No, your spouse does not need to receive a traditional W-2 wage for Section 105 — but your spouse must be a bona fide employee of your business. Under IRS rules, a Section 105 Health Reimbursement Arrangement can serve as the sole form of compensation for your employee-spouse, which means no cash wages, no W-2, and no payroll taxes in certain setups. The catch is that the IRS closely scrutinizes spousal employment arrangements, and many tax professionals still recommend issuing a small W-2 wage to create a stronger paper trail.
A 2024 survey by Thatch found that 36% of small businesses cite rising employee benefit costs as a top challenge — making Section 105 plans one of the most powerful, yet misunderstood, tax strategies available to business owners with a working spouse.
Here is what you will learn:
- 🔍 Whether the IRS actually requires a W-2 for your spouse under a Section 105 plan — and when skipping one is risky
- 💼 How Section 105 rules change depending on whether you run a sole proprietorship, partnership, C-corp, or S-corp
- ⚖️ The real court cases (Speltz and Shellito) that define what “bona fide employment” means for your spouse
- 🚫 The most common mistakes that trigger IRS audits and disqualify your entire Section 105 plan
- ✅ Step-by-step actions, do’s and don’ts, and pros and cons of using a spousal Section 105 strategy
What Section 105 Actually Says About Employee Benefits
Section 105 of the Internal Revenue Code governs how employees receive reimbursements under employer-funded accident and health plans. Under Section 105(b), an employee can exclude from gross income any amounts received as reimbursement for medical care expenses for themselves, their spouse, and their dependents. The employer, in turn, deducts those reimbursements as a business expense under IRC §162.
The key word in the entire statute is employee. Section 105 benefits flow only to individuals who have a legitimate employer-employee relationship with the business. A business owner — such as a sole proprietor — is not considered an employee of their own business under federal tax law. This is the fundamental reason the spousal employment strategy exists in the first place.
The IRS confirmed this approach works in Revenue Ruling 71-588, which held that amounts reimbursed under an accident and health plan covering all bona fide employees — including the owner’s wife — are excludable from income. The ruling also confirmed the reimbursement can cover the employee’s entire family, which means the business owner gets covered as a dependent of their employee-spouse.
Why “Bona Fide Employee” Is the Only Question That Matters
The IRS does not care whether your spouse receives a W-2 or not. What the IRS does care about is whether a real employment relationship exists. In a 1999 Industry Specialization Program paper, the IRS stated: “The extent and nature of a spouse’s involvement in the business operations is critical. Merely calling a spouse an ’employee’ is not sufficient to qualify a non-working spouse as an employee.”
This means your spouse must perform meaningful services that have economic substance. Part-time work counts — the IRS does not require full-time hours. The test is whether you would need to hire someone else to do the same work if your spouse were unavailable.
The IRS uses the common-law agency test to evaluate the relationship. Under this test, the business owner must have the right to control what work the spouse does and how they do it. The Tenth Circuit confirmed this is the correct standard when it reversed the Tax Court’s decision in the Shellito case.
The W-2 Question: Required or Optional?
Here is where most business owners get confused. The IRS has stated that a Section 105 HRA reimbursement can be the sole compensation paid to your employee-spouse. When that happens, no W-2 is needed, no federal payroll taxes apply, and no Social Security or Medicare taxes are owed on the reimbursement amounts.
This is because Section 105(b) reimbursements are excluded from gross income entirely. There is nothing to report on a W-2 if the employee-spouse receives zero cash wages. The Bradford Tax Institute explains that this can be the “best of all worlds” from a tax perspective — no payroll, no withholding, no filings.
But here is the risk. If the IRS audits your return and questions whether your spouse is actually an employee, you need proof. Many tax professionals recommend issuing a small W-2 — even just $1,000 per year — to help establish the employment relationship. A W-2 creates an official government record that your spouse worked for your business and received compensation.
| Compensation Structure | W-2 Required? |
|---|---|
| Spouse receives only Section 105 HRA reimbursements (no cash wages) | No — but employment must be proven through other documentation |
| Spouse receives cash wages plus Section 105 HRA reimbursements | Yes — W-2 must report the cash wage portion |
| Spouse receives cash wages only (no Section 105 plan) | Yes — standard W-2 rules apply |
Paying your spouse cash wages does trigger additional obligations. You must file a W-2, W-3, and I-9, plus quarterly 941 or 943 forms. However, you do not owe federal unemployment tax (FUTA) on wages paid to a spouse under IRC §3306(c)(5).
How Section 105 Rules Change by Business Entity
The type of business you operate dramatically affects whether you can use a Section 105 spousal strategy and how it works. The rules are not the same for every entity.
Sole Proprietorships: The Sweet Spot
Section 105 works best for sole proprietors. You hire your spouse as a W-2 employee, set up the plan in their name, and the plan reimburses them for all family medical expenses — including yours. Those reimbursements show up as employee benefit deductions on Schedule C, offsetting both income taxes and self-employment taxes.
The spouse must perform real work for the business, and the total compensation (reimbursements plus any wages) must be reasonable for the hours worked. A written employment agreement, time logs, and a formal Section 105 plan document are all essential.
Partnerships: The Spouse Cannot Be a Partner
The rules for partnerships mirror sole proprietorships with one critical restriction. Your spouse must be a bona fide employee of the partnership — and your spouse cannot be a partner. A husband-wife partnership does not qualify for Section 105 benefits because both spouses would be considered self-employed.
If only one spouse is a partner and the other is a legitimate employee, the arrangement works. The employee-spouse receives Section 105 reimbursements, and the partner-spouse is covered as a family member of the employee.
C-Corporations: Spousal Employment Not Required
C-corporations stand apart from every other entity. The owner of a C-corp is considered an employee of the corporation, which means they can receive Section 105 benefits directly without needing to hire their spouse. The corporation establishes a plan, and the owner-employee participates just like any other worker.
This does not mean you can skip the compliance requirements. The plan must still follow ERISA, DOL, and IRC rules, and all proper documentation must be maintained.
S-Corporations: The Strategy That Doesn’t Work
S-corp owners who hold 2% or more of the company’s shares face a unique problem. Under IRC §1372, these shareholders are treated as self-employed for health insurance purposes. They cannot receive tax-free Section 105 benefits.
The spousal workaround also fails for S-corps. Family members of a 2%+ shareholder — including a spouse — are treated as if they own shares too. This means hiring your spouse as an employee does nothing to unlock Section 105 benefits in an S-corp context. The reimbursements become taxable income.
| Business Entity | Spouse Must Be Employee? | Section 105 Available to Owner? |
|---|---|---|
| Sole Proprietorship | Yes — spouse must be bona fide W-2 employee | Indirectly — owner is covered as spouse’s dependent |
| Partnership | Yes — spouse must be employee, not a partner | Indirectly — same as sole proprietorship |
| C-Corporation | No — owner is already an employee | Directly — owner participates in plan |
| S-Corporation (2%+ owner) | N/A — spousal workaround does not apply | No — treated as self-employed |
Three Types of HRAs Under Section 105
Not all Section 105 plans are the same. The three most common HRA models each serve different business situations, and choosing the wrong one can disqualify your plan entirely.
One-Person 105 HRA
This plan is designed for businesses with exactly one employee — often the owner’s spouse. It allows unlimited reimbursement amounts (subject to reasonable compensation limits), and covers health insurance premiums, out-of-pocket costs, dental, vision, and all expenses listed under IRS §213(d). This plan cannot be used if you have other W-2 employees besides your spouse.
Qualified Small Employer HRA (QSEHRA)
A QSEHRA works for businesses with fewer than 50 full-time employees that do not offer a group health plan. It has fixed contribution limits — for 2026, those limits are $6,450 for self-only coverage and $13,100 for family coverage. Allowances must be reported on the W-2 in Box 12 using Code FF.
Individual Coverage HRA (ICHRA)
An ICHRA is available to businesses of any size and has no cap on reimbursement amounts. It requires employees to purchase their own individual health insurance policy. ICHRAs require Forms 1095-B and 1094-B instead of W-2 reporting.
| Feature | One-Person 105 HRA | QSEHRA | ICHRA |
|---|---|---|---|
| Reimbursement cap | No statutory cap (reasonable comp applies) | $6,450 / $13,100 (2026) | No cap |
| Employee count restriction | Exactly 1 employee | Fewer than 50 FTEs | None |
| Group health plan allowed? | No | No | Yes (but in separate class) |
What It Takes to Prove Your Spouse Is an Employee
The IRS has six key elements it evaluates when determining whether a spousal employment relationship is real. Failing even one of these can destroy your entire Section 105 deduction.
A written employment agreement must exist between you and your spouse. This agreement should describe the duties, hours, and compensation structure. The Tax Court in Speltz found that a proper employment contract was a key factor in ruling for the taxpayer.
Time records must document the hours your spouse works. A simple log showing dates, tasks, and hours is enough. The court in Speltz relied heavily on a log maintained by Mrs. Speltz to calculate whether compensation was reasonable.
A written Section 105 plan document must be signed by both spouses. The document should describe the reimbursement terms, eligible expenses, annual cap, and eligibility requirements. Without this document, the IRS can argue no valid plan exists.
Reasonable compensation is critical. Total compensation — wages plus reimbursements — must be reasonable for the work performed. If your spouse works 500 hours per year and receives $22,000 in reimbursements, that equals $44 per hour, which the Bradford Tax Institute notes would be the equivalent of roughly $91,520 for a full-time worker.
Receipts and documentation for every reimbursed expense must be retained. Your spouse must submit adequate evidence of medical expenses before receiving reimbursement. Keep copies of all bills, EOBs, and pharmacy receipts.
Separate payment channels should exist. Avoid reimbursing your spouse from a joint checking account for expenses paid from that same joint account. The IRS in the Shellito case focused heavily on the fact that medical expenses were paid from a joint account, making the reimbursements appear circular.
Court Cases That Define the Rules
Speltz v. Commissioner (T.C. Summary Opinion 2006-25)
Mrs. Speltz ran a daycare business and hired her husband to perform maintenance, cleaning, and administrative tasks. She set up a medical reimbursement plan with the help of a tax adviser. The plan provided up to $6,500 per year in reimbursements as his sole compensation — no cash wages were paid.
The IRS argued that Mr. Speltz was not a bona fide employee and that no proper plan existed. The Tax Court rejected every IRS argument. The court found Mrs. Speltz could control her husband’s work activities, which satisfied the common-law test for employment. The court also confirmed that medical reimbursements alone can serve as valid compensation.
The court used Mr. Speltz’s time log to divide total compensation by total hours worked and concluded the amount was reasonable. Speltz remains the strongest authority for the proposition that a Section 105 plan with no W-2 wages can survive IRS scrutiny.
| What the Speltz Family Did Right | Why It Mattered |
|---|---|
| Created a written Section 105 plan document | Proved a formal plan existed |
| Maintained detailed time logs of spouse’s hours | Allowed the court to calculate hourly rate |
| Set an annual reimbursement cap ($6,500) | Showed compensation was controlled and reasonable |
| Had employment contract signed by both spouses | Established the employer-employee relationship on paper |
| Submitted receipts for all reimbursed expenses | Met the substantiation requirement |
Shellito v. Commissioner (Tax Court 2010; Tenth Circuit 2011)
Milo Shellito was a Kansas farmer who hired his wife, Sharlyn, to perform farm work. He set up a Section 105 plan and reimbursed her for family medical expenses. He also paid her $100 per month in “wages” from their joint checking account.
The Tax Court denied the deduction. It found that Mrs. Shellito had performed the same farm work for 19 years without any compensation before the plan was established. The court also noted the $100 monthly “wage” appeared to be just another component of the medical reimbursement, not a separate wage. Medical expenses were paid from a joint account and “reimbursed” back into that same account — making the entire arrangement appear to be a paper shuffle with no economic substance.
The Shellitos appealed, and the Tenth Circuit vacated the decision. The appeals court held that the Tax Court used the wrong legal test — it should have applied the common-law agency doctrine. The Tenth Circuit also rejected the IRS’s argument that Kansas’s “doctrine of necessaries” eliminated any economic benefit to Mrs. Shellito.
| What the Shellito Family Did Wrong | The Consequence |
|---|---|
| Paid spouse from a joint checking account | IRS argued the reimbursement was circular — money never changed hands |
| Spouse worked 19 years without compensation before the plan | IRS argued the plan was a sham created only for tax benefits |
| $100 “wage” appeared to be part of medical reimbursements | Court found no separate, identifiable compensation for services |
| Failed to maintain strong documentation of work performed | Weakened their case before the Tax Court |
Three Real-World Scenarios
Scenario 1: The Solo Consultant With a Spouse Who Handles Admin
Marcus runs a consulting business as a sole proprietor. His wife, Dana, answers client emails, manages his calendar, and handles invoicing for about 15 hours per week. Marcus sets up a One-Person 105 HRA with an annual cap of $15,000. Dana’s only compensation is the HRA reimbursement — no cash wages.
| What Marcus Does | What Happens |
|---|---|
| Creates a written employment agreement with Dana | Establishes the employer-employee relationship |
| Dana logs 780 hours per year (15 hrs × 52 weeks) | $15,000 ÷ 780 = $19.23/hr — reasonable for admin work |
| Sets up a written Section 105 plan document | Plan is formally established and defensible |
| Dana submits receipts for all medical expenses | Substantiation requirement is met |
| Reports reimbursements as “employee benefits” on Schedule C | Deduction offsets income tax and self-employment tax |
Marcus does not file a W-2 for Dana because she receives no cash wages. The entire $15,000 is tax-free to Dana and fully deductible by Marcus.
Scenario 2: The Partnership Where One Spouse Is an Employee
Kevin and his business partner, Tom, run a landscaping partnership. Kevin’s wife, Sarah, works in the business as the office manager — answering phones, billing clients, and ordering supplies for 20 hours per week. Sarah is not a partner.
Kevin and Tom set up a Section 105 plan. Sarah is eligible as a bona fide employee of the partnership. The plan reimburses Sarah for her family’s medical expenses, which includes Kevin’s expenses because he is her spouse.
| What the Partnership Does | What Happens |
|---|---|
| Sarah receives $8,000/year in cash wages plus $12,000 in 105 reimbursements | Total comp of $20,000 for ~1,040 hours = $19.23/hr |
| Partnership files W-2 for Sarah (cash wage portion only) | Satisfies payroll reporting requirements |
| Partnership deducts wages and reimbursements as business expenses | Reduces taxable partnership income |
| Kevin’s medical expenses are covered through Sarah’s plan | Kevin gets indirect tax benefit as Sarah’s dependent |
This arrangement would not work if Sarah were a partner. A husband-wife partnership disqualifies both spouses from Section 105 benefits.
Scenario 3: The S-Corp Owner Who Tries (and Fails)
Jessica owns 60% of an S-corporation and hires her husband, Ryan, as a W-2 employee. She sets up a Section 105 HRA and tries to funnel family medical expenses through Ryan’s plan.
| What Jessica Tries | What Actually Happens |
|---|---|
| Hires Ryan as an employee of the S-corp | Ryan is treated as a 2%+ shareholder under IRC §1372 because he is a family member of a 2%+ owner |
| Sets up a Section 105 HRA for Ryan | Reimbursements are not tax-free — they must be included in Ryan’s W-2 income |
| Claims deduction on the corporate return | S-corp may deduct the reimbursements, but Ryan owes income tax on them |
| Expects the same result as a sole proprietorship | The entire tax benefit is negated because S-corp rules treat family members of 2%+ owners as self-employed |
Jessica’s best option is to report the health insurance premiums on her own W-2 and take the self-employed health insurance deduction on her personal return. The Section 105 spousal strategy does not save taxes in an S-corp.
Mistakes to Avoid
Calling your spouse an “employee” without real work. The IRS’s 1999 guidance explicitly states that nominal or insignificant services with no economic substance will be challenged. If your spouse does not perform meaningful work, the plan fails.
Paying from and reimbursing to the same joint account. This was the central problem in the Shellito case. The IRS views this as money going in a circle. Use separate bank accounts — your spouse should pay medical expenses from their account and receive reimbursement into that same account from the business account.
Failing to create a written plan document. Section 105 requires a formal written plan that describes eligible expenses, reimbursement procedures, the annual cap, and employee eligibility. Without this document, the IRS can deny every deduction.
Skipping time records. The Tax Court in both Speltz and Shellito examined whether the taxpayer kept records of hours worked. The Speltz family won in part because they had detailed logs. The Shellito family lost at the Tax Court level in part because their documentation was weaker.
Exceeding reasonable compensation. If your spouse works 200 hours per year and your plan reimburses $50,000, the IRS will flag this. The total compensation must be reasonable relative to hours worked and the type of work performed. Set an annual cap in the plan document that reflects a defensible hourly rate.
Using a Section 105 plan in an S-corp with a 2%+ owner-spouse. This is a common and costly error. Family members of 2%+ S-corp shareholders are treated as shareholders themselves, making them ineligible for tax-free Section 105 benefits.
Having other employees you don’t cover. If your business has employees besides your spouse, you may need to offer them comparable benefits. A One-Person 105 HRA requires that you have only one eligible employee. If you have more, you may need a QSEHRA or ICHRA to stay compliant with nondiscrimination rules.
Do’s and Don’ts for Section 105 Spousal Plans
| Do ✅ | Don’t ❌ |
|---|---|
| Do create a written employment agreement — this is your first line of defense in an audit | Don’t fabricate a job for your spouse that has no real business purpose |
| Do maintain a simple time log of your spouse’s hours and tasks each week | Don’t skip recordkeeping because you assume the IRS won’t audit a small business |
| Do establish a formal written Section 105 plan with a reimbursement cap | Don’t operate a Section 105 plan without a plan document — it’s legally required |
| Do keep all medical expense receipts and EOBs for a minimum of 7 years | Don’t reimburse expenses without requiring your spouse to submit proof first |
| Do use separate bank accounts for paying and reimbursing medical expenses | Don’t pay and reimburse medical expenses from the same joint checking account |
| Do consult a tax professional before establishing the plan | Don’t assume S-corp and sole proprietorship rules are the same — they are not |
| Do consider issuing a small W-2 wage ($1,000+) to strengthen proof of employment | Don’t assume that zero-wage arrangements are automatically suspicious — Speltz proved otherwise |
Pros and Cons of the Section 105 Spousal Strategy
| Pros ✅ | Cons ❌ |
|---|---|
| Converts personal medical expenses into tax-deductible business expenses — reduces income tax and self-employment tax | Requires your spouse to perform real work — you cannot use a passive or uninvolved spouse |
| Reimbursements cover the entire family — including the business owner and dependent children | IRS scrutiny on spousal employment is high — weak documentation invites audits |
| No dollar cap on a One-Person 105 HRA (unlike QSEHRA’s $13,100 family limit) | Does not work for S-corp owners with 2%+ ownership — the tax benefit is completely lost |
| Can serve as the spouse’s sole compensation — eliminating payroll taxes entirely | Requires ongoing compliance — written plan, receipts, time logs, and possibly W-2 filings |
| IRS and Tax Court have confirmed the strategy works (Rev. Rul. 71-588, Speltz) | If the plan is disqualified, all deductions are denied and you may owe penalties and back taxes |
| No FUTA tax owed on wages paid to a spouse under IRC §3306(c)(5) | Cannot be combined with a group health insurance plan offered by the same employer (for One-Person HRA) |
How to Set Up a Section 105 Plan Step by Step
Step 1: Confirm your business entity qualifies. Sole proprietorships and partnerships (where the spouse is not a partner) are the best candidates. C-corps can use Section 105 directly. S-corps with 2%+ owners should avoid this strategy.
Step 2: Establish a bona fide employment relationship. Draft a written employment agreement that describes your spouse’s job title, duties, hours, and compensation. Both spouses should sign and date the agreement.
Step 3: Create a written Section 105 plan document. This document must describe eligible expenses (typically all §213(d) medical expenses), the reimbursement process, the annual cap, and which employees are eligible. You can purchase pre-drafted plan documents from providers like Core Documents for as little as $199.
Step 4: Set a reasonable annual reimbursement cap. Calculate a defensible number by estimating your spouse’s annual hours and multiplying by a reasonable hourly rate for their type of work. The cap should be written into the plan document.
Step 5: Start documenting everything. Your spouse should begin logging hours worked, and all medical expenses should be paid from your spouse’s separate account. Reimbursements flow from the business account to your spouse’s account.
Step 6: Decide whether to issue a W-2. If your spouse receives only HRA reimbursements, a W-2 is not required. If your spouse receives any cash wages, you must file W-2, W-3, I-9, and 941/943 forms. Many tax pros recommend a small W-2 wage for audit protection.
Step 7: Report the deduction on your tax return. For sole proprietors, Section 105 reimbursements appear as employee benefit expenses on Schedule C. For partnerships, they appear on the partnership return. For C-corps, they appear as a corporate deduction.
IRS Rulings That Confirm the Strategy
Revenue Ruling 71-588 is the foundational ruling. It confirmed that a sole proprietor who employs his wife as a bona fide employee can exclude medical reimbursements from her income under Section 105(b), and the business can deduct the costs.
Technical Advice Memorandum 9409006 further supported the strategy. Combined with Rev. Rul. 71-588, the IRS has acknowledged the validity of using a spousal Section 105 plan when proper employment exists.
The IRS Industry Specialization Program Settlement Guideline (UIL No. 162.35-02, dated January 25, 2001) provided detailed guidance on evaluating spousal employment for Section 105 purposes. It emphasized that the IRS should apply the common-law test and that part-time employment is acceptable.
What Happens If You Have Other Employees
If your business has employees besides your spouse, the One-Person 105 HRA no longer works. The plan is designed for businesses with exactly one eligible employee. Adding a second employee means you need to either offer them comparable benefits or switch to a QSEHRA or ICHRA.
Common ownership rules also apply. If you own multiple businesses with employees, those employees may be counted under aggregation rules, disqualifying your One-Person HRA. A tax adviser should review your full ownership structure before you establish a plan.
Nondiscrimination rules under Section 105(h) require that self-insured medical reimbursement plans not favor highly compensated employees. If your plan covers only your spouse and excludes other eligible workers, the IRS can reclassify the reimbursements as taxable income.
FAQs
Can my spouse’s only pay be Section 105 reimbursements?
Yes. The IRS and Tax Court (Speltz) confirm that Section 105 reimbursements can be the sole form of compensation if the amount is reasonable for work performed.
Does my spouse need to work full time to qualify?
No. Part-time work counts as long as your spouse performs meaningful, non-trivial services for the business and you maintain time records.
Can I use Section 105 if I own an S-corp?
No. Owners with 2% or more of S-corp shares — and their family members — are treated as self-employed and cannot receive tax-free Section 105 benefits.
Do I owe payroll taxes on Section 105 reimbursements?
No. Amounts excluded under Section 105(b) are not subject to Social Security, Medicare, or federal unemployment taxes.
Is there a dollar limit on a One-Person 105 HRA?
No. There is no statutory cap, but total compensation must be reasonable for the work performed to avoid IRS challenge.
Can my spouse and I both be partners and use Section 105?
No. A husband-wife partnership disqualifies both spouses from Section 105 plan benefits.
Do I need a written plan document?
Yes. A written Section 105 plan is legally required and must describe eligible expenses, the annual cap, and reimbursement procedures.
What medical expenses can the plan reimburse?
Yes — all expenses qualifying under IRS §213(d), including premiums, copays, dental, vision, prescriptions, and long-term care.
Can the plan cover my children too?
Yes. Section 105 plans reimburse expenses for the employee-spouse, their spouse (the business owner), and all dependents including children.
Will this strategy survive an IRS audit?
Yes — if you maintain proper documentation. Written plan, employment agreement, time logs, and medical expense receipts are all essential to passing audit scrutiny.
Related reading
- How to Fill Out W-4: Married and Both Work + FAQs
- Which Parent Claims Dependents on W-4 When Married Filing Jointly? + FAQs
- Does My Spouse Need to Do Actual Work for Section 105? (w/Examples) + FAQs
- Do Contractors Fill Out a W-4? (w/Examples) + FAQs
- Can One Spouse Get REPS While the Other Works W-2? (w/Examples) + FAQs
- How Does the W-4 Multiple Jobs Worksheet Work? (w/Examples) + FAQs
- Is Section 105 Reimbursement Taxable Income? (w/Examples) + FAQs