A more than 2% S-corporation shareholder is not considered an employee for IRC Section 125 purposes. They are considered self-employed. Only employees can participate in pre-tax benefits through a Section 125 cafeteria plan. This means that individuals who are considered self-employed are not eligible to participate on a tax-advantaged basis. So, the health FSA and dependent care FSA (DCAP) options become less valuable because their only purpose is the tax savings. Once that is taken away, there really isn’t a point to participating.
On the other hand, they can still continue participation in the underlying health plans through a Section 125 plan (medical, dental, vision), but cannot make premium contributions on a pre-tax basis. The same would be true for any qualified benefit offered through the cafeteria plan. So, owners may generally participate in the plan, but certain owners cannot participate on a pre-tax basis under Section 125. In other words, self-employed owners are allowed to participate in the plan itself (assuming they are otherwise eligible per the terms of the plan), but self-employed owners are not allowed to participate on a tax-favored basis under Section 125, whether the plan is a fully insured plan or a self-insured plan. So, if the owner is not an employee, they would just have to participate by paying premiums post-tax. C-corporation owners are generally treated as employees and eligible to participate on a pre-tax basis.
In regards to an HSA, they may make post-tax contributions and then claim them as a deduction on their individual tax return. See IRS Form 8889 instructions, page 3. Since they are not employees, they also cannot receive pre-tax employer contributions to their HSAs.
In regards to an HRA, the IRS has stated that 2% S-corporation shareholders, sole proprietors, and partners in a partnership are treated as self-employed and are not eligible for the tax-free benefits of an HRA. Further, the IRS has informally stated that such individuals would not even be eligible for the HRA on a taxable basis. Conversely, C-corporation owners are typically considered employees and could participate in the HRA and receive tax-free benefits.
Lastly, these rules not only apply to the S-corporation shareholder but also to the shareholder’s children, parents, and grandparents due to ownership attribution rules contained in the IRC. Specifically for S-corporation shareholders, the Section 125 rules refer to 2% shareholder ownership as incorporating the family attribution rules (found in IRC Section 318). Section 318 basically says that someone that has a certain relationship with the owner is treated as having the same ownership interest as the owner. Specifically, an individual is deemed to own the interest held by his or her spouse, children, grandchildren and parents.