Yes, employers can deduct 100% of Section 105 reimbursements as ordinary business expenses under the Internal Revenue Code. Employees who receive these reimbursements can exclude them from gross income under IRC Section 105(b), making the money tax-free on both sides of the arrangement. IRC Section 105(h), however, imposes nondiscrimination requirements that can strip away these tax benefits if a plan favors highly compensated individuals over rank-and-file workers.
The average annual premium for employer-sponsored family health coverage reached $25,572 in 2024 — a cost that makes tax-efficient reimbursement plans more valuable than ever.
Here’s what you’ll learn in this article:
- 💰 How Section 105 reimbursements create tax deductions for employers and tax-free income for employees
- 🏢 Which business entity types (C-corp, S-corp, sole proprietor, partnership, LLC) qualify — and which face restrictions
- ⚠️ The nondiscrimination rules under IRC 105(h) that can trigger penalties if your plan design is wrong
- 📋 Step-by-step scenarios showing how real business owners use Section 105 plans to save thousands
- 🚫 The most common mistakes that lead to IRS audits and denied deductions
What IRC Section 105 Means for Your Business
IRC Section 105 is the part of the federal tax code that governs amounts received under employer-sponsored accident and health plans. It sets the rules for when medical reimbursements are included in — or excluded from — an employee’s taxable income.
Under IRC Section 105(b), reimbursements paid to an employee for medical care expenses (as defined in Section 213(d)) are excluded from the employee’s gross income. This exclusion applies only when the employer funds the plan entirely — employees cannot contribute through salary deductions.
The employer’s side of the equation falls under IRC Section 162, which allows businesses to deduct “ordinary and necessary” business expenses. Medical reimbursements paid through a properly structured Section 105 plan qualify as deductible employee compensation.
How the Two-Sided Tax Benefit Works
The tax advantage of a Section 105 plan flows in two directions. The employer deducts every dollar reimbursed as a business expense, reducing taxable business income. The employee receives the reimbursement tax-free — no federal income tax, no Social Security tax, and no Medicare tax owed on the amount.
This double benefit is what makes Section 105 plans more powerful than a simple raise. If an employer gives an employee a $5,000 raise to cover medical costs, both sides pay payroll taxes on that amount. A $5,000 Section 105 reimbursement avoids those taxes entirely.
| Compensation Method | Tax Treatment |
|---|---|
| $5,000 cash raise | Subject to federal income tax, FICA, and FUTA for both employer and employee |
| $5,000 Section 105 reimbursement | Tax-free to employee; fully deductible by employer; exempt from FICA and FUTA |
What Expenses Qualify for Reimbursement
Section 105 plans can reimburse any expense that meets the IRS definition of medical care under Section 213(d) of the Internal Revenue Code. This includes a broad range of costs that most people encounter every year.
Eligible expenses include health insurance premiums (individual, dental, vision, Medicare), prescription drugs, doctor and specialist co-pays, hospital bills, mental health services, chiropractic care, lab work, and medical equipment. Long-term care insurance premiums also qualify, up to age-based limits set by the IRS each year.
Cosmetic procedures do not qualify unless they treat a deformity from a congenital abnormality, injury, or disease. Gym memberships and general wellness programs also fall outside the Section 213(d) definition unless a physician prescribes them for a specific medical condition.
Which Business Entities Can Deduct Section 105 Reimbursements
The type of business entity you operate determines how you benefit from a Section 105 plan — and whether you can participate as an owner. Federal tax law treats each entity differently, and the consequences of getting this wrong range from lost deductions to unexpected tax bills.
C-Corporations: The Full Benefit
C-corporations receive the most complete tax benefit from Section 105 plans. The corporation deducts all reimbursements as ordinary business expenses, and owner-employees can participate in the plan just like any other employee. There is no requirement for spousal employment.
The C-corp owner-employee receives reimbursements free from federal income tax, Social Security tax, and Medicare tax. This structure works because the IRS treats C-corp owners as employees of the corporation, not as self-employed individuals.
S-Corporations: The 2% Shareholder Trap
S-corporations can establish Section 105 plans, but shareholders who own more than 2% of the company face a significant restriction. Under Revenue Ruling 91-26, a 2%-or-greater S-corp shareholder is treated as a partner — not an employee — for purposes of accident and health benefits.
This means a 2% S-corp shareholder’s Section 105 reimbursements are not tax-free. The reimbursements must be included in the shareholder’s W-2 wages as income subject to federal and state income tax. The reimbursements are exempt from FICA and FUTA taxes, which provides partial relief.
The shareholder may then claim the self-employed health insurance deduction on their personal Form 1040, but only for health insurance premiums — not for out-of-pocket medical expenses. Family members of a 2% shareholder (including a spouse and children) who also work at the company receive the same restricted treatment, even if they own no stock themselves.
| S-Corp Participant | Tax Treatment of Reimbursements |
|---|---|
| Employee with less than 2% ownership | Tax-free under IRC 105(b); employer deducts as business expense |
| Shareholder with 2% or more ownership | Included in W-2 wages; subject to income tax but exempt from FICA/FUTA |
Sole Proprietorships: The Spousal Employment Strategy
Sole proprietors cannot participate in their own Section 105 plan. The IRS does not consider a sole proprietor to be an employee of the business, so any reimbursement paid directly to the owner fails to qualify under IRC Section 105(b).
The workaround is spousal employment. A sole proprietor hires a spouse as a bona fide employee and offers a Section 105 plan as part of the spouse’s compensation package. Because the plan covers the employee’s family, the sole proprietor (as the employee’s spouse) and their dependents receive reimbursement through the employed spouse’s plan.
This strategy is supported by Revenue Ruling 71-588 and IRS Letter Ruling 9409006. The IRS scrutinizes these arrangements closely, so the spousal employment must be real. The spouse must perform legitimate work, receive reasonable compensation, and be treated like any other employee with proper payroll documentation.
Partnerships: Similar to Sole Proprietors
Partners in a partnership follow rules similar to sole proprietors. A partner is not an employee of the partnership under federal tax law, which means the partner cannot receive tax-free Section 105 reimbursements directly.
The spousal employment strategy works here too — a partner’s spouse can be hired as a bona fide employee and enrolled in the Section 105 plan. A husband-and-wife partnership, however, does not qualify for this strategy because both spouses are partners, not employees.
LLCs: It Depends on Your Tax Election
A limited liability company’s Section 105 treatment depends entirely on how it files its federal tax return. An LLC taxed as a C-corporation follows C-corp rules. An LLC taxed as an S-corporation follows S-corp rules. A single-member LLC follows sole proprietorship rules, and a multi-member LLC follows partnership rules.
| Business Entity | Section 105 Owner Treatment |
|---|---|
| C-Corporation | Owner participates directly; reimbursements are fully tax-free and deductible |
| S-Corporation (2%+ shareholder) | Reimbursements included in W-2 wages; subject to income tax, exempt from FICA |
| Sole Proprietorship | Owner cannot participate directly; must use spousal employment strategy |
| Partnership | Partner cannot participate directly; must use spousal employment strategy |
| LLC | Follows the rules of whichever entity type it elects for federal tax filing |
Types of Section 105 Plans and How They Differ
Several types of arrangements fall under the Section 105 umbrella. Each one has different rules about who can use it, how much can be reimbursed, and what expenses qualify.
Qualified Small Employer HRA (QSEHRA)
The QSEHRA was created by the 21st Century Cures Act in 2016. It is available only to employers with fewer than 50 full-time equivalent employees who do not offer group health insurance.
For 2026, the IRS set QSEHRA reimbursement limits at $6,450 per year for self-only coverage and $13,100 per year for family coverage. All eligible employees must receive the same allowance amount (except for differences based on family status). Employers must provide a written notice to each eligible employee at least 90 days before the start of the plan year.
Employees must have minimum essential coverage (MEC) to receive reimbursements. Any QSEHRA allowance reduces the employee’s eligibility for premium tax credits on the ACA marketplace, dollar for dollar.
Individual Coverage HRA (ICHRA)
The ICHRA became available in January 2020 and has no limit on how much employers can reimburse. There is also no restriction on employer size — businesses with 1 employee or 10,000 employees can offer an ICHRA.
Employers can offer different allowance amounts to different classes of employees, such as full-time vs. part-time, salaried vs. hourly, or employees in different geographic locations. Employees must have individual health insurance coverage to participate and cannot receive premium tax credits while enrolled in an ICHRA.
Group Coverage HRA (GCHRA)
A GCHRA works alongside a traditional group health insurance plan. It reimburses employees for out-of-pocket costs like deductibles and co-pays that the group plan does not cover. Employees must be enrolled in the employer’s group plan to participate in the GCHRA.
Excepted Benefit HRA (EBHRA)
The EBHRA allows employers to reimburse up to $2,150 per year (2026) for certain medical expenses. Unlike other HRAs, it can be offered alongside a group health plan, and employees do not need individual coverage to participate. This makes it a flexible add-on for employers who already sponsor group insurance.
Health Flexible Spending Account (FSA)
Health FSAs are another form of Section 105 plan, but they differ in one key way: employees fund FSAs through pre-tax salary reductions. The employer may also contribute, but the employee contribution is what distinguishes FSAs from other Section 105 arrangements.
| Plan Type | Key Feature |
|---|---|
| QSEHRA | Employers with fewer than 50 FTEs; annual caps of $6,450/$13,100 for 2026 |
| ICHRA | No employer size limit; no reimbursement cap; allows employee classes |
| GCHRA | Must pair with group health insurance; reimburses out-of-pocket costs only |
| EBHRA | $2,150 annual cap for 2026; pairs with group plan; no individual coverage required |
| Health FSA | Employee-funded through pre-tax salary reductions; employer may also contribute |
How QSEHRA and ICHRA Limits Have Changed
The IRS adjusts QSEHRA limits each year based on the chained Consumer Price Index. These annual adjustments reflect rising healthcare costs and help small employers keep pace with inflation.
| Year and Coverage Type | Annual Reimbursement Limit |
|---|---|
| 2025 — Self-only | $6,350 |
| 2025 — Family | $12,800 |
| 2026 — Self-only | $6,450 (increase of $100) |
| 2026 — Family | $13,100 (increase of $300) |
The ICHRA has no annual reimbursement cap set by the IRS. Employers decide how much to offer, making it far more flexible for businesses that want to provide generous benefits. The ICHRA’s unlimited structure is one reason it has grown faster than the QSEHRA since its 2020 launch.
Three Real-World Scenarios That Show Section 105 Deductions in Action
Scenario 1: The Sole Proprietor With a Working Spouse
Marcus runs a landscaping business as a sole proprietor. His wife Tina handles scheduling, billing, and customer calls 20 hours per week. Marcus pays Tina $24,000 per year — $12,000 in cash wages and $12,000 through a Section 105 HRA. The family’s health insurance premiums cost $9,600 per year, and they have $2,400 in out-of-pocket dental and vision expenses.
Marcus deducts the full $12,000 in Section 105 reimbursements as a business expense. Tina pays no federal income tax, Social Security tax, or Medicare tax on the reimbursed amount. At a combined marginal tax rate of 35% (including self-employment tax savings), the family saves approximately $4,200 in taxes.
| Action Marcus Takes | Tax Result |
|---|---|
| Hires Tina as a bona fide employee with proper payroll | Establishes legitimate employer-employee relationship required by IRS |
| Creates a written Section 105 HRA plan document | Meets IRS documentation requirements for tax-free treatment |
| Reimburses $12,000 in medical expenses through the plan | Deducts $12,000 as a business expense; Tina excludes it from gross income |
| Keeps receipts and expense records for 10 years | Protects the deduction if the IRS audits the business |
Scenario 2: The S-Corp Owner Who Hits the 2% Wall
Diana owns 100% of an S-corporation that employs 8 people. She sets up a Section 105 HRA and reimburses herself $10,000 for health insurance and medical expenses. Because Diana owns more than 2% of the S-corp, her reimbursements are not tax-free. The $10,000 is added to her W-2 as taxable income subject to federal and state income tax.
Diana can claim the self-employed health insurance deduction on her Form 1040 for the insurance premium portion — but not for out-of-pocket medical costs. Her 8 non-owner employees, however, receive their reimbursements completely tax-free under IRC 105(b).
| What Diana Does | Tax Result |
|---|---|
| Reimburses herself $10,000 through the Section 105 plan | Amount is included in her W-2; subject to income tax but exempt from FICA/FUTA |
| Claims self-employed health insurance deduction on Form 1040 | Deducts insurance premiums only (not out-of-pocket costs) as adjustment to income |
| Reimburses non-owner employees through the same plan | Employees exclude all reimbursements from income; S-corp deducts as business expense |
Scenario 3: The C-Corp Owner Who Gets the Full Benefit
Robert is the sole owner and employee of a C-corporation consulting firm. He establishes a Section 105 plan and reimburses himself $15,000 for health insurance premiums, dental work, and prescription costs. Because the IRS treats him as an employee of the C-corp, the corporation deducts the full $15,000, and Robert pays zero tax on the reimbursement.
Robert does not need to hire his spouse or meet the spousal employment requirements that sole proprietors face. The C-corp structure gives him direct access to the Section 105 benefit without any workarounds.
| What Robert Does | Tax Result |
|---|---|
| Sets up a Section 105 plan with formal plan documents | Corporation meets IRS requirements for deductibility |
| Reimburses himself $15,000 for qualified medical expenses | Corporation deducts $15,000; Robert excludes it from gross income entirely |
| Keeps all receipts and substantiation records on file | Protects against IRS disallowance during an audit |
The Nondiscrimination Rules Under IRC 105(h) That Can Destroy Your Deduction
IRC Section 105(h) applies to self-insured medical reimbursement plans — the category that includes most HRAs and MERPs. It requires that a plan not discriminate in favor of highly compensated individuals (HCIs) in either eligibility or benefits. Violating these rules does not disqualify the entire plan — it causes only the HCIs to lose their tax-free treatment.
Who Counts as a Highly Compensated Individual
Under IRC Section 105(h)(5), a highly compensated individual falls into one of three categories. The first is one of the five highest-paid officers of the company. The second is a shareholder who owns more than 10% of the company’s stock. The third is an employee among the highest-paid 25% of all employees.
The Two Tests Your Plan Must Pass
The Eligibility Test requires the plan to benefit at least 70% of all employees, or at least 80% of eligible employees if 70% or more of all employees are eligible. The plan can also pass by covering employees under a classification the IRS finds nondiscriminatory.
The Benefits Test requires the plan to provide the same benefits to all participants. If HCIs receive larger reimbursements or access to a broader range of covered expenses, the plan fails. Certain employees can be excluded from the eligibility test without causing a failure: employees with fewer than 3 years of service, employees under age 25, part-time or seasonal employees, and employees covered by a collective bargaining agreement.
| Test | What It Measures |
|---|---|
| Eligibility Test | Whether the plan covers a broad enough group of employees — not just HCIs |
| Benefits Test | Whether HCIs receive the same benefits — not better benefits — than other participants |
What Happens When Your Plan Fails
If a self-insured plan fails the 105(h) nondiscrimination tests, the discriminatory excess reimbursements paid to HCIs become included in their gross income. The rank-and-file employees keep their tax-free treatment. The employer can still deduct the reimbursements as a business expense, but the HCIs owe income tax on the amounts that violate the rules.
The penalty is calculated using a fraction: total reimbursements paid to HCIs divided by total reimbursements paid to all plan participants. This fraction determines how much of the HCIs’ reimbursements become taxable.
Compliance Requirements That Keep Your Plan Legal
A Section 105 plan is classified as a group health plan under federal law. This means it must comply with multiple federal regulations beyond the Internal Revenue Code, including ERISA, HIPAA, COBRA, and the ACA.
Written Plan Document
The IRS requires a formal, written plan document that spells out which expenses are eligible, how much the employer will reimburse, the plan year dates, and the rules for participation. Operating a Section 105 plan without a written document is one of the fastest ways to lose your tax benefits in an audit.
Expense Substantiation
Employees must submit proof of every expense before receiving reimbursement. Acceptable proof includes itemized receipts, Explanation of Benefits (EOB) statements from insurers, and pharmacy printouts. The IRS requires employers to keep these records for at least 10 years.
A plan that reimburses expenses without proper substantiation violates IRS rules. The reimbursements become taxable income to the employee, and the employer may face penalties.
ERISA and HIPAA
Section 105 plans are employee welfare benefit plans under the Employee Retirement Income Security Act (ERISA). Employers must create and distribute a Summary Plan Description (SPD) to every participant. HIPAA privacy rules also apply because plan administrators handle protected health information during the claims review process.
COBRA
Employers with 20 or more employees must offer COBRA continuation coverage when an employee leaves or loses eligibility. The terminated employee can continue participating in the Section 105 plan, and the employer may charge up to 102% of the plan’s cost for COBRA coverage.
ACA Requirements
The Affordable Care Act imposes several requirements on Section 105 plans. These include covering preventive care without cost-sharing, extending dependent coverage to children up to age 26, paying the annual PCORI fee through IRS Form 720, and providing 60 days’ advance notice before making material changes to the plan.
Mistakes That Turn Section 105 Tax Savings Into IRS Problems
No Written Plan Document
Running a Section 105 plan without a formal written document is the single most common compliance failure. The IRS has consistently ruled that verbal or informal arrangements do not qualify. Without a plan document, every reimbursement becomes taxable income to the employee, and the employer loses the deduction.
Failing Nondiscrimination Testing
Many small business owners design Section 105 plans that give the owner-employee generous benefits while offering little or nothing to other staff. This triggers a Section 105(h) failure. The owner’s reimbursements become taxable, and back taxes plus interest may apply.
The Sole Proprietor Self-Reimbursement Error
Sole proprietors sometimes reimburse themselves through a Section 105 plan. This does not work. The IRS does not recognize a sole proprietor as an employee of the business, so the reimbursement is not deductible as a business expense and is not excludable from income.
Fake Spousal Employment
Some sole proprietors “hire” a spouse on paper without requiring any real work. The IRS looks for evidence of actual services, reasonable compensation, and proper payroll records. In cases like Sheldon v. Commissioner, the Tax Court has denied Section 105 deductions when spousal employment was not genuine.
Allowing Employee Salary Reductions to Fund the Plan
A Section 105 plan must be funded entirely by the employer. If employees contribute to the plan through salary reductions, the arrangement is no longer a pure Section 105 plan. It may be reclassified as a Section 125 cafeteria plan, which has different rules, testing requirements, and filing obligations.
Missing Expense Substantiation
Reimbursing employees based on estimates, verbal claims, or incomplete receipts violates IRS substantiation rules. The IRS requires itemized documentation showing the date of service, the provider, the type of expense, and the amount paid. Failure to substantiate can turn tax-free reimbursements into taxable wages for the employee.
Ignoring the S-Corp 2% Shareholder Rules
S-corp owners who treat their reimbursements as tax-free — ignoring the 2% shareholder restriction — risk reclassification of the amounts as unreported W-2 income. This triggers back taxes, penalties, and interest from the IRS.
Do’s and Don’ts for Section 105 Plan Success
| Do ✅ | Don’t ❌ |
|---|---|
| Do create a written plan document before making any reimbursements — the IRS requires it | Don’t operate the plan informally or verbally; you will lose all tax benefits |
| Do substantiate every expense with itemized receipts and keep records for 10 years | Don’t reimburse based on estimates or verbal claims; the IRS will disallow the deduction |
| Do run Section 105(h) nondiscrimination testing each year for self-insured plans | Don’t design the plan to benefit only owners and highly compensated employees |
| Do pay all plan costs from employer funds with no employee salary deductions | Don’t let employees fund the plan through payroll deductions; it changes the plan’s legal status |
| Do consult a tax professional before setting up a plan if you are a 2%+ S-corp shareholder | Don’t assume S-corp owners get the same tax-free treatment as C-corp owner-employees |
| Do ensure spousal employment is genuine with real duties, reasonable pay, and proper payroll | Don’t create a paper-only job for your spouse; the IRS and Tax Court will deny the deduction |
The Pros and Cons of Section 105 Plans
| Pros ✅ | Cons ❌ |
|---|---|
| Employer deducts 100% of reimbursements as a business expense | S-corp 2%+ shareholders cannot receive tax-free reimbursements |
| Reimbursements are tax-free to employees — no income tax, FICA, or FUTA | Sole proprietors and partners cannot participate directly; spousal employment is required |
| Employer controls the budget by setting reimbursement limits each year | Nondiscrimination rules under IRC 105(h) add compliance complexity for multi-employee plans |
| Unused funds stay with the employer, unlike HSAs which belong to the employee | Employees may be unfamiliar with reimbursement-based plans and need education |
| Plans are flexible — employers choose eligible expenses and allowance amounts | Must comply with IRS, ERISA, HIPAA, COBRA, and ACA rules |
| No employer size restrictions for ICHRAs; QSEHRAs serve small employers | QSEHRAs are limited to employers with fewer than 50 FTEs and have annual caps |
| Can be offered alongside group health insurance using GCHRA or EBHRA | Written plan documents, substantiation records, and SPDs require ongoing administrative effort |
Court Rulings and IRS Guidance That Shape Section 105 Law
Revenue Ruling 71-588: The Foundation for Spousal Employment
This IRS ruling established that a sole proprietor who employs a spouse can offer a Section 105 medical reimbursement plan covering the employee-spouse and the employee-spouse’s family. Because the business owner qualifies as the spouse’s dependent, the owner receives coverage through the plan. This ruling remains the cornerstone of spousal strategies for sole proprietors and partnerships.
Revenue Ruling 91-26: The S-Corp 2% Shareholder Rule
Revenue Ruling 91-26 clarified that a 2%-or-greater S-corporation shareholder must be treated as a self-employed individual for accident and health benefit purposes. The shareholder cannot exclude Section 105 reimbursements from gross income. IRS Announcement 92-16 supplemented this ruling with guidance on how to report these amounts on the shareholder’s W-2.
IRS Notice 2008-1: S-Corp Health Insurance Premiums
This notice confirmed that 2% S-corp shareholders can claim the self-employed health insurance deduction on Form 1040 — but only if the S-corporation either pays the premiums directly or reimburses the shareholder and reports the amounts as W-2 wages. The shareholder cannot pay premiums personally and claim the deduction without running the amounts through the corporation’s payroll.
Revenue Ruling 2002-41: Carry Over of Unused Benefits
This ruling allows Section 105 plans to include a carry-over provision. If an employee does not use their full reimbursement allowance in a given year, the unused amount can roll over to future years. Business owners may set a maximum carry-over amount. The carry-over continues until the plan terminates, the business closes, the balance reaches zero, or the employee becomes ineligible.
Related reading
- Should I Use a Section 105 or HSA? (w/Examples) + FAQs
- How Does a Section 105 Plan Work? (w/Examples) + FAQs
- Can I Cover My Children Under a Section 105 Plan? (w/Examples) + FAQs
- Is Section 105 Reimbursement Taxable Income? (w/Examples) + FAQs
- Can a Sole Proprietor Have a Section 105 Plan? (w/Examples) + FAQs
- Can Section 105 Reimburse Health Insurance Premiums? (w/Examples) + FAQs