A Section 105 plan is an employer-funded health benefit that lets businesses reimburse employees for qualified medical expenses and health insurance premiums completely tax-free. IRC Section 105 provides the legal basis: any reimbursement an employer makes for medical expenses defined under Section 213(d) of the Internal Revenue Code is excluded from the employee’s gross income. The employer deducts 100% of the reimbursement as a business expense.
Without a proper written plan document, the IRS treats these reimbursements as regular taxable wages. The consequence is immediate: both the employer and employee owe back taxes, payroll taxes, and potential penalties. Small business owners who set up a Section 105 plan correctly save an average of $5,000 per year in federal, state, and self-employment taxes.
What you’ll learn in this article:
- 💰 How Section 105 plans create triple tax savings for your business and employees
- 🏢 Which business structures (C-corp, S-corp, sole proprietor) get the biggest benefits — and which face restrictions
- 🔄 The spousal employment strategy that unlocks tax-free medical reimbursements for sole proprietors
- ⚖️ Nondiscrimination rules that can strip highly compensated employees of their tax-free status
- 🛡️ Step-by-step compliance requirements under the IRS, ERISA, HIPAA, and ACA to keep your plan penalty-free
What IRC Section 105 Actually Says
IRC Section 105 is the part of the federal tax code that covers “amounts received under accident and health plans.” It allows qualified distributions from employer-funded health plans to be excluded from an employee’s gross income. This tax-free treatment applies only when the expenses meet the definition of “medical care” under IRC Section 213(d).
Section 213(d) covers a broad range of medical costs. These include doctor visits, prescriptions, dental work, vision care, mental health services, and health insurance premiums. The full list of qualifying expenses appears in IRS Publication 502. An employer can choose to reimburse all of these expenses or limit the plan to specific categories.
The critical requirement is that the employer must fund the plan entirely. No portion of a Section 105 plan can come from employee salary deductions. If an employer routes the plan through payroll deductions, the arrangement falls under Section 125 (cafeteria plan) rules instead — with different tax consequences and compliance requirements.
How a Section 105 Plan Works Step by Step
The employer creates a formal written plan document. This document outlines which expenses are eligible, how much the employer will reimburse per employee, and the plan’s effective dates. The IRS mandates these written documents — without them, the plan does not exist in the eyes of the law.
The employer sets a monthly or annual allowance for each employee. This allowance can be the same for all employees, or it can vary by employee class (such as full-time vs. part-time), depending on the type of Section 105 plan chosen. The employer has complete control over how much to contribute.
Employees incur medical expenses and submit proof to the employer or a third-party administrator (TPA). This proof includes receipts, invoices, Explanation of Benefits (EOB) statements, or doctor’s notes. Many businesses use benefits administration software to streamline the review process.
The employer verifies the expense is eligible under the plan and reimburses the employee. These reimbursements are tax-free to the employee and fully deductible for the employer. Both parties must keep records of every reimbursement for ten years.
What a Section 105 Plan Can Reimburse
A Section 105 plan can reimburse health insurance premiums, dental insurance premiums, long-term care insurance premiums, Medicare Part A and B premiums, Medicare supplement insurance, and COBRA premiums. It also covers out-of-pocket medical, dental, and vision expenses. The employer can even reimburse life insurance, disability income insurance, and cancer insurance premiums for eligible employees and their families.
The plan covers the employee, the employee’s spouse, and the employee’s dependents (including children up to age 26 under ACA rules). This is what makes the Section 105 plan so powerful — it wraps an entire family’s medical costs into one tax-advantaged business deduction.
The Five Types of Section 105 Plans
Section 105 plans come in several forms. Each type has its own rules for employer size, contribution limits, and eligible expenses.
Qualified Small Employer HRA (QSEHRA)
The QSEHRA is designed for businesses with fewer than 50 full-time equivalent employees that do not offer a group health insurance plan. For 2026, the IRS caps contributions at $6,450 per year for self-only coverage and $13,100 per year for family coverage. Every eligible employee must receive the same allowance amount, with the only variation being self-only vs. family status.
Employees who receive QSEHRA benefits must reduce their premium tax credit by the amount of their QSEHRA allowance. Employees who buy insurance through the ACA Marketplace could see a lower subsidy. The 21st Century Cures Act created the QSEHRA in 2016, making it the first standalone HRA available to small employers.
Individual Coverage HRA (ICHRA)
The ICHRA has no employer size restriction and no annual contribution limit. Employers can offer different allowance amounts to different classes of employees, using up to 11 IRS-defined employee classes — full-time, part-time, seasonal, salaried, hourly, and more. Employees must have individual health insurance coverage to participate.
An employee cannot collect premium tax credits and participate in an ICHRA at the same time. If the employer’s ICHRA allowance is deemed “unaffordable” under ACA standards, the employee can waive the ICHRA and keep their marketplace subsidy instead.
Group Coverage HRA (GCHRA)
The GCHRA — also called an integrated HRA — works alongside a traditional group health insurance plan. It reimburses employees for out-of-pocket costs like copays, deductibles, and coinsurance that the group plan does not cover. Employees cannot use a GCHRA to pay for individual health insurance premiums.
There is no employer size restriction and no annual contribution limit for the GCHRA. The only requirement is that the employer must already offer a group health insurance plan.
Excepted Benefit HRA (EBHRA)
The EBHRA allows employers to reimburse employees for certain medical expenses not covered by the employer’s primary group health plan. The annual limit for an EBHRA is $2,200 in 2026. Employees do not need to have other health coverage to participate.
The EBHRA works well as a supplement for dental, vision, and short-term medical costs. It gives employers a low-cost way to offer additional health benefits without replacing their existing group plan.
One-Person Section 105 HRA
The one-person 105 HRA is popular among self-employed business owners who hire their spouse as a legitimate employee. This plan turns personal medical expenses into business deductions, reducing federal income tax, state income tax, and self-employment tax. There is no statutory limit on how much the business can reimburse through this arrangement.
The spousal employee receives the HRA benefit, which covers the employee, their spouse (the business owner), and dependents. If you need reimbursement amounts higher than the QSEHRA annual caps, the one-person 105 HRA route is the better choice because it has no dollar ceiling.
QSEHRA vs. ICHRA at a Glance
| Feature | Key Difference |
|---|---|
| Employer size | QSEHRA: under 50 FTEs only; ICHRA: any size |
| Contribution limits | QSEHRA: $6,450 self / $13,100 family (2026); ICHRA: no limit |
| Employee classes | QSEHRA: same amount for all; ICHRA: up to 11 different classes |
| Group health plan | QSEHRA: cannot offer alongside group plan; ICHRA: can offer to different classes |
| Individual insurance required | QSEHRA: no; ICHRA: yes |
| Premium tax credit | QSEHRA: reduced by allowance amount; ICHRA: employee must choose one or the other |
| Rollover | QSEHRA: yes, capped at annual max; ICHRA: yes, no cap |
Which Business Owners Can Participate — and Who Can’t
Your business structure determines whether you receive tax-free reimbursements from a Section 105 plan. C-corp owners get the most favorable treatment. Sole proprietors, S-corp owners with more than 2% ownership, and partners face restrictions that limit or eliminate the tax-free benefit.
C-Corporations: Full Tax-Free Access
C-corp owners who draw a regular W-2 salary are legally considered employees of the corporation. The corporation acts as the employer, and the owner is the employee. The owner can participate in the Section 105 plan and receive all reimbursements 100% tax-free, exactly like any non-owner employee.
Any qualified health expense incurred by the C-corp owner or their family members flows through the plan. The corporation deducts the full amount as a business expense. This is the most favorable tax treatment available under Section 105.
Sole Proprietors: The Spousal Employment Path
A sole proprietor cannot set up a Section 105 plan solely for themselves and receive tax-free reimbursements. The reimbursements are subject to federal and state income tax. The self-employed health insurance deduction (Form 1040, Schedule 1) allows premium deductions, but it does not cover out-of-pocket medical costs and does not reduce self-employment tax.
The proven workaround: hire your spouse as a bona fide W-2 employee. The plan goes in the spouse’s name, and the business owner is listed as a dependent. The business reimburses the spousal employee for the family’s health insurance premiums, copays, prescriptions, dental work, and vision care — all as tax-free fringe benefits.
S-Corporations: The 2% Ownership Trap
S-corp owners who hold more than 2% of the company’s shares face a unique restriction. They can participate in the plan, but the reimbursements are not tax-free. The reimbursed amounts are subject to federal and state income tax — though they are exempt from FICA taxes (Social Security and Medicare).
The spousal workaround does not work for S-corps. Family members who do not have ownership — including spouses and children — are treated as if they owned more than 2%. S-corp owners holding less than 2% and active in the business qualify for full tax-free reimbursements without needing the spousal strategy.
Partnerships: Spouse Cannot Be a Partner
Partners follow rules similar to sole proprietors. The spouse of a partner must be a bona fide employee of the partnership. A husband-and-wife partnership disqualifies both spouses — if both are partners, neither can participate in a Section 105 plan.
LLCs: Follow Your Tax Filing Status
LLC owners follow the rules that match their tax filing election. C-corp filing means C-corp rules. Sole proprietorship filing means sole proprietor rules. The same applies for partnership and S-corp filings.
| Business Structure | Tax-Free for Owner? |
|---|---|
| C-Corporation | Yes — owner is treated as W-2 employee |
| Sole Proprietorship | No — unless spouse is a bona fide employee |
| S-Corp (≤2% owner) | Yes — treated as regular employee |
| S-Corp (>2% owner) | No — taxable income, but exempt from FICA |
| Partnership | No — unless spouse is bona fide employee and not a partner |
| LLC | Depends on tax filing status |
The Triple Tax Advantage Explained
A properly structured Section 105 plan creates three layers of tax savings. The reimbursement is excluded from gross income, so the employee pays no federal income tax. The employer deducts the reimbursement as a business expense, lowering taxable income. The reimbursement is exempt from FICA and FUTA taxes for both the employer and employee.
For a sole proprietor using the spousal employment strategy, the savings go even further. The reimbursement shifts from a personal expense to a Schedule C business deduction. This reduces not just income tax, but also the 15.3% self-employment tax that sole proprietors pay on net business income.
| Tax Benefit | How Section 105 Helps |
|---|---|
| Federal Income Tax | Reimbursements are excluded from employee’s gross income — tax-free |
| FICA Taxes | Exempt from both employer (7.65%) and employee (7.65%) shares |
| FUTA | Employer excludes reimbursements from FUTA wages |
| Self-Employment Tax | Schedule C deduction reduces the 15.3% SE tax for sole proprietors |
| Business Deduction | 100% of reimbursements are deductible as a business expense |
The Spousal Employment Strategy That Unlocks Tax-Free Benefits
A self-employed business owner can employ their spouse and offer a medical benefits package through a Section 105 plan. The benefits cover the employee-spouse, the employee-spouse’s spouse (the business owner), and all dependents. This strategy is legal and IRS-approved — but it requires strict compliance.
The IRS requires the spouse to perform real, meaningful work for the business. Simply putting a spouse “on the books” is not enough. Part-time work counts, but it must be legitimate and non-trivial. You must document the spouse’s job duties, hours worked, and compensation.
Using a properly designed 105 HRA, a business owner can reimburse an employee-spouse for $22,000 or more in medical expenses — including health insurance, copays, and other qualified costs. The entire amount becomes a business deduction, and the employee-spouse receives it tax-free.
What Makes Spousal Employment “Bona Fide”
The IRS looks at several factors when determining whether spousal employment is legitimate. The spouse must have a written job description, regular work hours, and pay that is reasonable for the work performed. The spouse must also receive a W-2 at year-end.
Paying the spouse only through the Section 105 plan is risky. The IRS expects some form of cash wages in addition to the health benefit. A reasonable approach is to pay the spouse a modest salary plus the Section 105 reimbursement as a fringe benefit.
Three Real-World Scenarios
Scenario 1: C-Corp Owner Covers the Whole Family
Maria owns a C-corporation and pays herself a W-2 salary of $120,000. She sets up an ICHRA with a $15,000 annual allowance. Her family’s health insurance premiums cost $12,000 per year, and they have $3,000 in copays, prescriptions, and dental bills.
Maria submits all $15,000 in expenses. The corporation reimburses her tax-free and deducts the full $15,000 as a business expense. Maria pays zero income tax and zero FICA tax on the reimbursement.
| What Maria Does | Tax Result |
|---|---|
| Sets up ICHRA with $15,000 annual allowance | Corporation establishes formal plan document |
| Submits $12,000 for family health insurance premiums | Premiums reimbursed tax-free |
| Submits $3,000 in copays, dental, and prescriptions | Out-of-pocket costs reimbursed tax-free |
| Receives $15,000 in total reimbursements | Zero income tax, zero FICA on the full amount |
| Corporation claims business deduction | $15,000 deducted from corporate taxable income |
Scenario 2: Sole Proprietor Uses the Spousal Strategy
Jake runs a web design business as a sole proprietor. His wife, Lisa, handles bookkeeping, answers client emails, and manages invoicing 15 hours per week. Jake hires Lisa as a W-2 employee and sets up a one-person 105 HRA in her name.
The plan reimburses Lisa for the family’s health insurance premiums ($10,000), dental expenses ($2,000), and Jake’s knee surgery ($5,000). These $17,000 in reimbursements become Schedule C deductions for Jake’s business — reducing his federal income tax and his 15.3% self-employment tax.
| What Jake and Lisa Do | Tax Result |
|---|---|
| Lisa works 15 hrs/week doing real business tasks | Meets IRS bona fide employment requirement |
| Jake sets up one-person 105 HRA for Lisa | Plan covers Lisa, Jake (spouse), and dependents |
| Lisa submits $17,000 in family medical expenses | Insurance, dental, and surgery all qualify |
| Jake’s business reimburses Lisa tax-free | Lisa pays zero tax on the reimbursement |
| Jake deducts $17,000 on Schedule C | Lowers income tax and 15.3% self-employment tax |
Scenario 3: S-Corp Owner Hits the 2% Wall
David owns 80% of an S-corporation and employs five other workers. He sets up a Section 105 plan for all employees. David’s non-owner employees receive their reimbursements completely tax-free. David submits $8,000 in medical expenses to the plan.
Because David owns more than 2% of the S-corp, his $8,000 reimbursement is treated as taxable income. The S-corp includes this amount on David’s W-2. David owes federal and state income tax on the $8,000, but he does not owe FICA taxes. His wife is treated as a >2% owner too — the spousal workaround is unavailable.
| What David Does | Tax Result |
|---|---|
| Sets up Section 105 plan for all employees | Five non-owner employees get tax-free reimbursements |
| Submits $8,000 in personal medical expenses | Reimbursement is taxable income on David’s W-2 |
| Explores spousal employment workaround | IRS treats spouse as >2% owner — not available |
| Pays taxes on the $8,000 reimbursement | Owes income tax but no FICA taxes |
Section 105 vs. HSA vs. FSA vs. Section 125
Section 105 Plan vs. Health Savings Account (HSA)
The biggest difference: the employer owns the Section 105 plan funds, while the employee owns HSA funds. An HSA requires a high-deductible health plan (HDHP); a Section 105 plan does not. HSAs have strict annual contribution limits ($4,400 individual / $8,750 family in 2026), while ICHRAs have no limit at all.
| Feature | Key Difference |
|---|---|
| Fund ownership | Section 105: employer owns funds; HSA: employee owns funds |
| Portability | Section 105: funds stay with employer; HSA: fully portable |
| HDHP required | Section 105: no; HSA: yes |
| Contribution limits | Section 105 (ICHRA): none; HSA: $4,400 / $8,750 (2026) |
| Who contributes | Section 105: employer only; HSA: employer, employee, or both |
| Unused funds | Section 105: stay with employer (or roll over per plan); HSA: roll over indefinitely |
Section 105 Plan vs. Flexible Spending Account (FSA)
FSAs are funded through employee pre-tax salary deductions under Section 125, while Section 105 plans are funded solely by the employer. FSA funds follow a “use it or lose it” rule — employees forfeit unspent money at year-end (with limited carryover or grace period options). Section 105 plans can allow rollovers per Revenue Ruling 2002-41.
| Feature | Key Difference |
|---|---|
| Who funds it | Section 105: employer only; FSA: employee salary deductions |
| IRS Code section | Section 105 vs. Section 125 |
| Use-it-or-lose-it | Section 105: rollover possible; FSA: funds forfeited at year-end |
| Nondiscrimination testing | Section 105: yes — Section 105(h); FSA: yes — Section 125 |
| Employer control | Section 105: employer sets allowance and eligible expenses; FSA: employee chooses contribution amount |
Section 105 Plan vs. Section 125 Cafeteria Plan
A Section 125 cafeteria plan allows employees to pay for benefits with pre-tax salary deductions. Section 105 plans allow a much broader range of reimbursable medical expenses compared to Section 125 cafeteria plans. Both plans give employers a tax deduction, and both reduce the employee’s taxable income — but the funding source and eligible expenses differ.
| Feature | Key Difference |
|---|---|
| Funding method | Section 105: employer-funded; Section 125: employee pre-tax salary deductions |
| Eligible expenses | Section 105: all IRS Pub 502 expenses (employer choice); Section 125: limited to plan options |
| Employer payroll savings | Both save employers ~7.65% in FICA taxes on contributions |
| Can be combined | Yes — many employers use Section 105 and Section 125 plans together |
2026 Contribution Limits You Need to Know
The IRS adjusts QSEHRA limits annually using the chained Consumer Price Index (CPI). ICHRA and GCHRA plans have no statutory contribution limit — the employer decides how much to offer. The EBHRA has a modest cap.
| Plan Type | 2026 Annual Limit |
|---|---|
| QSEHRA (self-only) | $6,450 ($537.50/month) |
| QSEHRA (family) | $13,100 ($1,091.66/month) |
| ICHRA | No limit — employer decides |
| GCHRA | No limit — employer decides |
| EBHRA | $2,200 |
| One-Person 105 HRA | No statutory limit |
QSEHRA limits increased $100 for self-only and $300 for family coverage from 2025 to 2026. For employees who become eligible midyear, the employer must prorate the limits based on months of eligibility. A self-only employee eligible for eight months in 2026 can receive up to $4,300.
Nondiscrimination Rules Under Section 105(h)
Self-insured Section 105 plans must pass nondiscrimination testing under IRC Section 105(h). These rules prohibit plan designs that favor highly compensated employees (HCEs) over rank-and-file workers. An HCE is generally one of the five highest-paid officers, a shareholder owning more than 10% of the company, or an employee among the highest-paid 25%.
The Two Tests Your Plan Must Pass
The Eligibility Test asks whether the plan discriminates in favor of HCEs when it comes to who can participate. A plan that covers only management and not enough non-highly compensated employees will likely fail this test. The plan must benefit at least 70% of all employees, or at least 80% of eligible employees if 70% or more of all employees are eligible.
The Benefits Test asks whether the benefits available to HCEs are also available to all other participants on the same terms. If highly compensated employees receive larger allowances or access to more expense categories, the plan fails the benefits test. The consequence: HCEs lose their tax-free treatment on “excess reimbursements,” while rank-and-file employees keep their tax-free benefits.
There are no monetary penalties for the employer for offering a discriminatory plan design. The consequence falls solely on the affected HCEs, whose reimbursements become taxable income. QSEHRAs and ICHRAs have their own nondiscrimination frameworks built into their design rules, which is one reason they are popular with small employers.
Compliance Requirements That Protect Your Plan
Section 105 plans are classified as group health plans under federal law. They must comply with the IRS, ERISA, HIPAA, COBRA, and the ACA. Failing to meet these requirements can trigger penalties, back taxes, or plan disqualification.
IRS Requirements
The IRS requires a written plan document that defines eligible expenses, employer contributions, and plan terms. Employees must submit proper documentation — such as receipts and doctor’s notes — to substantiate every reimbursement claim. Records must be kept on file for ten years.
ERISA Requirements
Section 105 plans are employee welfare plans under the Employee Retirement Income Security Act (ERISA). ERISA requires a summary plan description (SPD) that must be given to each participant. The employer also cannot endorse specific individual health insurance policies or pay insurers directly for employees’ individual plans — doing so triggers ERISA plan status for those individual policies.
HIPAA Privacy Rules
The entity processing employee reimbursement claims receives protected health information (PHI). This information must be held confidentially under HIPAA privacy rules. Employers must have safeguards to prevent unauthorized disclosure of employees’ medical information.
COBRA Rules
COBRA applies only to employers with 20 or more employees. Employers must offer terminated employees the option to continue their Section 105 plan participation for a period after termination. The employer may charge up to 102% of the allowance value if the former employee elects COBRA continuation.
ACA Requirements
The ACA adds several requirements for Section 105 plans. The plan must cover basic preventive health services without cost-sharing under Section 2713 of the PHS Act. Dependent coverage must extend to children up to age 26 under Section 2714.
Employers must pay an annual PCORI fee (Patient-Centered Outcomes Research Institute fee) via IRS Form 720. This applies to 105-HRAs, QSEHRAs, and ICHRAs. Employers must also provide 60 days’ advance notice to participants before making material changes to the plan.
The Carry-Over Rule
Revenue Ruling 2002-41 allows a Section 105 plan to carry over unused portions of an employee’s allowance to future years. If an employee does not use their full allowance, the unused amount can roll forward. This protects employees in low-expense years and gives them a cushion for high-expense “shock” years down the road.
Mistakes to Avoid With a Section 105 Plan
Failing to Create a Written Plan Document
The IRS requires formal written documents before the plan takes effect. Without a plan document, every reimbursement is treated as taxable wages. The employer loses the business deduction, and the employee owes income tax plus payroll taxes on every dollar received.
Funding the Plan Through Employee Salary Deductions
Section 105 plans must be 100% employer-funded. If any portion comes from employee payroll deductions, the arrangement becomes a Section 125 cafeteria plan. This changes the tax treatment, compliance rules, and reporting requirements entirely.
Claiming Spousal Employment Without Proof
The IRS actively scrutinizes spousal employment arrangements. A spouse must perform legitimate, meaningful work for the business. If the IRS determines the spouse is not a bona fide employee, it reclassifies all Section 105 reimbursements as taxable income — plus penalties and interest.
Related reading
- Should I Use a Section 105 or HSA? (w/Examples) + FAQs
- Can an S Corporation Owner Use a Section 105 Plan? (w/Examples) + FAQs
- Can an LLC Have a Section 105 Plan? (w/Examples) + FAQs
- Is Section 105 Reimbursement Taxable Income? (w/Examples) + FAQs
- Can I Deduct Section 105 Reimbursements? (w/Examples) + FAQs
- Is Section 105 Considered Tax Avoidance? (w/Examples) + FAQs