There is a pattern we see often enough to write about. A founder, a partner, someone running their own business but as a W-2 employee, has been funding a Health Savings Account for years through payroll.
The money goes in. The HDHP covers the family. The account compounds. The business entity structure changes to an S Corps and the assumption is that everything works the way it would for a regular W-2 employee. Pre-tax contribution, automatic deduction, payroll
handles the reporting. That assumption is often wrong.
The cost shows up in two places: contributions that were never actually deducted, and FICA savings
that were never available.
The rule sits in a corner of the code that gets little attention. A more-than-2-percent shareholder in an S corporation is treated as a partner for fringe benefit purposes under $1372.
Partners in a partnership are treated similarly. The practical consequence is that owners cannot fund an HSA through a Section 125 cafeteria plan, which is the mechanism that allows ordinary employees to contribute pre-tax through payroll. Owners are excluded from cafeteria plans by definition. Sole proprietors share the same posture.
What this means in plain terms: when an S corporation contributes to a more-than-2-percent shareholder’s HSA, the contribution is added to the shareholder’s W-2 as taxable wages in Box 1. The owner then claims an above-the-line deduction on their personal return under §223. The deduction is preserved, but only if the personal return captures it. If the W-2 reflects the contribution as Code W Box 12, the way it would for rank-and-file employee, the treatment is incorrect. The owner has been taxed on the contribution and may have missed the offsetting deduction on Form 8889.
A few things follow from this for clients who own their businesses.
Unlike employees using a cafeteria plan—which avoids both income tax and employee FICA—owners only recover income tax through the personal deduction. The employee‑side FICA savings are unavailable. An ordinary employee funding an HSA through a cafeteria plan avoids both income tax and FICA. An owner gets the income tax deduction at the personal level. The HSA still works. It remains a triple-tax-advantaged account. The mechanics are simply less efficient than a non-owner employee experiences, and that is worth naming directly.
The W-2 reporting matters. Owners should pull last year’s W-2 and confirm where the HSA contribution appears. If it was treated as Code W rather than added to Box 1 wages, the return likely needs review. The fix is mechanical, but it requires looking.
A few adjacent strategies are worth holding alongside this conversation.
The HSA itself remains one of the most efficient long-term vehicles available to a healthy owner. Contribute the maximum, pay current medical costs out of pocket, save the receipts, and let the account grow as a stealth retirement vehicle. Withdrawals against documented prior expenses are tax-free at any age. For 2026, the contribution limits are $4,400 for self-only coverage and $8,750 for family coverage, with a $1,000 catch-up at age 55.
The HSA also coordinates with charitable planning in a way most owners overlook. Once Medicare enrollment ends HSA contribution eligibility, the account becomes a holding vehicle for medical reserves through retirement. Naming a spouse as beneficiary preserves HSA treatment after death. Naming anyone else collapses the account into ordinary income for the beneficiary in the year of death, which is a meaningful planning consideration for unmarried owners or second marriages.
The takeaway for founders: the HSA still works, but the mechanics require attention.
The deduction is available. The FICA savings are not. The W-2 reporting is the place errors hide, and the fix is straightforward once identified.
If any of this prompts a question about your own situation, that is the right instinct. We are happy to review prior W-2s and returns alongside your CPA to confirm the treatment was correct.
Lauren Pearson is the founding partner and Managing Director of Somerset Advisory, an independent wealth management firm built to serve the complex needs of multigenerational families, entrepreneurs, and executives.