA. In a state with an income tax, employee savings would be higher.

The owner and spouse are not left out completely. An S corporation that pays health premiums for a more-than-2% shareholder reports them as W-2 wages for income tax but not for Social Security and Medicare, according to IRS Notice 2008-1. The shareholder can then usually claim the self-employed health insurance deduction under Section 162(l). It is a different path to a similar income tax result, just without the FICA savings.

If you want the FICA math for your own payroll, the Section 125 cafeteria plan guide covers how the savings scale with headcount.

Should You Handle Section 125 Eligibility Yourself or Use a Provider?

A business owner can write a Section 125 plan alone, but most small employers use a plan administrator for the document, eligibility rules, and annual testing. The risk sits in the details: one wrong owner in the plan, or no signed document, can make every deduction taxable.

Summit Health Benefits sets up Section 125 plans for small and mid-size employers. Summit provides the written plan document and summary plan description, supports nondiscrimination testing, and has its documents reviewed by ERISA attorneys. Summit also checks your ownership and entity type at the start, so excluded owners and family members are kept out of the plan from day one.

The best time to fix eligibility is before the first deduction. Once a plan runs for a year with the wrong people in it, the correction is always more expensive than the setup.

Frequently Asked Questions

Sources

Internal Revenue Code Section 125 (Cornell Legal Information Institute); Proposed Treasury Regulations 1.125-1 and 1.125-2 (IRS, 2007); Internal Revenue Code Sections 318, 1372, and 162(l); IRS Notice 2025-67 (2026 highly compensated and key employee thresholds); IRS Notice 2002-24 (Form 5500 Schedule F suspension); IRS Notice 2008-1 (S corporation shareholder health premiums); IRS Publication 15 (2026 FICA rates); IRS Revenue Procedure 2025-32 (2026 tax brackets); IRS 2026 General Instructions for Forms W-2 and W-3.