Who Is Ineligible to Participate in a Section 125 Plan?

People who are ineligible to participate in a Section 125 cafeteria plan fall into two groups: those the tax code shuts out by statute, and those the employer’s own plan document keeps out. The statutory group is the strict one. Sole proprietors, partners, LLC members taxed as partners, independent contractors, and S-corporation shareholders who own more than two percent of the company cannot make pre-tax salary reduction elections through a cafeteria plan, no matter what the employer wants to do.¹ On top of that, common-law employees can be excluded by waiting periods, hours thresholds, or union carve-outs written into the plan, and highly paid employees can lose the pre-tax benefit after the fact if the plan fails federal nondiscrimination testing.

The Self-Employed Are Excluded by Statute

The tax code defines a cafeteria plan as a written arrangement in which “all participants are employees.”¹ One word does the work. If you are not a common-law employee of the sponsoring company, you cannot make pre-tax elections. An employer cannot waive this in the plan document.

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, which places them outside the definition of “employee.”² This is true even if you work full-time in the business and draw a regular paycheck structured as a guaranteed payment.

Independent contractors paid on a 1099 are out for the same reason. They are not employees of the company sponsoring the plan, and there are no employee wages to reduce on a pre-tax basis. If a business lets a misclassified contractor participate anyway, the IRS can strip the pre-tax treatment retroactively and pursue back taxes against both the worker and the employer.

S-Corporation Shareholders Above Two Percent

S-corporation shareholders have their own exclusion. If you own more than two percent of the corporation’s stock or voting power at any point during the tax year, the code treats you as a partner rather than an employee for fringe benefit purposes.² You lose the pre-tax advantage of a Section 125 plan even if you also draw a W-2 from the corporation.

This reaches further than the shareholder personally. Constructive ownership rules attribute stock held by your spouse, children, grandchildren, and parents to you.³ If a parent owns three percent of the S-corp and an adult child works there as a regular employee, the child is treated as a more-than-two-percent shareholder and is barred from the cafeteria plan. Family-run S-corporations get caught by this constantly, because the ownership stake seems minor and the working family member looks like an ordinary employee.

Employees the Plan Itself Keeps Out

Even among common-law employees who are legally eligible, the employer controls who actually gets in through the written plan document. These restrictions are allowed as long as they are applied consistently and don’t create a nondiscrimination problem.

Waiting periods. The plan can require a defined stretch of continuous service before enrollment. Ninety days or six months is typical, and federal nondiscrimination rules cap the wait at three years for the plan to qualify for safe harbor treatment on eligibility testing.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.
Collective bargaining agreements. Union-covered employees can be excluded if the cafeteria benefits were subject to good-faith bargaining between the employer and the union.⁴
Work location. The plan can restrict eligibility to employees working within the United States, leaving out those stationed in territories or abroad.

These exclusions are the employer’s choice, but they have to be documented up front. An employer cannot enforce a waiting period for some employees in a classification and waive it for others without creating a discrimination issue.

Retirees and Former Employees

A cafeteria plan can extend benefits to former employees, but it cannot exist primarily for them.⁵ In practice, retirees rarely participate. The salary reduction mechanism relies on W-2 wages, and pension distributions and annuity payments reported on Form 1099-R are not wages that can fund a pre-tax election.

Domestic Partners

A domestic partner cannot participate in a cafeteria plan because they are not an employee of the sponsor. The employee can still elect family health coverage that includes a domestic partner, but the pre-tax question turns on tax dependency. Coverage for a legal spouse and tax dependents qualifies for pre-tax treatment automatically. Coverage for a domestic partner qualifies only if the partner meets the definition of a tax dependent, which generally requires that the partner live in your household and receive more than half of their support from you.⁵ If the partner isn’t a dependent, the fair market value of their coverage is added to your taxable income and their share of the premium comes out of after-tax dollars.

Failing Nondiscrimination Tests Can Wipe Out the Pre-Tax Benefit

You can be a common-law employee, fully enrolled in the plan, and still lose the pre-tax benefit. It happens when the plan fails federal nondiscrimination testing. The consequences land on the highest-paid participants, not on rank-and-file workers, so this is where “eligible on paper” and “eligible in practice” can part ways.

Section 125 imposes two separate requirements aimed at two different groups: highly compensated participants and key employees.

Highly Compensated Participants

Section 125 uses a broad definition of “highly compensated participant.” You fall into this group if you are any of the following:¹

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

Two tests apply. The eligibility test bars the plan from making participation easier for highly compensated individuals than for everyone else. The contributions and benefits test bars the plan from providing richer benefits or higher employer contributions to highly compensated participants than to other employees.¹

Key Employees

Key employees face a separate concentration test. You are a key employee if you meet any of these criteria during the plan year: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 total qualified benefits flowing to key employees to no more than 25 percent of the aggregate benefits provided to all employees under the plan.¹ When a small company has a handful of highly paid owners and officers running large FSA elections while most other employees opt out, this test fails quickly.

What Failure Actually Costs

When a test fails, tax-free treatment is revoked only for the favored group. Rank-and-file employees keep their pre-tax benefits either way. For highly compensated participants, benefits attributable to the failed plan year 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. Those individuals were enrolled, but received no tax advantage.

Small Employers Can Sidestep the Tests

Nondiscrimination testing can be onerous for small businesses, and the code offers a shortcut. An employer with 100 or fewer employees who received at least $5,000 in compensation in the preceding year can establish a “simple cafeteria plan” and skip the tests entirely.⁴

The safe harbor comes with strings. On contributions, the employer must either make a nonelective contribution of at least two percent of each qualifying employee’s compensation or provide a dollar-for-dollar match on salary reductions up to six percent of compensation. The match rate for highly compensated and key employees cannot exceed the rate offered to everyone else.⁴

On eligibility, the plan must let all employees with at least 1,000 hours of service in the preceding plan year participate. The employer can still exclude employees under age 21, those with less than one year of service, and union-covered workers whose cafeteria benefits were subject to good-faith bargaining.⁴ Meet those conditions, and the plan is treated as nondiscriminatory for the year. No highly compensated participant or key employee loses their pre-tax benefit to a failed test.

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