Can I Set Up a Section 105 Plan for Myself? (w/Examples) + FAQs

Yes, you can set up a Section 105 plan for yourself — but only if your business structure allows it. IRC Section 105 governs how employers reimburse employees for medical expenses on a tax-free basis. The catch is that sole proprietors, partners, and S-corporation shareholders who own more than 2% are not treated as employees under federal tax law. That single rule blocks thousands of small business owners from participating in their own plan each year.

A Kaiser Family Foundation survey found that the average annual premium for employer-sponsored family health coverage reached over $25,000 in recent years. A Section 105 plan can turn a large chunk of those costs — plus out-of-pocket medical expenses — into 100% tax-deductible business expenses, free from income tax and self-employment tax.

Here is what you will learn in this article:

🏢 Which business structures let you participate in a Section 105 plan — and which ones lock you out
💍 How the spouse-employee workaround gives sole proprietors and partners a legal path to full medical deductions
📊 The real differences between ICHRA, QSEHRA, and the One-Person 105 HRA — and when each one fits
⚖️ How Section 105 stacks up against Section 162 and Section 213 deductions in actual tax savings
🚨 The costly mistakes that trigger IRS audits, including the $100-per-day ACA penalty most business owners miss

What IRC Section 105 Means for Your Medical Expenses

Section 105 of the Internal Revenue Code allows employers to set up a written plan that reimburses employees for medical expenses tax-free. The plan must be fully funded by the employer — employees cannot pay into it through salary deductions. Eligible expenses include health insurance premiums, dental and vision costs, prescription drugs, long-term care insurance, and virtually any expense that qualifies under IRS Section 213(d).

The employer gets a business deduction for every dollar reimbursed. The employee receives the reimbursement free from federal income tax, state income tax, and FICA taxes (Social Security and Medicare). This double tax benefit is what makes Section 105 plans one of the most powerful health benefit tools in the tax code.

A Section 105 plan is not health insurance. It is a reimbursement arrangement classified as a group health plan under federal law. That means it must comply with IRS rules, ERISA, HIPAA, COBRA (for employers with 20+ employees), and certain ACA provisions — including preventive care requirements and dependent coverage for children up to age 26.

Why Your Business Structure Decides Everything

Your ability to participate in your own Section 105 plan depends entirely on how the IRS classifies you. The IRS draws a hard line between employees and self-employed individuals. If you are not treated as an employee of your business, you cannot receive tax-free reimbursements from your own plan.

C-Corporation Owners Get the Best Deal

C-corporation owners who draw a regular W-2 salary are treated as employees of their own corporation. The corporation is the employer; you are the employee. This means you can fully participate in a Section 105 plan and receive 100% tax-free reimbursements for yourself and your family — just like any non-owner employee.

The corporation deducts all reimbursements as a business expense under Section 162(a). You pay zero income tax and zero payroll tax on the amounts you receive. There is no ownership percentage restriction for C-corporation shareholders.

S-Corporation Shareholders Hit a Tax Wall

S-corporations can set up a Section 105 plan, but special rules apply to any shareholder who owns more than 2% of the company’s stock. Under Revenue Ruling 91-26, a greater-than-2% S-corp shareholder is not treated as an employee for purposes of tax-free fringe benefits — even if that shareholder draws a W-2 salary.

Medical reimbursements paid to a 2%+ shareholder must be included in their W-2 wages. These amounts are subject to federal and state income tax, but they are exempt from FICA taxes. Family members of the 2%+ shareholder — including a spouse or children who work for the S-corp — are treated as if they also own more than 2%. They face the same restrictions.

S-Corp Participant	Tax Treatment
Employee (no ownership)	Reimbursements are 100% tax-free — no income tax, no FICA
2%+ Shareholder-employee	Reimbursements added to W-2; subject to income tax but exempt from FICA
Spouse of 2%+ shareholder	Treated as 2%+ shareholder — same restricted tax treatment

Sole Proprietors Cannot Participate Directly

A sole proprietor is not an employee under federal tax law. You and your business are the same legal entity. Because Section 105 requires an employer-employee relationship, a sole proprietor cannot receive tax-free reimbursements from their own plan. The same rule applies to single-member LLC owners who file on Schedule C.

This does not mean a sole proprietor is shut out entirely. The spouse-employee strategy — covered below — is the most common and IRS-approved workaround.

Partners Face the Same Barrier

A partner in a partnership is treated like a self-employed individual, not an employee. A partner’s spouse must be a bona fide employee of the partnership to access Section 105 benefits. A husband-and-wife partnership does not qualify because both spouses are partners — neither one is an employee.

LLCs Follow Their Tax Filing Status

An LLC does not have its own Section 105 rules. The rules that apply depend on how the LLC files its federal tax return. If the LLC files as a sole proprietorship, sole proprietor rules apply. If it files as a partnership, partnership rules apply. If it elects C-corp or S-corp taxation, the corresponding corporate rules apply.

Business Type	Owner Can Participate Directly?
C-Corporation	Yes — full tax-free reimbursements
S-Corporation (2%+ shareholder)	Partially — reimbursements are taxable income but FICA-exempt
Sole Proprietorship	No — must use spouse-employee workaround
Partnership	No — partner’s spouse must be a bona fide employee
LLC	Depends on federal tax election (sole prop, partnership, C-corp, or S-corp)

The Spouse-Employee Strategy That Unlocks Section 105

The most powerful workaround for sole proprietors and partners is to hire your spouse as a W-2 employee and offer them a Section 105 plan as part of their compensation package. Because the plan covers the employee and the employee’s spouse and dependents, you — the business owner — receive coverage through your spouse’s plan.

The IRS has confirmed this approach in multiple revenue rulings and letter rulings, including Revenue Ruling 71-588 and Letter Ruling 9409006. The Tax Court has also upheld it in several cases, provided the arrangement meets strict documentation and substance requirements.

How the Tax Math Works

When you reimburse your employee-spouse under a Section 105 plan, those reimbursements are deductible on Schedule C of your Form 1040 as employee benefit expenses (Line 14). The Bradford Tax Institute notes that this deduction offsets both your income tax and your self-employment tax — a benefit you cannot get from a standard Section 162(l) self-employed health insurance deduction.

Your spouse receives the reimbursements completely tax-free as a fringe benefit. The reimbursements are not subject to Social Security tax, Medicare tax, or federal income tax. If the IRS has stated that the total compensation can be in the form of Section 105 reimbursements, there may be no need to issue a W-2 or withhold payroll taxes — as long as the amount is reasonable for the work performed.

What “Bona Fide Employee” Means in Practice

The IRS scrutinizes spousal employment arrangements closely. Your spouse must perform real, legitimate work for your business. The employment relationship must exist in substance, not just on paper. Core Documents explains that fabricated relationships are the number one reason the IRS denies Section 105 deductions.

You need all of the following in place:

A written employment agreement that describes the spouse’s duties, hours, and compensation
A written Section 105 plan document that outlines eligible expenses, reimbursement limits, and plan terms
Time records showing actual hours worked
Compensation that is reasonable for the type and amount of work your spouse performs
Proper employment tax forms — the same forms required for any non-related employee (W-4, I-9, state withholding forms)

Example: How Jim and Mary Save $4,200 a Year

Jim runs a sole proprietorship. His wife, Mary, handles bookkeeping, runs business errands, and helps in the field. Jim hires Mary as a W-2 employee and establishes a Section 105 HRA through a plan document. Jim sets Mary’s total annual compensation at $14,000.

Compensation Detail	Amount
Section 105 HRA reimbursements (insurance premiums + out-of-pocket medical)	$12,000
Cash wages	$2,000

Jim deducts the entire $14,000 on Schedule C. The $12,000 in medical reimbursements is tax-free to Mary and deductible by Jim — reducing his income tax and self-employment tax. Jim saves approximately $4,200 per year in taxes compared to paying those medical costs out of pocket.

Three Scenarios Every Business Owner Should See

Scenario 1: Sole Proprietor With a Spouse Employee

Background: Sarah owns a freelance design business (Schedule C). Her husband, Dave, manages client emails, sends invoices, and maintains the website 15 hours per week. Their family’s annual health insurance premium is $14,400. They have $6,000 in out-of-pocket medical costs.

Sarah hires Dave as a W-2 employee and creates a written Section 105 plan. The plan reimburses Dave for the family’s insurance premiums and out-of-pocket expenses. Dave’s total compensation is $20,400 (all paid as Section 105 reimbursements).

What Sarah Does	What Happens on Her Taxes
Hires Dave as a W-2 employee with employment agreement and time records	Creates a valid employer-employee relationship
Establishes a written Section 105 plan	Meets IRS documentation requirement
Reimburses $14,400 in premiums + $6,000 in medical costs through the plan	Deducts $20,400 on Schedule C, Line 14
Files employment tax forms for Dave	Stays compliant with IRS payroll rules

Sarah’s $20,400 deduction reduces her federal income tax and her self-employment tax (15.3%). At a combined marginal rate of about 37%, Sarah saves roughly $7,548 per year.

Scenario 2: C-Corp Owner Participates Directly

Background: Marcus owns 100% of a C-corporation and draws a $120,000 annual salary. The corporation sets up a Section 105 plan. Marcus’s family health insurance premium is $18,000 per year, and their out-of-pocket expenses total $5,000.

What the Corporation Does	What Happens on Its Taxes
Establishes a written Section 105 plan for employees	Meets IRS plan document requirement
Reimburses Marcus $23,000 for premiums and medical expenses	Corporation deducts $23,000 as a business expense
Marcus receives reimbursement	Marcus pays $0 income tax and $0 FICA on the $23,000

Because Marcus is a W-2 employee of his own C-corp, he receives the reimbursement 100% tax-free. The corporation takes a full deduction. No spouse-employee workaround is needed.

Scenario 3: S-Corp Owner With 60% Ownership

Background: Lisa owns 60% of an S-corporation and draws a W-2 salary. She sets up a Section 105 plan. Her family’s total medical costs are $15,000 per year.

What the S-Corp Does	What Happens on Lisa’s Taxes
Establishes a Section 105 plan	Meets plan document requirements
Reimburses Lisa $15,000 for medical expenses	S-corp includes $15,000 on Lisa’s W-2 as income
Lisa reports additional W-2 income	Lisa pays federal and state income tax on $15,000 but pays no FICA

Lisa’s reimbursements are not fully tax-free because she owns more than 2% of the S-corp. She can then deduct the $15,000 on her personal return as a self-employed health insurance deduction under Section 162(l), but she does not get the FICA savings that a C-corp owner or a spouse-employee would receive.

How Section 105, Section 162, and Section 213 Stack Up

Three sections of the Internal Revenue Code let you deduct medical costs. They work differently, and choosing the wrong one can cost you thousands.

Section 162(l) allows self-employed individuals to deduct health insurance premiums — but only premiums, not out-of-pocket expenses. The deduction reduces income tax but does not reduce self-employment tax. Section 213(a) allows anyone to deduct unreimbursed medical expenses — but only the portion that exceeds 7.5% of adjusted gross income (AGI). Section 105 has no AGI floor and no limit on the types of medical expenses covered.

A sole proprietor earning $100,000 who pays $20,000 in total medical costs would save approximately $3,060 more per year using a Section 105 plan (through a spouse-employee) compared to using the Section 162(l) deduction alone. That difference comes from the self-employment tax savings (15.3% × $20,000 = $3,060) that Section 162(l) does not provide.

ICHRA, QSEHRA, and the One-Person 105 HRA Explained

A Section 105 plan often takes the form of a Health Reimbursement Arrangement (HRA). Three HRA types matter most for small business owners: the Individual Coverage HRA (ICHRA), the Qualified Small Employer HRA (QSEHRA), and the One-Person 105 HRA.

ICHRA: No Size Limits, Maximum Flexibility

An ICHRA is available to businesses of any size. There are no caps on how much you can reimburse employees. You can divide employees into up to 11 different classes and offer different amounts to each class. Employees must have individual health insurance coverage to participate. ICHRA reimbursements require Forms 1095-B and 1094-B at tax time.

QSEHRA: Built for Small Teams

A QSEHRA is only available to employers with fewer than 50 full-time equivalent employees. For 2026, contribution limits are $6,450 for individual coverage and $13,100 for family coverage. You cannot vary amounts by employee class — only by family status (single vs. family). QSEHRA allowances must be reported on the employee’s W-2 in Box 12, Code FF.

One-Person 105 HRA: The Solo Strategy

The One-Person 105 HRA is designed for businesses with one eligible employee. It works under the standard Section 105 rules and avoids nondiscrimination problems under Section 105(h) because there is only one participant. If you hire a second eligible employee, the plan fails nondiscrimination testing unless that employee also receives coverage.

Mistakes That Trigger IRS Audits and Steep Penalties

No Written Plan Document

The IRS requires a formal, written Section 105 plan document before any reimbursements are made. A verbal agreement or informal arrangement does not count. Without a written plan, every reimbursement becomes taxable income — and the employer loses the business deduction.

Spouse Is Not a Real Employee

The most common audit trigger is a spousal employment arrangement that exists only on paper. In Haeder v. Commissioner, the Tax Court denied the deduction because the spouse performed no services “other than those reasonably expected of a family member.” You need time records, a job description, and proof of actual work performed.

Compensation Exceeds Reasonable Levels

The total compensation paid to your spouse — cash wages plus Section 105 reimbursements — must be reasonable for the work performed. A spouse who answers phones 5 hours a week should not receive $80,000 in annual reimbursements. Unreasonable compensation invites the IRS to reclassify the entire amount as a non-deductible personal expense.

Ignoring ACA Market Reform Rules

The ACA imposes a $100-per-day, per-employee penalty (under IRC Section 4980D) on employers who reimburse individual health insurance premiums outside of a compliant HRA. A standalone reimbursement arrangement that is not structured as an ICHRA or QSEHRA can trigger penalties of up to $36,500 per employee per year. A properly written Section 105 HRA avoids this penalty.

Failing to File Employment Tax Forms

If your spouse is a W-2 employee, you must handle employment tax filings — including Form 941 (quarterly federal tax return) and Form 940 (FUTA). Missing these filings triggers a failure-to-file penalty of 5% per month on unpaid tax, up to 25%. The IRS also imposes a failure-to-deposit penalty ranging from 2% to 15% depending on how late the deposit is.

Not Keeping Expense Documentation

The IRS requires employees to substantiate every reimbursement with proper documentation — receipts, explanation of benefits (EOBs), or invoices. Documentation must be kept on file for ten years. Reimbursements without documentation are treated as taxable wages.

How to Set Up Your Section 105 Plan Step by Step

Step 1: Choose Your Business Structure Path

Determine whether you can participate directly (C-corp) or need the spouse-employee strategy (sole proprietor, partnership). S-corp owners with more than 2% ownership should calculate whether the partial tax benefit is worth the compliance cost.

Step 2: Establish Bona Fide Employment (If Using a Spouse)

Create a written employment agreement. Define job duties, work schedule, and compensation. Set up payroll and obtain an Employer Identification Number (EIN) if you do not already have one. Complete Form W-4 and Form I-9 for your spouse.

Step 3: Draft the Written Plan Document

The plan document must specify eligible expenses, the maximum annual reimbursement amount, the plan year (usually January through December), and the carry-over policy if unused funds roll forward. Revenue Ruling 2002-41 allows unused HRA amounts to carry over to future years.

Step 4: Set a Reasonable Reimbursement Cap

Your plan should include a maximum annual reimbursement cap. This cap must reflect what is reasonable compensation for your spouse’s work. Your tax adviser can help you determine whether additional cash wages are needed because the Section 105 reimbursements alone would not represent enough compensation.

Step 5: Process Reimbursements and Keep Records

Reimburse your employee only after they submit documentation of an eligible expense. Keep copies of all receipts, insurance EOBs, and reimbursement records. Record each reimbursement on Schedule C, Line 14 (“Employee benefit programs”) at tax filing time.

Step 6: Handle Compliance Requirements

File employment tax returns on time. If you have 20 or more employees, provide COBRA continuation notices. Maintain a Summary Plan Description (SPD) as required by ERISA. Pay the annual PCORI fee via Form 720 if applicable under the ACA.

Do’s and Don’ts for Section 105 Plans

Do ✅	Don’t ❌
Do create a written plan document before making any reimbursements — the IRS requires it to exist in advance	Don’t reimburse medical expenses without a formal written plan — every dollar becomes taxable
Do keep time records and a job description for your employee-spouse — they prove the employment is real	Don’t hire your spouse “on paper” without assigning real duties — the IRS calls this a fabricated relationship
Do set a reimbursement cap that matches reasonable compensation for work performed	Don’t set reimbursement amounts that far exceed what a non-family employee would earn for the same job
Do require expense substantiation (receipts, EOBs) before issuing reimbursements	Don’t reimburse expenses without documentation — unsubstantiated payments are taxable wages
Do structure your HRA as an ICHRA or QSEHRA if reimbursing individual insurance premiums	Don’t create a standalone reimbursement arrangement outside a compliant HRA — the ACA penalty is $100/day per employee
Do file all employment tax forms (941, 940, W-2) on time	Don’t skip payroll filings — penalties range from 2% to 25% of unpaid tax

Pros and Cons of a Section 105 Plan

Pros ✅	Cons ❌
100% tax-deductible — reimbursements reduce income tax and self-employment tax when deducted on Schedule C	Requires documentation — written plan, employment agreement, time records, and expense receipts all must be maintained
Tax-free to the employee — reimbursements are exempt from federal income tax and FICA	Not available to all owners — sole proprietors and partners cannot participate directly; S-corp 2%+ shareholders get limited benefits
No AGI threshold — unlike Section 213, there is no 7.5% floor before deductions kick in	Spouse must do real work — fabricated employment relationships are the #1 audit trigger
Covers more than premiums — out-of-pocket medical, dental, vision, long-term care, and prescription costs are all eligible	ACA penalties for non-compliance — improperly structured plans face a $100/day per-employee penalty
Unused funds can carry over — Revenue Ruling 2002-41 allows carry-over of unused HRA balances to future years	Compliance burden — ERISA, HIPAA, COBRA, and ACA rules all apply to Section 105 plans as group health plans
Employer controls the budget — you set the reimbursement cap and keep any unused funds	Reasonable compensation limits — total reimbursements plus wages cannot exceed what is fair for the spouse’s work

Court Rulings That Shaped Section 105 Plans

Shellito v. Commissioner — The Case That Almost Killed Spouse-Employee Plans

Milo Shellito was a Kansas farmer. His wife, Sharlyn, worked on the farm for 19 years without formal pay. In 2001, Milo hired Sharlyn as a W-2 employee, set up a Section 105 plan, and deducted the family’s medical expenses as employee benefits on Schedule C.

The IRS disallowed the deductions and assessed deficiencies of $3,995 and $6,947 for 2001 and 2002. The Tax Court sided with the IRS, ruling that Sharlyn was not Milo’s bona fide employee because she had done the same work for years without pay, and nothing in 2001 changed their economic relationship.

The Shellitos appealed to the Tenth Circuit Court of Appeals. The Tenth Circuit vacated the Tax Court’s decision and sent the case back for a new analysis. The appeals court held that the Tax Court should have used the common-law agency doctrine to determine whether an employer-employee relationship existed. The Tenth Circuit also rejected the IRS’s argument that Sharlyn’s medical reimbursements were just converting a personal support obligation into a deductible expense.

The court pointed out that the IRS had taken inconsistent positions in six prior cases involving employee-spouses. On remand, the Tax Court ruled in the Shellitos’ favor — a major win for spouse-employee plans nationwide.

What the Shellitos Did Right

Their case offers a blueprint for any business owner setting up a spouse-employee Section 105 plan:

There was a written employment agreement between Milo and Sharlyn describing her duties and qualifications
The Section 105 plan was established in writing before reimbursements began
Reimbursements from the plan were designated as a form of compensation for the employee-spouse
Sharlyn was clearly qualified to perform the work assigned to her

Haeder v. Commissioner — When Spousal Employment Fails

In Haeder, the Tax Court denied the Section 105 deduction because the taxpayer’s wife performed no services beyond what a family member would normally do. There was no written employment agreement. There were no time records. The arrangement existed on paper only. The court treated the medical reimbursements as personal expenses — non-deductible.

Frahm v. Commissioner — Reasonable Compensation Matters

In Frahm v. Commissioner (T.C. Memo. 2007-351), the Tax Court allowed most of the Section 105 deductions because the taxpayer’s spouse was a legitimate employee. The court disallowed a portion of the claimed deduction because the total compensation was not reasonable in relation to the services performed. This case reinforces that compensation must match the work — you cannot inflate reimbursements beyond what the job is worth.

How Section 105 Reimbursements Flow Through Your Tax Return

Sole Proprietors (Schedule C)

You deduct Section 105 reimbursements on Schedule C, Line 14 (“Employee benefit programs”). This deduction reduces your net business income, which lowers your income tax and your self-employment tax. Your employee-spouse does not report the reimbursement as income if the plan is properly structured.

C-Corporations (Form 1120)

The corporation deducts reimbursements as a business expense under Section 162(a). The owner-employee does not include the reimbursement in gross income. The W-2 does not reflect Section 105 reimbursements because they are a tax-free fringe benefit.

S-Corporations (Form 1120-S)

Reimbursements paid to a 2%+ shareholder-employee must be included in the shareholder’s W-2. The shareholder can then claim a self-employed health insurance deduction on Line 17 of Schedule 1 (Form 1040). This offsets the income inclusion, but the deduction only applies to insurance premiums — not out-of-pocket expenses — and it does not reduce self-employment tax.

Partnerships (Form 1065)

If a partner’s spouse is a bona fide employee of the partnership, reimbursements are deducted as a business expense on the partnership return. The spouse receives the reimbursement tax-free. The partner then receives the benefit through reduced partnership income on their Schedule K-1, which lowers their income tax and self-employment tax.

State-Level Nuances You Should Know

Most states follow the federal tax treatment of Section 105 plans, but not all. New Jersey, for example, does not conform to the federal exclusion for employer-provided health benefits in all cases. California generally follows federal rules for Section 105 but has its own nondiscrimination requirements for certain state-level benefits.

States with no income tax — like Texas, Florida, Wyoming, Nevada, Washington, South Dakota, and Alaska — provide an automatic additional benefit because reimbursements are free from both federal and state income tax with no extra planning. If you live in a high-income-tax state like New York or California, the state income tax savings from a Section 105 plan can add another 5% to 13% in tax reduction on top of the federal savings.

Check your state’s Department of Revenue website or consult a local tax professional to confirm your state’s treatment of Section 105 reimbursements.

FAQs

Can a sole proprietor set up a Section 105 plan?

Yes, but you cannot participate directly. You must hire your spouse as a bona fide W-2 employee and provide Section 105 benefits as part of their compensation package.

Can an S-corp owner get tax-free Section 105 reimbursements?

No. Shareholders owning more than 2% must include reimbursements in W-2 wages. The amounts are subject to income tax but exempt from FICA taxes.

Does a Section 105 plan reduce self-employment tax?

Yes. When reimbursements are deducted on Schedule C, they reduce net self-employment income. This lowers both income tax and the 15.3% self-employment tax.

Can I reimburse my spouse’s entire compensation through a Section 105 plan?

Yes. The IRS allows total compensation to consist entirely of Section 105 reimbursements, provided the amount is reasonable for the work the spouse performs.

Do I need a written plan document?

Yes. The IRS requires a formal written Section 105 plan document to exist before reimbursements begin. Without it, all reimbursements become taxable.

Can a husband-and-wife partnership use a Section 105 plan?

No. Both spouses are partners, and neither qualifies as an employee. One spouse must be a bona fide employee — not a partner — for the plan to work.

What is the $100-per-day ACA penalty?

Yes, it is real. Employers who reimburse individual health insurance premiums outside a compliant HRA face a penalty of $100 per day per affected employee under IRC Section 4980D.

Can I use a Section 105 plan and an HSA at the same time?

Yes. Special rules limit which expenses the Section 105 plan can reimburse when the employee also participates in a health savings account with a high-deductible plan.

What expenses does a Section 105 plan cover?

Yes, it covers a wide range. Eligible items include insurance premiums, copays, prescriptions, dental, vision, long-term care, hearing aids, and any expense qualifying under IRS Section 213(d).

Can I carry over unused Section 105 funds to next year?

Yes. Revenue Ruling 2002-41 allows unused HRA amounts to carry over. The business owner sets the carry-over maximum, and unused amounts accumulate year after year.

Will a Section 105 plan survive an IRS audit?

Yes, if you have a written plan, a written employment agreement, time records, expense documentation, and reasonable compensation. The Shellito case proves properly structured plans hold up in court.

Is a Section 105 plan the same as health insurance?

No. A Section 105 plan is a reimbursement arrangement — not an insurance policy. It is classified as a group health plan for compliance purposes but does not provide insurance coverage itself.

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