My client has acquired an S Corporation with a 125 Plan where the S Corp owner has been participating in the 125 Plan. Does this disqualify the 125 Plan or is does this only affect the S Corp owner who should have included these benefits into income?

The requirement that all participants are employees is a basic requirement to be a cafeteria plan (see IRC 125(d)(1)(A)). The nondiscrimination rules are different (see IRC 125(b)). If the arrangement includes non-employees, it isn't a cafeteria plan and none of the pre-tax elections of any participants will be effective.

For an S Corp, the rule is greater than 2% owners may not participate. Your client should inquire if the company had a TPA or administrator for the 125 Plan and why the owner was permitted to participate. It may be an E & O issue.