Federal Tax Law Treats Certain Business/HSA Owners Differently

This column is an excerpt (Question 41) from a book to be published later this year to help guide account owners, employers, benefits managers, and administrators understand Health Savings Account compliance issues. The format consists of a common question, an explanation in easy-to-understand English (often with an appropriate example), and a citation from government documents to support the answer. The book is designed to inform. It is not a legal document, and the contents should not be construed as legal advice.

Question: I own my own small business. I can’t participate in a Health FSA. Can I open and fund a Health Savings Account?

Answer: Yes, if you satisfy all Health Savings Account eligibility requirements.

Owners of certain business structures cannot participate in some tax-advantaged accounts, including Health FSAs and Health Reimbursement Arrangements. These owners include

• partners in a partnership,
• members of a Limited Liability Company (LLC), and
• 2% or greater owners of a Subchapter S Corporation.

If your business is a C Corporation, you’re treated as a common-law employee and can fund and use a Health Savings Account just as any other employee can (and? participate in a Health FSA and other components of a Cafeteria Plan). If, however, you are a full or partial owner of an LLC, partnership, or Subchapter S Corporation, you face two limitations on how you fund your Health Savings Account.

First, you can’t make pre-tax payroll contributions through a Cafeteria Plan (also called a Section 125 Plan to reflect the relevant section of the Internal Revenue Code), as your employees can if you offer this option. Instead, you can contribute after-tax funds, including direct deposit through your company’s payroll system, and then deduct that amount on your personal income tax return. The deduction is above the line on page 1 of your Form 1040, which means that your contribution reduces your adjusted gross income dollar-for-dollar. You don’t have to itemize your deductions to receive the full tax benefit of your Health Savings Account contribution. That’s good news for the growing number of Americans who, because of changes to the tax law stemming from the Tax Cut and Jobs Act of 2017, can minimize their taxable income by claiming the standard deduction instead of itemizing.

When you deduct your contributions, you recover the federal and state (except in California and New Jersey, which don’t allow a state income-tax deduction for Health Savings Account contributions) income taxes that you paid on the money when you received it. You don’t recover your federal payroll (FICA) taxes. The first $169,600 (the 2024 ceiling for Social Security taxes) of your income is subject to a 15.3% payroll tax. On income above that figure, your payroll taxes are 2.9%.

Second, you can’t receive a tax-free contribution from the business, as your employees can if you offer this benefit. Any funds that move from the company to your Health Savings Account are included in your taxable income. The company can contribute directly to your Health Savings Account or give you funds to place in your account. In either case, the funds are taxable at the time that you receive them and tax-deductible when you file your tax return for that year.

Besides these two funding limitations, the rules that govern all other owners’ Health Savings Account apply equally to you. You can deposit up to the statutory limit (or lower, if you experience a disqualifying event during part of the year), make tax-free distributions for qualified expenses, invest balances, and name a beneficiary. See Question 75 for further discussion on owners’ contributions.

?IRS Publication 15-B, Employer’s Tax Guide to Fringe Benefits? (2025 edition):

?Partnerships and S corporations.

?Partners and 2% shareholders of an S corporation aren't eligible for salary reduction (pre-tax) contributions to an HSA. Employer contributions to the HSA of a bona fide partner or 2% shareholder are treated as distributions or guaranteed payments, as determined by the facts and circumstances. For more information, see Notice 2005-8, 2005-4 I.R.B. 368, available at?IRS.gov/irb/2005-04_IRB#NOT-2005-8 .

?

IRS Notice 2005-8:

?Q-1. What is the tax treatment of a partnership’s contributions to a partner’s HSA that are treated as distributions to the partner under section 731?

A-1. Contributions by a partnership to a bona fide partner’s HSA are not contributions by an employer to the HSA of an employee. See Rev. Rul. 69-184, 1969-1.C.B. 256. Contributions by a partnership to a partner’s HSA that are treated as distributions to the partner under section 731 are not deductible by the partnership and do not affect the distributive shares of partnership income and deductions. See Rev. Rul. 91-26, 1991-1 C.B. 184 (analysis of situation 1, last paragraph). The contributions are reported as distributions of money on Schedule K-1 (Form 1065). These distributions are not included in the partner’s net earnings from self-employment under section 1402(a) because the distributions under section 731 do not affect a partner’s distributive share of partnership income or loss under section 702(a)(8). The partner, if an eligible 2 individual as defined in section 223(c)(1), is entitled under sections 223(a) and 62(a)(19) to deduct the amount of the contributions made to the partner’s HSA during the taxable year as an adjustment to gross income on his or her federal income tax return.

?Q-3. What is the tax treatment of an S corporation’s contributions to the HSA of a 2- percent shareholder (as defined in section 1372(b)) who is also an employee (2-percent shareholder-employee) in consideration for services rendered to the S corporation?

A-3. Under section 1372, for purposes of applying the provisions of Subtitle A that relate to fringe benefits, an S corporation is treated as a partnership, and any 2-percent shareholder of the S corporation is treated as a partner of such partnership. Therefore, contributions by an S corporation to an HSA of a 2-percent shareholder-employee in consideration for services rendered are treated as guaranteed payments under section 707(c). Accordingly, the contributions are deductible by the S corporation under section 162 (if the requirements of that section are satisfied (taking into account the rules of section 263)) and are includible in the 2-percent shareholder-employee's gross income. In addition, the 2-percent shareholder-employee is not entitled to exclude the contribution from gross income under section 106(d). See Rev. Rul. 91-26.

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The content of this column is informational only. It is not intended, nor should the reader construe the content, as legal advice. Please consult your personal legal, tax, or financial counsel for information about how this information applies to you or your entity.

HSA Question of the Week is published every week, alternating every other Wednesday with HSA Wednesday Wisdom and every other Monday with HSA Monday Mythbuster.