By Laurence Bernstein, CPA | CEO, Proseer
Published: September 8, 2026 | Last Updated: September 8, 2026
Key Takeaway: Health FSAs, HSAs, and Dependent Care FSAs all save employer payroll tax on employee salary reductions — but only C corporation owner-employees can participate in the FSAs. S corp shareholders over 2%, partners, and sole proprietors are locked out of cafeteria plans. The HSA is the one account every business owner can use regardless of entity type. New for 2026: the dependent care FSA limit rose to $7,500, HSA eligibility expanded under the One Big Beautiful Bill Act, and proposed IRS regulations under Code Sec. 129 could ease nondiscrimination testing for closely held businesses.
We get asked about these three accounts constantly, and almost always in the same two-part form: should I offer this to my people, and can I use it myself?
The first answer depends on your headcount and what health plan you already offer. The second answer depends almost entirely on how your business is taxed — and for a lot of our clients, it’s not the answer they expect.
Here’s the whole picture, plus the 2026 numbers and a couple of rule changes worth knowing about before your next enrollment cycle.
The short version
| Worth offering to your team? | Can you participate as the owner? | |
|---|---|---|
| Health FSA | Yes, if you offer a non-HDHP plan and have enough employees to justify the admin | Only if you’re a C corp. S corp >2% shareholders, partners, and sole proprietors are locked out |
| HSA | Almost always, if you offer any health coverage | Yes, regardless of entity — just not pre-tax through payroll if you’re a pass-through owner |
| Dependent Care FSA | Yes, if real demand exists below the management level | Only if you’re a C corp — same lockout as the health FSA |
If you take one thing from this post: the HSA is the one you can use yourself. The two FSAs are staff benefits.
Nothing happens without a Section 125 plan document
Both FSAs run on pre-tax salary reduction, and salary reduction requires a written Section 125 cafeteria plan. You cannot start withholding pre-tax dollars from paychecks because your payroll system has a checkbox for it. You need an adopted plan document, and it has to be adopted prospectively — there’s no retroactive fix in December for something you started running in March.
The good news is that this is not expensive. A basic plan document runs a few hundred dollars, and third-party administration for FSAs typically runs a few dollars per participant per month, sometimes with a small monthly base fee. For most of our clients the administrative cost is a rounding error against the tax savings. Which brings us to the part owners tend to overlook.
What’s actually in it for the business
Employees think of these accounts as their tax break. They’re yours too.
Salary reductions into a health FSA or dependent care FSA are excluded from wages for FICA and FUTA purposes — meaning you don’t pay the employer’s 7.65% on those dollars either.
Rough math: fifteen employees, average health FSA election of $2,000. That’s $30,000 of payroll that never becomes wages, and roughly $2,295 of employer payroll tax you don’t owe. Add a handful of dependent care elections and the number climbs fast. Against a plan document and a few hundred dollars a year of TPA fees, it pays for itself well before you get to the retention argument.
And for a pass-through, that savings drops straight to your K-1. So even when you personally can’t participate in the plan, you’re not getting nothing out of offering it.
The same holds for HSA contributions run through the cafeteria plan — those escape FICA too. HSA contributions made outside payroll only get you an income tax deduction. More on that distinction below, because it matters more than it sounds like it should.
Health FSA: the employer’s view
What your employees get: up to $3,400 in 2026 of pre-tax money for deductibles, copays, prescriptions, dental, and vision — and the entire election is available to them on day one of the plan year, not as it accrues. That’s the “uniform coverage” rule, and employees genuinely value it.
What it costs you beyond admin fees: that same uniform coverage rule is the employer’s risk. An employee elects $3,400, gets a crown in January, and leaves in February having contributed $280. You eat the difference. In practice this is usually modest, and year-end forfeitures from other participants tend to more than cover it — forfeited amounts revert to the plan and can be used to offset administration costs. But if you have high turnover, cap elections below the statutory maximum. You’re allowed to.
Design decisions you’ll have to make:
- Your own contribution cap. You can set the plan limit anywhere at or below $3,400.
- Carryover, grace period, or neither. You may offer a carryover (up to $680 of unused 2026 money into 2027) or a grace period of two and a half extra months — never both. Neither is required. Carryover is generally the more popular choice with employees.
- Employer contributions. If you want to seed the accounts, note that employer contributions to a health FSA are generally capped at $500 per plan year (or a dollar-for-dollar match) to preserve the FSA’s “excepted benefit” status. Go above that and you create compliance problems.
Compliance you’re taking on: a health FSA is a group health plan. That means ERISA, a summary plan description, COBRA continuation rights when someone terminates, and a Form 5500 once you’re at 100+ participants. It’s also subject to nondiscrimination testing. None of this is onerous, but it’s real, and it’s why we usually tell clients under ten employees to think hard about whether the health FSA is worth it versus just pointing people at an HSA.
The one trap that will actually hurt you: a general-purpose health FSA destroys HSA eligibility for anyone who enrolls — including a spouse whose coverage reaches your employee. If you’re steering your workforce toward an HDHP and HSAs, do not put a general-purpose health FSA on the same menu without also offering a limited-purpose FSA (dental and vision only). We have seen employees unknowingly disqualify themselves from a year of HSA contributions this way.
HSA: usually the best value for a small business
The HSA is structurally different, and the difference is all in your favor as an employer: you don’t sponsor the account. Your employee owns it. There’s no plan you administer, no uniform coverage risk, no COBRA, no forfeiture mechanics. Your obligation is essentially to facilitate contributions.
2026 limits: $4,400 self-only, $8,750 family, plus $1,000 for anyone 55 or older and not on Medicare. To qualify, the health plan needs a deductible of at least $1,700 (self-only) or $3,400 (family), with out-of-pocket maximums capped at $8,500 and $17,000. 2027 limits are already out: $4,500 and $9,000.
The strategic case for the HDHP/HSA pairing: HDHP premiums are meaningfully cheaper than a low-deductible plan. Move the plan, hand part of the premium savings back to employees as an employer HSA contribution, and you can often come out ahead on total spend while employees feel like they got a raise. It’s one of the few benefit moves that’s genuinely a win on both sides of the ledger.
Here’s the technical point worth the price of admission. There are two ways to fund employees’ HSAs, and they’re governed by completely different rules:
- Outside the cafeteria plan — you’re subject to the HSA comparability rules. Contributions must be comparable (same dollar amount or same percentage of the deductible) across all comparable participating employees. Get it wrong and the excise tax is 35% of your aggregate HSA contributions for the period. That’s a harsh penalty for wanting to give your managers more.
- Through the cafeteria plan — comparability doesn’t apply at all. You’re subject to the Section 125 nondiscrimination rules instead, which are far more flexible. Matching structures, different contribution levels by class, wellness-linked contributions — all workable.
So: if you plan to contribute to employees’ HSAs at all, and especially if you want any variation in what you contribute, run it through the cafeteria plan. This is a documentation decision that costs you nothing and eliminates an entire penalty regime. It’s also the version that saves you FICA.
Three HSA eligibility expansions that took effect for 2026
The One Big Beautiful Bill Act, enacted July 4, 2025, amended the HSA rules in Code Sec. 223 in three ways that took effect for 2026. The IRS implemented all three in Notice 2026-5:
- Direct primary care memberships no longer disqualify you. Under new Code Sec. 223(c)(1)(E), a direct primary care arrangement isn’t treated as disqualifying coverage, provided the fees stay at or under $150 per month for an individual or $300 for an arrangement covering more than one person. Those fees also count as qualified medical expenses now. Two limits worth knowing: an HDHP can’t pay the membership fee pre-deductible, and the fees don’t count toward the plan’s deductible or out-of-pocket maximum.
- Bronze and catastrophic marketplace plans are now HSA-compatible. Under new Code Sec. 223(c)(2)(H), a bronze- or catastrophic-tier plan available through an exchange is treated as an HDHP whether or not it meets the normal deductible and out-of-pocket tests. Notice 2026-5 confirms this reaches identical plans bought off-exchange, as long as the same plan is offered on an exchange. This is a genuine opening for owners who buy their own individual coverage, and for employers using an individual-coverage HRA.
- Pre-deductible telehealth coverage is permanent. The safe harbor that had been expiring and getting extended is now written into the Code, retroactive to plan years beginning on or after January 1, 2025.
Dependent Care FSA: bigger limit, and a testing problem you need to know about
The limit moved for the first time in decades — and it came from legislation, not an inflation adjustment. The dependent care exclusion under Code Sec. 129 had been $5,000 ($2,500 for married filing separately) since 1986. The One Big Beautiful Bill Act amended the statute to raise it to $7,500 ($3,750 for married filing separately) for tax years beginning in 2026. It is not indexed for inflation, so it will sit there until Congress acts again.
That distinction matters practically. Because the increase came from a change in the statute rather than the IRS’s annual inflation revenue procedure, administrative guidance is still catching up in places. Don’t be surprised if a plan document, a TPA’s enrollment portal, or an older IRS publication still shows $5,000. That’s a lag, not a contradiction — but it does mean you should confirm the figure with your administrator rather than assuming their system was updated.
Two things follow for you as an employer:
- Adoption is optional, and requires a plan amendment. If you already sponsor a dependent care plan and want to give your people the higher limit, the Section 125 plan has to be amended — the deadline is December 31, 2026. If your enrollment materials still say $5,000, this is usually why.
- It’s a strong benefit for the right workforce. If you employ people with kids in full-time daycare, an extra $2,500 of pre-tax room is real money to them and costs you nothing but administration — while saving you FICA on every dollar elected.
Now the problem. Dependent care plans face four nondiscrimination tests, and two of them are hostile to closely held businesses:
- The 55% average benefits test. Average benefits for non-highly-compensated employees must be at least 55% of the average for highly compensated employees. In a small business where the owner and two managers have daycare-age kids and nobody on the floor does, you fail. And the jump to $7,500 made this worse, because it raised the elections on the highly compensated side while non-HCE participation stayed flat.
- The owner concentration test. No more than 25% of total dependent care benefits may go to individuals owning more than 5% of the business, or their spouses and dependents. If you’re the primary user of your own plan, this is a hard fail.
When either test fails, the plan itself isn’t disqualified and rank-and-file employees aren’t affected — but the excess benefit for the affected owners and highly compensated employees gets converted to taxable wages and reported on their W-2. In other words, the owner loses the tax break, which was the point.
A development to watch — but not to rely on yet. On August 11, 2026, the IRS issued proposed regulations under Code Sec. 129 — the first comprehensive guidance in the 45 years the section has been on the books. These are proposals, not final rules, and they have not been finalized as of this writing.
If finalized in their current form, the regulations would:
- compute average benefits using only employees who actually receive dependent care benefits, rather than counting every non-participating employee in the denominator at zero — which addresses the single most common cause of failure, and would let some plans that failed year after year pass with no design change at all; and
- provide a formal correction path for a failed average benefits test or owner concentration test, by including the excess in the affected employee’s income and reporting it on a timely Form W-2.
If you’ve previously been told a dependent care FSA wouldn’t work for your business because of testing, the answer may be about to change. But confirm the final form of the regulations and their effective dates before building a plan design around the relief — proposed regulations can be modified substantially before they’re finalized, and they can’t be relied on in the meantime.
One adjacent option, and it’s a different mechanism entirely. If childcare is a genuine recruiting problem for you, look at the employer-provided childcare credit under Code Sec. 45F, which the One Big Beautiful Bill Act expanded substantially starting in 2026 — up to $500,000 of credit at 40% of qualified childcare expenditures, or $600,000 at 50% for eligible small businesses. Note how this differs from a dependent care FSA: Sec. 45F is a credit for money the employer spends providing or contracting for care, while a dependent care FSA is built on employee salary reduction elections. They’re not alternatives to weigh against each other so much as two separate tools, and a larger employer might use both. IRS guidance on the expanded credit is still developing, so treat the numbers as the ceiling and let us model your specific situation.
Can you participate yourself? Your entity type decides
This is where owners are most often surprised, so let’s be specific.
The core rule is a definitional one. Cafeteria plans are only for employees, and the tax code doesn’t treat every owner as an employee for this purpose. Sole proprietors and partners are self-employed. And under Code Sec. 1372, an S corporation is treated like a partnership for fringe benefit purposes, so a more-than-2% shareholder is treated as a partner — self-employed, not an employee. The cafeteria plan regulations then expressly exclude self-employed individuals and 2% S corp shareholders from participating. You can sponsor the plan for your employees. You just aren’t one of them.
| Entity | Health FSA & Dependent Care FSA | HSA |
|---|---|---|
| C corporation | Yes. Owner-employees are employees | Yes, pre-tax through payroll |
| S corp, >2% shareholder | No | Yes — but not through payroll |
| Partnership / multi-member LLC partner | No | Yes — but not through payroll |
| Sole proprietor / single-member LLC | No | Yes — but not through payroll |
Details that matter:
The S corp attribution rule is the real sting. The 2% test applies the family attribution rules, so stock owned by your spouse, children, grandchildren, or parents counts toward your threshold. That means your spouse on payroll also cannot participate, and neither can your kids or your parents if they work for you. For a typical husband-and-wife S corp, the cafeteria plan is simply not available to either of you.
It’s a whole-year test. Cross 2% on any single day of the tax year and you’re treated as a more-than-2% shareholder for the entire year.
Don’t let an ineligible owner enroll anyway. This is the part that turns a personal disappointment into a business problem: if someone who isn’t an eligible employee participates, it puts the cafeteria plan’s tax-qualified status at risk for everyone in it — meaning your employees’ pre-tax elections, not just yours. Your plan document and your enrollment process both need to exclude these people affirmatively. If your payroll provider set up your Section 125 plan without ever asking about your ownership structure, we should look at it.
Sole proprietors have one avenue S corp owners don’t. A sole proprietor can’t participate in their own cafeteria plan, but a spouse who is a bona fide employee of the business can — the family attribution that blocks the S corp spouse doesn’t reach here. Family coverage elected by that spouse can extend to the proprietor. This works, but it requires a genuine employment relationship with real duties and reasonable compensation, and it draws scrutiny. Talk to us before building a plan around it.
The HSA is the equalizer. Nothing about your entity type affects your ability to fund an HSA. If you’re covered by a qualifying HDHP and don’t have disqualifying coverage, you can contribute and take the above-the-line deduction on your 1040 — S corp shareholder, partner, or sole proprietor alike. What you lose is the payroll route: for a more-than-2% S corp shareholder, company HSA contributions have to be included in your W-2 Box 1 wages rather than excluded from income, and you claim the deduction personally. Same net income tax result, but no FICA savings on the way through.
So the honest summary for most of our clients, who are S corps: the FSAs are things you offer. The HSA is the thing you use.
So — should you offer them?
The HDHP/HSA combination: usually yes. Lowest administrative burden of the three, best for you personally, and it can reduce your premium spend. If you offer health coverage at all, this deserves a serious look.
Health FSA: yes if the fit is there. Good sense if you offer a traditional low-deductible plan and have enough employees to spread the admin cost. Skip it — or use limited-purpose — if you’re building your benefits around HSA eligibility.
Dependent Care FSA: depends on who actually needs it. If you have meaningful demand among non-management staff, it’s a cheap, well-liked benefit and the payroll tax savings are real. If the only people who’d use it are you and your leadership team, expect testing failures under current rules — with the caveat that the proposed regulations, if finalized as written, could change that math considerably.
Timing note: cafeteria plans have to be adopted before the plan year they cover, and elections are generally locked in for the year absent a qualifying change in status. If you want any of this in place for 2027, the work happens this fall.
Let’s look at your situation specifically
The answers above turn on facts we can pull in an hour: your entity type, your ownership percentages, who’s on payroll, your current health plan design, and whether you already have a Section 125 plan document (and whether it says what you think it says). If you’re heading into open enrollment or considering adding benefits for 2027, reach out and we’ll work through it with you.
This post is general information and not tax or legal advice for your specific situation. Benefit plan rules depend heavily on your entity structure, ownership, and existing plan documents. Please also note that several items discussed above are still in motion: the Section 129 nondiscrimination regulations described here are proposed and not final, administrative guidance implementing the new 2026 dependent care limit and the expanded Section 45F childcare credit continues to develop, and effective dates and details may change. Confirm the current state of the rules with us before acting.
