how would a 2% shareholder be enrolled in a 125 plan?

[Erica23]

I thought it was common knowledge that 2% shareholders cannot enroll in a 125 plan?  I read that if a 2% shareholder is enrolled, it can cause issues for the plan.  Does anyone have any practical experience how this is handled?  How would this have happened?

[jpod]

Is the employer a C corporation or an S corporation?  This is an issue only for an S corporation.  There is no tax benefit under Section 125 for a 2% shareholder of an S corporation.  (However, he  would get an above-the-line tax deduction for health insurance premiums paid by him or on his behalf.)   Whether his purported participation in the plan "causes issues for the plan" is not something I am sure about.   

[Erica23]

S Corp.  I read that if a 2% shareholder is enrolled in a 125 plan, it could cause an issue.   I understand the tax issue (and the 2% shareholder was not having any insurance premiums added to box 1 wages), but am just wondering how much of a concern this is plan-wise.

[jpod]

Well, if I were in your shoes I would turn to the IRS' regulations under Section 125, and the proposed regulations, and find the answer.  I just don't know what it is.

[Luke Bailey]

Section 125 plans are only for "employees." See Section 125(d)(1) of Code ("means a written plan...under which all participants are employees.") Section 1372(a) says that 2% s corp shareholders are treated as partners for "fringe benefit purposes." Proposed regs confirmed that 125 plans are "fringe benefit" for purposes ot this rule. So clearly, no 2% S corp shareholders are allowed in your 125 plan.

If a 2% shareholder has participated, then what is the result? In theory, the IRS could say your 125 plan is bad for everyone for all years, I think, because the plan didn't meet the requirement that it only cover employees, as quoted above from 125(d)(1). That's certainly the doctrine based on similar language in 401(a) for qualified plans. Would they really do that to you in an audit, given that there is little precedent (or none), no EPCRS, etc. for 125 plans? Probably not. But you should certainly stop the individual's participation and consider impact on current and prior year w-2's.

[Larry Starr]

Erica, when you post here please give the details of what has happened if you want advice that you can apply.  I assume this is not just a theoretical case?

Did he make contributions to a flexible spending account under a 125 plan?  Is that what happened?  if that's what happened, then those contributions are NOT deductible to him and should be reflected in his W-2.  Any payments made by the 125 plan on his behalf would be fine because the funds are his own money.  Any remaining funds in the 125 plan should be paid back to him.  

The reality is, however, that NO ONE is checking on 125  plans; it is a self-policing system (or, we are the policemen if you prefer).  We have lots of 125 plan and never (NEVER) have had a single question about them from any governmental organization.

What should you do?  Fix any open W-2; stop withholding; pay him back any money being held for a FSA, and don't do it anymore.