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"So by doing so, there will be no taxable income reported on Sch 1 line 8e, no 20% penalty on form 8889, no form #5329 needed."
I don't see it like that. You have to work through each year. You'll need both forms.
"You must file Form 8889 with your Form 1040, 1040-SR, or 1040-NR if you (or your spouse, if married filing jointly) had any activity in your HSA during the year."
"Generally, you must pay a 6% excise tax on excess contributions. See Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, to figure the excise tax. The excise tax applies to each tax year the excess contribution remains in the account."
If they didn't have qualifying coverage, then they were ineligible for all of it. If the contributions were not made through their employer (as pre-tax), then there is no contribution amount to add to income. There is, however, the amendments to remove the deduction, there is the excise tax, and there is income tax on any earnings. You need to examine if they also used the account for anything, whether medical or not.
Pub 969 covers the eligibility rules, functionality, HDHP coverage requirements, provisions, and noncovered spouse details. And various types of distributions.
"Generally, you must pay a 6% excise tax on excess contributions. See Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, to figure the excise tax. The excise tax applies to each tax year the excess contribution remains in the account.
You may withdraw some or all of the excess contributions and avoid paying the excise tax on the amount withdrawn if you meet the following conditions.
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You withdraw the excess contributions by the due date, including extensions, of your tax return for the year the contributions were made. (this would be apply to their 2020 contribution)
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You withdraw any income earned on the withdrawn contributions and include the earnings in “Other income” on your tax return for the year you withdraw the contributions and earnings." (these earnings are taxed as part of their 2021 return)
You don't seem to have a condition where they used the money for a nonqualified event. You didn't mention if they used it for medically qualified expenses. A corrective distribution would not be subject to penalty, as that is not the same as ineligible spending.
Pub 969 covers "deemed distribution" so you would want to confirm there was no activity that results in the HSA being no longer considered an HSA account (which really would be your easiest route, if it applies, since it only happens once). It turns into a regular personal account and triggers that 20% penalty. It also tells you:
"Additional tax.
There is an additional 20% tax on the part of your distributions not used for qualified medical expenses. Figure the tax on Form 8889 and file it with your Form 1040, 1040-SR, or 1040-NR.
Exceptions.
There is no additional tax on distributions made after the date you are disabled, reach age 65, or die."
You didn't state how old this taxpayer is.
Yes, you are going to need Forms 8889 and 5329:
2018 = remove the deduction, pay excise tax; include earnings in income tax
2019 = a corrective distribution (partial) and/or medical spending? And excise tax accordingly, for carryover, and income tax on new earnings, if any.
2020 = that amount removed in 2021 was in time to be "for" 2020, a corrective distribution would make the May 2020 contribution moot. That means no excise tax on $3,550. Excise tax on the difference, income tax on the carryover earnings.
2021 = income tax on the earnings removed in 2021.
I think that's the list to work on.
"Made contribution in 2020, although was not deducted on tax return, but distributed/withdrew"
Yes, that contribution is moot.
"So if we treat the distribution as none qualified distribution, will have 20% penalty"
No.
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