By: HUB’s EB Compliance Team

A Section 125 plan, sometimes called a cafeteria plan, is one of the most valuable tools available to employers for helping employees pay for benefits with pre-tax dollars. However, the tax rules that make Section 125 plans valuable for employees can also create limitations for certain business owners. Individuals who are treated as self-employed are generally not permitted to participate in a Section 125 plan as employees, and attempting to include them can jeopardize the tax advantages of the arrangement for everyone else utilizing the plan. This article explains who is affected, why the restriction exists and what alternatives may be available.

What is a Section 125 plan?

Under Section 125 of the Internal Revenue Code (IRC), an employer can establish a plan that allows employees to choose between taxable compensation (cash) and certain non-taxable benefits. When an employee elects a benefit under the plan, such as health insurance premiums, a Health Flexible Spending Account (FSA) or a Dependent Care FSA (DCFSA), the amount is deducted from their paycheck before federal income and payroll taxes are calculated. This reduces the employee’s taxable income, as well as the employer’s payroll tax obligation.

The tax exclusion under Section 125 is available only to employees as defined by the IRC. Put simply, if the Internal Revenue Service (IRS) treats an individual as an owner rather than an employee, they are not eligible for pre-tax deductions under Section 125. Therefore, individuals who are considered self-employed for tax purposes do not qualify as employees under this definition and cannot participate in a Section 125 plan on the same basis as W-2 employees.

It is also important to remember that eligibility for pre-tax deductions is separate and distinct from eligibility for an underlying health plan or benefit. It is possible that someone may be eligible for an employer’s health benefit, like the medical or dental plan, but may also NOT be eligible to pay premiums for that benefit on a pre-tax basis.

Who is considered self-employed?

The restriction noted above applies to four categories of individuals, each treated as self-employed under the Internal Revenue Code:

  • Sole proprietors are individuals who own and operate a business as a single person without forming a separate legal entity. The business and the owner are treated as the same taxpayer for federal tax purposes, which means the owner cannot also be an employee of their own sole proprietorship.
  • Partners in a partnership are also treated as self-employed, regardless of how active they are in the business. A partner who works full-time in the partnership is still not considered an employee for purposes of Section 125.
  • S corporation shareholders who own more than two percent of the corporation’s stock are treated similarly to partners under the tax code. This two-percent threshold is important: a shareholder who owns two percent or less is treated as an employee and may participate in the Section 125 plan. A shareholder above that threshold is not.
  • LLC members are treated based on how the LLC is taxed. If the LLC is taxed as a sole proprietorship or partnership, the members are treated as self-employed and cannot participate. If the LLC has elected to be taxed as a C corporation, its members may be treated as employees. If taxed as an S corporation, the two-percent ownership rule described above applies.

Entity names that include terms such as “Corporation” or “LLC” do not provide enough detail on how the entity is taxed. Thus, an entity’s name alone does not indicate whether the owners can participate in a cafeteria plan.

Health FSA restrictions

A Health FSA allows employees to set aside pre-tax dollars to pay for eligible out-of-pocket medical expenses such as deductibles, copays and certain over-the-counter items. Because a Health FSA is offered through a Section 125 plan, the individuals described in the prior section cannot participate.

Any arrangement that attempts to give these individuals access to a Health FSA on a pre-tax basis would not be recognized by the IRS, and the amounts involved would be treated as taxable income. For 2026, the Health FSA contribution limit for eligible employees is $3,400. Self-employed individuals do not have access to this benefit through a Section 125 plan, though some alternatives exist and are discussed at the end of this article.

HSA restrictions and contribution rules

A Health Savings Account (HSA) is a tax-advantaged account available to individuals enrolled in a qualifying High Deductible Health Plan (HDHP). Unlike a Health FSA, an HSA is not tied to an employer plan, which means self-employed individuals can open and contribute to one directly. However, the Section 125 restriction still affects how contributions work.

W-2 employees who contribute to an HSA through their employer’s Section 125 plan avoid both income taxes and payroll taxes (Social Security and Medicare) on those contributions. Self-employed individuals who contribute directly to an HSA can deduct the contributions on their personal tax return, which reduces their income tax. But those contributions are still subject to self-employment tax. The practical effect is that self-employed individuals pay slightly more in tax on the same HSA contribution than a W-2 employee would.

Dependent Care FSA restrictions

A DCFSA allows employees to set aside pre-tax dollars to pay for eligible dependent care expenses, such as daycare, after-school programs or care for a dependent adult. Like the Health FSA, a DCFSA is offered through a Section 125 plan, and the same restrictions apply.

Self-employed individuals in the covered categories cannot participate in a DCFSA through their business on a pre-tax basis. They may, however, claim the federal Dependent Care Tax Credit on their personal income tax return, which provides a separate mechanism for offsetting dependent care costs. The credit and the FSA exclusion cannot be used for the same expenses, so individuals need to evaluate which approach is more advantageous for their situation.

Premium-Only Plan restrictions

A Premium-Only Plan (POP) is the simplest form of a Section 125 plan. It only allows employees to pay their share of employer-sponsored health insurance premiums with pre-tax dollars. Many employers establish a POP simply to reduce the payroll tax cost of offering health coverage.

Self-employed individuals in the covered categories cannot participate in a POP for the same reason they cannot participate in any other Section 125 arrangement. A more-than-two-percent S corporation shareholder, for example, cannot have their health insurance premium deducted on a pre-tax basis through the company’s POP. Instead, the premium must be included in the shareholder’s W-2 wages in Box 1. The shareholder may then claim the self-employed health insurance deduction on their personal return. The deduction is still available, but it works differently and does not reduce self-employment tax the way a POP deduction would for a regular employee.

Takeaways

Section 125 plans provide real tax benefits, but those benefits are limited to employees as defined by the tax code. Sole proprietors, partners, more-than-two-percent S corporation shareholders and most LLC members cannot participate in a Health FSA, DCFSA, HSA salary reduction arrangement or POP through their own business. Including these individuals in a Section 125 plan without recognizing these restrictions can create tax compliance problems for the business and for the individual.

HR professionals who support businesses with owner-employees should flag these situations early, particularly during open enrollment when elections are collected. Identifying affected individuals and referring them to their CPA or tax counsel before they make elections can prevent errors that are difficult and costly to unwind after the plan year has begun.

If you have any questions, please contact your HUB advisor. View more compliance articles in our Compliance Directory.

NOTICE OF DISCLAIMER

Neither Hub International Limited nor any of its affiliated companies is a law or accounting firm, and therefore they cannot provide legal or tax advice. The information herein is provided for general information only and is not intended to constitute legal or tax advice as to an organization’s or individual’s specific circumstances. It is based on HUB International’s understanding of the law as it exists on the date of this publication. Subsequent developments may result in this information becoming outdated or incorrect, and HUB International does not have an obligation to update this information. You should consult an attorney, accountant or other legal or tax professional regarding the application of the general information provided here to your organization’s specific situation in light of your or your organization’s particular needs.