Who Is Ineligible to Participate in a Section 125 Plan?

A Section 125 cafeteria plan is open only to common-law employees of the sponsoring company, so the people ineligible to participate in a Section 125 plan are sole proprietors, partners, LLC members taxed as partners, independent contractors, and S-corporation shareholders who own more than two percent of the stock. Rank-and-file employees can also be shut out by the plan’s own waiting periods or hours requirements, and highly compensated participants and key employees can lose the pre-tax benefit if the plan fails federal nondiscrimination tests.

Self-Employed People, Partners, LLC Members, and 1099 Contractors

The tax code defines a cafeteria plan as a written arrangement in which “all participants are employees.”¹ That one word does the heavy lifting. If you are not a common-law employee of the sponsoring company, you cannot make pre-tax salary reduction elections through the plan. It is a statutory line, not something the employer can waive.

Sole proprietors, partners in a partnership, and members of an LLC taxed as a partnership are all treated as self-employed for fringe benefit purposes. They fall outside the definition of “employee” and cannot participate.² That remains true even when the person works full-time in the business and draws a regular paycheck structured as a guaranteed payment.

Independent contractors paid on a 1099 basis are excluded for the same reason: they are not employees of the sponsoring company. If a business misclassifies a contractor and lets them participate anyway, the IRS can disqualify the pre-tax treatment retroactively and assess back taxes on both the worker and the employer.

More-Than-Two-Percent S-Corporation Shareholders

S-corporation shareholders get their own exclusion. If you own more than two percent of the company’s outstanding stock or voting power at any point during the tax year, the tax code treats you as a partner rather than an employee for fringe benefit purposes.² That partner treatment makes you ineligible for a Section 125 plan on a pre-tax basis, even though you are otherwise a W-2 employee of the corporation.

The exclusion reaches further than the shareholder. Stock ownership is attributed to close family members under the constructive ownership rules, which treat you as owning stock held by your spouse, children, grandchildren, and parents.³ If a parent owns three percent of the S-corp and their adult child works there as a regular employee, the child is treated as a more-than-two-percent shareholder and cannot participate on a pre-tax basis. Small family-run S-corps run into this constantly, because the ownership share involved can look minor.

Employees the Plan Itself Excludes

Even common-law employees who are legally eligible can be kept out by the plan document. The employer controls who actually gets in, and plan-design restrictions are lawful as long as they are applied consistently and don’t collide with the nondiscrimination rules.

Waiting periods. The plan can require a defined period of continuous service before an employee enrolls. Ninety days or six months is typical. For safe harbor treatment on eligibility testing, the cap is three years of service.⁴
Minimum hours. The plan can limit eligibility to employees working a set number of hours per week. A 30-hour threshold is common and effectively excludes part-time workers.
Union employees. Workers covered by a collective bargaining agreement can be excluded if the benefits were the subject of good-faith bargaining.⁴
Work location. The plan can restrict eligibility to employees working within the United States, so workers stationed primarily in U.S. territories or abroad may be excluded at the employer’s discretion.

These exclusions have to be documented upfront. An employer cannot selectively enforce a waiting period for some employees and waive it for others in the same classification without creating a nondiscrimination problem.

Retirees

A cafeteria plan can extend benefits to former employees, but the plan cannot exist primarily for them.⁵ In practice, retirees rarely participate. The salary reduction mechanism that makes a 125 plan work depends on W-2 wages, and pension distributions and annuity payments reported on Form 1099-R are not wages. Without ongoing W-2 compensation from the employer, there is nothing to reduce.

Losing the Benefit Through Failed Nondiscrimination Testing

This is the category that catches people off guard. You can be a common-law employee, fully enrolled, and still lose the pre-tax benefit. It happens when the plan fails federal nondiscrimination testing, and the consequences land on the highest-paid participants rather than on rank-and-file workers.

Section 125 imposes two separate sets of requirements aimed at two different groups.

Highly Compensated Participants

Section 125 uses a broader definition than many employers expect. You are a highly compensated participant if you are any of the following:¹

An officer of the company, regardless of pay.
A shareholder who owns more than five percent of the company’s voting power or value.
Highly compensated, meaning you earned more than $160,000 (the threshold for both 2025 and 2026) in the preceding year.⁶
A spouse or dependent of anyone in the categories above.

The plan must pass two tests for this group. The eligibility test says the plan cannot make it easier for highly compensated individuals to participate than for other employees. The contributions and benefits test says the plan cannot provide richer benefits or higher employer contributions to highly compensated participants than to everyone else.¹

Key Employees

Key employees face a separate concentration test. You are a key employee during the plan year if you meet any of these criteria:⁷

An officer with annual compensation above $235,000 (the 2026 threshold, up from $230,000 in 2025).⁶
A five-percent owner of the employer.
A one-percent owner with annual compensation above $150,000.

The concentration test limits the total qualified benefits going to key employees to no more than 25 percent of the aggregate benefits provided to all employees under the plan.¹ A small company with a handful of highly paid owners taking large FSA elections while most workers opt out can fail this one quickly.

What a Failed Test Does

Tax-free treatment is revoked only for the favored group. Rank-and-file employees keep their pre-tax benefits regardless. For highly compensated participants, the benefits attributable to the plan year that failed the test become taxable income. The same result applies to key employees when the 25 percent concentration limit is breached.¹ The employer adds the value of those benefits to the affected individuals’ W-2 income for the year the plan year ends. These participants were enrolled but got no tax advantage, which makes them functionally ineligible for the benefit that makes a 125 plan worth using.

The Simple Cafeteria Plan Safe Harbor

Small employers have a way out. An employer with 100 or fewer employees who received at least $5,000 in compensation during the preceding year can establish a “simple cafeteria plan” and skip the nondiscrimination tests entirely. The employer must either make a nonelective contribution of at least two percent of each qualifying employee’s compensation or match salary reductions dollar-for-dollar up to six percent of compensation, and the matching rate for highly compensated and key employees cannot exceed the rate offered to everyone else. The plan also has to let all employees with at least 1,000 hours of service during the prior plan year participate, though employees under age 21, employees with less than a year of service, and union employees whose benefits were the subject of good-faith bargaining can be excluded.⁴ When those conditions are met, the plan is treated as nondiscriminatory for the year, and highly compensated participants and key employees keep their pre-tax benefit.

A Note on Domestic Partners

Domestic partners cannot participate in a cafeteria plan, because they are not employees of the sponsoring company. The employee can still elect family health coverage that includes a domestic partner, but pre-tax treatment only applies if the partner qualifies as the employee’s tax dependent, which generally requires that the partner live in the employee’s household and receive more than half of their financial support from the employee.⁵ Otherwise, the partner’s portion of the coverage is paid with after-tax dollars and the fair market value of that coverage is added to the employee’s taxable income.

No Written Plan, No Pre-Tax Treatment for Anyone

Every Section 125 plan must be established under a written document describing the available benefits, the eligibility rules, and the election procedures. If the plan document was never formally adopted, pre-tax treatment is not available for any participant. Courts have held that cafeteria plan exclusions from income are unavailable before formal adoption, which means an employer running an informal arrangement can expose every participant to back taxes on what they thought were pre-tax deductions.⁵ In that scenario, no one is eligible, regardless of their employment status.

1
Office of the Law Revision Counsel. 26 USC 125 Cafeteria Plans
2
Office of the Law Revision Counsel. 26 USC 1372 – Partnership Rules to Apply for Fringe Benefit Purposes
3
Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock
4
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans
5
Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans
6
Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions
7
Office of the Law Revision Counsel. 26 USC 416 – Special Rules for Top-Heavy Plans