Yes, your spouse must perform real, legitimate work for your business to qualify under a Section 105 medical reimbursement plan. The IRS requires your spouse to be a bona fide employee, and fabricated or token employment will not survive an audit. Under IRC Section 105, a business can reimburse employees for medical expenses tax-free — but only if the person receiving the benefit is a genuine employee performing actual services.
The IRS scrutinizes spouse-employee arrangements more than almost any other small business deduction. In Shellito v. Commissioner, the Tenth Circuit Court of Appeals vacated a Tax Court decision that denied a farmer’s medical reimbursement deductions because the lower court applied the wrong legal test. The appeals court held that the common-law agency doctrine — not some stricter standard — determines whether a spouse is a bona fide employee.
According to a Bradford Tax Institute analysis, a properly designed 105-HRA can save a sole proprietor in the 25% federal bracket, 15.3% self-employment tax bracket, and 8% state bracket over $10,000 per year. That figure turns personal medical costs into fully deductible business expenses — but only when the spouse-employee relationship is real.
Here’s what you’ll learn in this article:
- 🔍 What “actual work” means under IRS rules and how courts define a bona fide employee
- 💰 How the Section 105 plan turns personal medical bills into business deductions worth thousands
- ⚖️ Real Tax Court cases where spouse employment was challenged — and what decided the outcome
- 🚫 The specific mistakes that guarantee you’ll lose your deductions in an audit
- 📋 Step-by-step documentation requirements that make your plan audit-proof
What Section 105 Actually Does for Your Family’s Medical Bills
Section 105 of the Internal Revenue Code allows a business to reimburse an employee for medical expenses, health insurance premiums, and out-of-pocket costs through a Health Reimbursement Arrangement (HRA). These reimbursements are tax-free to the employee and tax-deductible for the business. The plan covers the employee, the employee’s spouse, and the employee’s dependents.
For sole proprietors, this creates a powerful loophole. Tax law does not consider a sole proprietor to be an employee for purposes of medical plans. This means a sole proprietor cannot directly deduct family medical expenses as business expenses on Schedule C. The workaround is hiring your spouse as your one and only employee, then offering a Section 105 plan with family coverage.
The family coverage is the key. Because the plan covers the employee and the employee’s spouse, the business owner (who is the employee’s spouse) gets covered too. Revenue Ruling 71-588 and IRS Letter Ruling 9409006 confirm that this arrangement is legal when done correctly.
How the Math Works: Henry’s $10,626 Tax Savings
Consider Henry, a sole proprietor in the 25% federal tax bracket. He hires his spouse as his only employee and reimburses her $22,000 for family medical expenses through a 105-HRA.
| Without Section 105 | With Section 105 |
|---|---|
| $22,000 in medical expenses goes on Schedule A as itemized deductions | $22,000 is a business deduction on Schedule C |
| Subject to 7.5% AGI floor — Henry can only deduct $10,000 | Full $22,000 is deductible with no AGI floor |
| No self-employment tax savings | Saves on federal income tax, self-employment tax, and state tax |
| Net cash benefit: $3,300 | Net cash benefit: $10,626 |
The difference is $7,326 per year — money that stays in Henry’s pocket because the 105-HRA converts personal expenses into business expenses.
Which Business Types Qualify (and Which Don’t)
Not every business entity can use the Section 105 spouse strategy. The rules change depending on how your business is structured.
| Business Type | Section 105 Spouse Strategy? |
|---|---|
| Sole proprietorship (Schedule C) | Yes — hire spouse as only employee |
| Single-member LLC taxed as sole proprietorship | Yes — same rules as sole proprietorship |
| Partnership with non-spouse partners | Yes — partner’s spouse must be bona fide employee |
| Husband-and-wife partnership | No — both spouses are partners, neither qualifies as employee |
| S corporation | No — spouse’s ownership is attributed to the owner, creating a more-than-2% shareholder problem |
| C corporation (solo owner, no spouse) | Yes — owner is the sole employee and can receive benefits directly |
A husband-and-wife LLC taxed as a partnership is one of the biggest traps in Section 105 planning. Both spouses are treated as partners, meaning neither qualifies as an employee eligible for the plan. The fix is restructuring so only one spouse is the business owner, while the other becomes a W-2 employee.
For S corporation owners, the problem is attribution. The IRS attributes the owner-spouse’s stock to the employee-spouse, making the employee-spouse a more-than-2% shareholder. Shareholders at that level cannot receive tax-free health benefits through a Section 105 plan.
The Bona Fide Employee Test: What Courts Actually Look For
The IRS uses the common-law agency doctrine to determine whether your spouse is a real employee. This is the same test used for all employer-employee relationships. The Tenth Circuit confirmed this standard in Shellito v. Commissioner, rejecting the Tax Court’s earlier, stricter approach.
Under the common-law test, the key question is: Does the business owner have the right to direct and control the means and manner of the spouse’s work? The IRS does not require that you stand over your spouse’s shoulder. It requires that you could direct how, when, and where the work gets done.
The Six Factors the IRS Examines
The IRS and courts look at these factors when auditing a spouse-employee arrangement:
- Work performed — The spouse must do identifiable tasks that serve a real business purpose
- Hours documented — A weekly time sheet showing dates, descriptions, and hours is critical
- Compensation — The total pay (including 105-HRA reimbursements) must be reasonable for the work performed
- Control — The business owner must have the right to direct and control the work
- Tools and workspace — The spouse should use business equipment and workspace to perform duties
- Consistency — The work pattern must look like real employment, not a one-time favor
Real Tax Court Cases: When the IRS Challenged Spouse Employment
Shellito v. Commissioner — The Landmark Reversal
Kenneth Shellito, a Kansas farmer, hired his wife Sharlyn to do farm work and established a Section 105 medical reimbursement plan. He paid her $100 per month in wages plus medical reimbursements. The Tax Court originally denied the deductions, ruling that Sharlyn received no economic benefit from the arrangement because payments came from a joint checking account.
The Tenth Circuit disagreed and vacated the Tax Court’s decision. The appeals court held that the Tax Court made two errors. First, it should have applied the common-law agency doctrine to determine employment status. Second, the Kansas “doctrine of necessaries” — which the Tax Court used to say Sharlyn got no benefit — only applies when one spouse cannot provide for themselves.
The appeals court also cited Revenue Ruling 73-393, which holds that a legal obligation to support a family member does not prevent wages paid to that person from being deductible. On remand, the Tax Court reversed its decision and granted the Shellitos their full deductions.
| What the Tax Court Said | What the Appeals Court Said |
|---|---|
| Sharlyn got no economic benefit from the reimbursements | The doctrine of necessaries doesn’t apply when both spouses can provide for themselves |
| The $100 monthly wage was just part of the medical reimbursement | The common-law agency test should determine employee status |
| Joint checking account means no real payment occurred | Revenue Ruling 73-393 says family support obligations don’t block deductibility |
Speltz v. Commissioner — When Medical Benefits Are the Only Pay
In the Speltz case, the taxpayers paid their spouse no cash wages at all. The only compensation was the Section 105 medical reimbursement benefit. The court ruled in the taxpayer’s favor, finding that medical reimbursement alone constitutes compensation and can be a reasonable amount. The court emphasized that the taxpayers had documented the hours worked and the services performed.
This case is significant because it answers a common question: No, you do not have to pay a W-2 wage. The 105-HRA reimbursement itself can serve as your spouse’s entire compensation package. This eliminates the need for payroll, payroll tax payments, and payroll filings in a spouse-only operation.
Albers v. Commissioner — How $8,216 Disappeared
Darwin Albers employed his wife and claimed an $8,216 Section 105 deduction. He lost every penny because of easily avoidable documentation errors. The IRS successfully argued that his wife was not a bona fide employee because there was insufficient proof of actual work performed, no time records, and no formal plan document.
What Counts as “Actual Work” — Three Real-World Scenarios
Your spouse does not need to work full-time. Part-time work is perfectly acceptable, as long as the work is real, documented, and serves a legitimate business purpose. Here are three common scenarios.
Scenario 1: The Freelance Graphic Designer
Maria runs a freelance graphic design business as a sole proprietor. She hires her husband Carlos to handle client invoicing, manage her business email, and organize receipts for tax purposes. Carlos works 10 hours per week.
| Task Carlos Performs | Business Purpose Served |
|---|---|
| Sends and tracks invoices | Ensures timely payment from clients |
| Responds to scheduling emails | Frees Maria to focus on design work |
| Organizes financial records | Maintains audit-ready documentation |
| Updates client contact database | Supports business development |
Maria reimburses Carlos $18,000 annually through a 105-HRA for the family’s health insurance and medical expenses. At 520 hours per year, that equals about $34.60 per hour — a reasonable rate for administrative work.
Scenario 2: The E-Commerce Seller
Jake sells products online through his Schedule C business. He hires his wife Priya to manage inventory, package orders, and handle customer service returns. Priya works roughly 15 hours per week during the busy season and 5 hours per week during slower months.
| Task Priya Performs | Business Purpose Served |
|---|---|
| Counts and logs incoming inventory | Maintains accurate stock records |
| Packages and labels shipments | Fulfills customer orders |
| Processes return requests | Maintains customer satisfaction ratings |
| Photographs new products | Creates listings for online store |
Priya submits a weekly time sheet to Jake. The 105-HRA reimburses her $24,000 per year for the family’s premiums and out-of-pocket medical costs. Her average hourly rate works out to about $46 — reasonable for the tasks she performs.
Scenario 3: The Real Estate Investor
Tom owns rental properties reported on Schedule E through a single-member LLC. He hires his wife Sarah to coordinate with tenants, schedule maintenance, and keep the property records. Sarah works 8 hours per week.
| Task Sarah Performs | Business Purpose Served |
|---|---|
| Answers tenant calls and emails | Handles day-to-day property management |
| Schedules and oversees repairs | Maintains property condition |
| Collects and records rent payments | Tracks rental income |
| Manages lease agreements | Ensures legal compliance |
The 105-HRA reimburses Sarah $15,000 per year. At approximately 416 hours per year, her effective rate is about $36 per hour — well within the range for property management assistants.
The Reasonable Compensation Trap
The 105-HRA reimbursement is treated as compensation to your spouse. The total amount must be reasonable for the work performed. If your spouse works 200 hours per year and the 105-HRA reimburses $30,000, that works out to $150 per hour. Unless your spouse is performing highly skilled work, the IRS will argue that compensation is unreasonable.
Here is how to check your numbers. Divide the total annual reimbursement by the total hours worked. Compare that hourly figure to market rates for similar work found in job postings, salary guides, and Bureau of Labor Statistics data. Print the proof and keep it in your tax file.
If the hourly rate looks too high, you have two options. You can either increase your spouse’s documented work hours or decrease the reimbursement amount. Do not inflate hours that were not actually worked — that creates fraud risk far worse than losing the deduction.
Documentation That Makes Your Plan Audit-Proof
The IRS has a well-known playbook for attacking Section 105 plans. Every attack focuses on one of three weak points: the spouse is not a real employee, the expenses are not properly substantiated, or the reimbursement process is not businesslike. Strong documentation defeats all three.
The Weekly Time Sheet
This is your single most important document. The Gold Standard Tax guide recommends that every part-time spousal employee submit a weekly time sheet showing the date, a description of work performed, and the time spent on each task. In Speltz, the court specifically noted that the taxpayers had substantiated the services provided and kept records of hours — and that was a winning factor.
The Formal Plan Document
You and your spouse must sign and maintain a written Section 105 plan document. This document spells out what expenses the plan covers, who is eligible, and how reimbursements work. Without a formal plan document, the IRS will argue that no plan existed — and you lose everything.
The Reimbursement Paper Trail
Your spouse should pay all family medical expenses from a separate personal checking account. Then, the spouse submits those expenses to the business for reimbursement no less than monthly. The business reimburses the spouse from the business checking account. This creates a clean paper trail that proves the reimbursement process is real.
If the proprietorship pays a medical expense directly, have the spouse reimburse the business first. Then the business reimburses the spouse under the 105-HRA. This seems circular, but it maintains the proper flow of funds that the IRS expects.
Employment Agreement: Skip It
This may surprise you. The Gold Standard Tax guide advises against using an employment contract for your spouse. The reason: after a month or two, the tasks your spouse actually performs will no longer match what the contract says. That mismatch gives the IRS ammunition. A weekly time sheet showing actual work performed is far better proof of employment than a contract that describes planned work.
Do’s and Don’ts for Your Section 105 Spouse Arrangement
Do’s
- Do have your spouse submit a weekly time sheet with dates, task descriptions, and hours
- Do maintain a signed, formal 105-HRA plan document
- Do reimburse medical expenses from the business checking account
- Do have your spouse pay all medical bills from a separate personal account
- Do keep proof that compensation is reasonable (job postings, salary data)
- Do put the family health insurance in your spouse’s name, not yours
- Do require monthly expense substantiation before reimbursing
Don’ts
- Don’t fabricate or exaggerate hours worked — this is fraud
- Don’t use a joint checking account for both medical payments and reimbursements
- Don’t skip the formal plan document
- Don’t reimburse expenses incurred before the plan was established
- Don’t use an employment contract instead of a time sheet
- Don’t set your spouse’s effective hourly rate far above market rates for the work performed
Mistakes That Guarantee You’ll Lose Your Deductions
Mistake 1: No Time Records at All
The article titled “Lack of a Time Sheet Kills the Section 105 Plan” on the Bradford Tax Institute says it plainly. If you cannot prove your spouse worked, the IRS will deny every dollar of your deductions. Time sheets are cheap and easy. Skipping them is the most common — and most preventable — reason people lose their 105-HRA benefits.
Mistake 2: Paying Medical Bills from the Wrong Account
In another case documented as “Who-Paid-the-Bills Mystery Sinks Section 105 Plan”, the taxpayer lost deductions because it was impossible to tell who paid the medical expenses. The IRS demands a clear trail: spouse pays from personal account, then the business reimburses the spouse.
Mistake 3: No Formal Plan Document
Darwin Albers lost $8,216 in deductions partly because there was no written plan in place. The IRS position is simple: if there is no written plan, there is no plan. You can download sample plan documents from several tax resources and customize them for your business.
Mistake 4: Husband-and-Wife Partnership Filing
If you and your spouse file your LLC as a partnership, neither spouse qualifies as an employee. Both are treated as partners, and partners cannot receive Section 105 benefits. The fix is to file as a single-member LLC with one spouse as sole owner and the other as a W-2 employee.
Mistake 5: Insurance in the Wrong Name
The family health insurance should be in the employee-spouse’s name. If it is in the business owner’s name, the owner may qualify for the self-employed health insurance deduction on Form 1040 — but you lose the more valuable 105-HRA deduction that also saves self-employment tax.
Pros and Cons of a Section 105 Spouse Plan
| Pros | Cons |
|---|---|
| Converts personal medical expenses into full business deductions | Requires ongoing documentation (time sheets, receipts, reimbursement records) |
| Saves federal income tax, self-employment tax, and state income tax | IRS scrutinizes spouse-employee arrangements more than other deductions |
| No AGI floor — every dollar is deductible, unlike itemized medical deductions | Does not work for S corporations or husband-and-wife partnerships |
| 105-HRA reimbursement can be the only compensation — no payroll needed | Total compensation must be reasonable for the hours and work performed |
| Covers health insurance, dental, vision, co-pays, prescriptions, and other 213(d) expenses | Cannot reimburse expenses incurred before the plan was established |
| Plan can continue into retirement with proper planning | The PCORI fee applies annually to 105-HRA plans |
The W-2 Question: Do You Need One?
You do not need to pay a W-2 wage to make the 105-HRA work. The Speltz court held that medical reimbursement benefits alone constitute adequate compensation. Many tax professionals recommend paying a small W-2 salary (even $1,000 per year) to help establish the employment relationship, but this is a preference, not a legal requirement.
If you choose to go the no-W-2 route, your documentation of actual work becomes even more important. The 105-HRA reimbursement is the only evidence of compensation, so the time sheets, plan document, and reimbursement records must be flawless.
When you do pay a W-2 wage, you must file the standard employment forms: W-2 and W-3 annually, I-9 at hire, and 941 or 943 quarterly. Form 940 (federal unemployment tax) is not required for a spouse-employee.
The PCORI Fee Most Owners Forget
If you establish a 105-HRA, you must pay an annual fee to the Patient-Centered Outcomes Research Institute (PCORI). This applies to all HRA plans, including the 105-HRA, QSEHRA, and ICHRA. The fee is small — a few dollars per covered life per year — but failing to pay it is a compliance issue that can draw IRS attention to your plan.
The PCORI fee is reported and paid using IRS Form 720. The deadline is July 31 of each year for plan years ending in the prior calendar year. Missing this filing does not destroy your plan, but it signals to the IRS that your plan may not be properly administered.
State-Level Considerations That Change the Picture
Federal law governs Section 105 plans, but your state tax treatment may differ. Most states conform to the federal treatment of 105-HRA reimbursements as deductible business expenses. A few states have quirks worth knowing.
Community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) raise a special issue. In these states, income earned during marriage is generally owned equally by both spouses. This can complicate the argument that one spouse is an employee and the other is the sole business owner. Proper business formation documents and clear employment records become even more critical in community property states.
States with no income tax (Texas, Florida, Nevada, Wyoming, Washington, South Dakota, Alaska) provide no state tax savings from the 105-HRA — the federal and self-employment tax savings still apply. States with high income taxes (California, New York, New Jersey) provide the largest total tax savings because the 105-HRA deduction reduces both federal and state taxable income.
FAQs
Can the 105-HRA be my spouse’s only compensation?
Yes. The Speltz court confirmed that medical reimbursement alone qualifies as compensation. No W-2 wage is required if the reimbursement is reasonable for the work performed.
Does my spouse need to work full-time?
No. Part-time work is acceptable. The total reimbursement must be reasonable relative to the hours worked and the type of tasks performed.
Can I use a Section 105 plan in my S corporation?
No. The IRS attributes ownership to your spouse, making them a more-than-2% shareholder ineligible for tax-free Section 105 benefits.
Do I need an employment contract for my spouse?
No. Tax experts recommend weekly time sheets instead. Employment contracts become outdated quickly and can create mismatches the IRS exploits.
Can I reimburse medical expenses from before the plan started?
No. The 105-HRA cannot reimburse expenses incurred before the plan’s effective date or before the employee enrolled.
Does the health insurance need to be in my spouse’s name?
Yes. Putting insurance in the employee-spouse’s name prevents the owner from claiming the self-employed health insurance deduction, preserving the more valuable 105-HRA deduction.
Can a husband-and-wife LLC use Section 105?
No — not if taxed as a partnership. Both spouses are treated as partners, and partners cannot be employees eligible for the plan.
What happens if the IRS says my spouse isn’t a real employee?
You lose everything. The IRS will deny all 105-HRA deductions, reclassify reimbursements as nondeductible personal expenses, and assess back taxes plus penalties.
Can my spouse work from home for the Section 105 plan?
Yes. The location of work does not matter. What matters is that the work is real, documented, and serves a legitimate business purpose.
Do I need to file Form 940 for my spouse-employee?
No. Spouse-employees are exempt from federal unemployment tax (FUTA). You do not file Form 940 for a spouse.
Related reading
- Can a Sole Proprietor Have a Section 105 Plan? (w/Examples) + FAQs
- Can I Set Up a Section 105 Plan for Myself? (w/Examples) + FAQs
- Does My Spouse Need to Be a W-2 Employee for Section 105? (w/Examples) + FAQs
- Is Section 105 Considered Tax Avoidance? (w/Examples) + FAQs
- Which Professions Can Claim the QBI Deduction? (w/Examples) + FAQs
- Who Qualifies for the QBI Deduction? (w/Examples) + FAQs
- Is Section 105 Reimbursement Taxable Income? (w/Examples) + FAQs