Is a Section 105 Plan Worth It for Employers? (w/Examples) + FAQs

Yes, a Section 105 plan is worth it for most employers. It allows businesses to reimburse employees for medical expenses on a tax-free basis while taking a full business deduction — a combination that saves thousands in taxes each year. The IRS created this benefit under Section 105 of the Internal Revenue Code, and it applies to health insurance premiums, dental costs, vision expenses, and out-of-pocket medical bills.

A 2023 KFF Employer Health Benefits Survey found that family health insurance premiums reached an average of $23,968 per year, with employers paying roughly 73% of that cost. Section 105 plans give employers a way to control those rising costs while still offering meaningful health benefits.

Here’s what you’ll learn:

💰 How a Section 105 plan creates tax savings for both you and your employees
⚖️ Which business structures benefit most — and which ones face restrictions under federal law
📋 The exact IRS requirements you need to meet so your plan survives an audit
🚫 The costly mistakes employers make that trigger IRS penalties and lost deductions
🔍 Real-world examples showing how employers use Section 105 plans to cut healthcare spending

What a Section 105 Plan Does (And Why the IRS Allows It)

A Section 105 plan is not health insurance. It is an employer-funded reimbursement arrangement that pays employees back for qualifying medical costs. The employer sets the reimbursement amount, defines which expenses qualify, and funds the plan — all on a pre-tax basis.

The IRS allows this because Section 105(b) of the Internal Revenue Code excludes employer-provided health reimbursements from an employee’s gross income. The employer gets a full tax deduction for every dollar reimbursed. The employee pays zero federal income tax on the money received.

This creates a dual tax advantage that regular salary or bonuses cannot match. When an employer hands an employee a $5,000 bonus, both sides pay payroll taxes on it, and the employee pays income tax. When an employer reimburses $5,000 through a Section 105 plan, neither side pays payroll or income tax on that amount.

The Four Types of Section 105 Plans Employers Can Offer

Not all Section 105 plans work the same way. The IRS recognizes several plan variations, and each one serves a different purpose depending on business size, structure, and goals.

Qualified Small Employer HRA (QSEHRA)

The QSEHRA exists for businesses with fewer than 50 employees that do not offer a group health insurance plan. Employers reimburse workers for individual health insurance premiums and out-of-pocket medical expenses. The IRS caps contributions each year. For 2026, the limits are $6,450 per year for self-only coverage and $13,100 for family coverage, according to IRS guidance released through Revenue Procedure 2025-32.

QSEHRA Detail	2026 Limit
Self-only coverage	$6,450/year ($537.50/month)
Family coverage	$13,100/year ($1,091.67/month)

Individual Coverage HRA (ICHRA)

The ICHRA is available to employers of any size, including those with 1,000+ employees. Unlike the QSEHRA, the ICHRA has no cap on employer contributions. Employers can offer as much or as little as they choose, as long as the reimbursement amount is offered fairly within each employee class. The employer cannot offer both a traditional group plan and an ICHRA to the same class of employees.

Employers using an ICHRA can create up to 11 different employee classes (full-time, part-time, salaried, hourly, seasonal, etc.) and set different allowance amounts for each class. This gives large and mid-size employers a level of flexibility that group plans cannot match.

Integrated HRA (Group Coverage HRA)

An Integrated HRA works alongside a traditional group health insurance plan. The employer uses the HRA to reimburse employees for costs that the group plan does not cover — like deductibles, copays, and coinsurance. Employers use this approach to reduce the amount they pay in insurance premiums by choosing higher-deductible group plans while still protecting employees from large out-of-pocket costs.

Excepted Benefit HRA (EBHRA)

An EBHRA lets employers who already offer a group health plan provide additional tax-free funds for specific benefits like dental, vision, and short-term medical expenses. This plan type has a modest annual limit and works as a supplement — not a replacement — for core health coverage.

How Business Structure Changes Everything

The tax benefits of a Section 105 plan depend heavily on how your business is organized. The IRS treats each entity type differently, and getting this wrong can wipe out every dollar of expected savings.

C-Corporations Get the Cleanest Tax Break

C-corporation owners who are also employees of the business get the most straightforward benefit. The corporation deducts all Section 105 reimbursement costs as a business expense. Owner-employees are eligible to participate in the plan just like any other employee. Reimbursements are tax-free to the employee, and the corporation pays no FICA taxes on the amounts.

S-Corporation Owners Face a 2% Shareholder Problem

S-corporations can set up Section 105 plans, but any shareholder who owns more than 2% of the company hits a wall. The IRS does not allow these shareholders to receive tax-free reimbursements. Instead, their reimbursements are subject to federal and state income tax (though they are exempt from FICA taxes). Family members of 2%-or-more shareholders — including spouses and children — face the same restriction, even if they own zero shares.

Business Type	Owner Eligible for Tax-Free Benefits?
C-Corporation	Yes — owner-employees participate like any other employee
S-Corporation (2%+ shareholder)	No — reimbursements are taxable income (but exempt from FICA)
Sole Proprietorship	Only through a bona fide employed spouse
Partnership	Only through a bona fide employed spouse (husband-wife partnerships do not qualify)

Sole Proprietors Must Hire Their Spouse (For Real)

A sole proprietor cannot participate in their own Section 105 plan. The IRS does not consider a business owner to be their own employee. The workaround is legitimate spousal employment. If the sole proprietor hires their spouse as a bona fide employee, the business can offer the spouse a Section 105 plan. Because the plan covers the employee’s family, the owner gets covered as the spouse’s dependent.

This strategy works — but only when the spousal employment is real. The IRS scrutinizes these arrangements, and the spouse must perform significant business duties. Part-time work counts, as long as it is genuine and non-trivial.

Partnerships Follow the Spousal Employment Route

Partners in a partnership face rules similar to sole proprietors. A partner’s spouse must be a bona fide employee to access Section 105 benefits. A husband-and-wife partnership does not qualify for the plan at all. This is one of the most overlooked restrictions in Section 105 planning.

The Section 105(h) Nondiscrimination Rules You Cannot Ignore

Self-insured health plans — including most HRAs — must pass nondiscrimination testing under IRC Section 105(h). These rules exist to prevent employers from giving better health benefits to highly compensated individuals (HCIs) while leaving rank-and-file employees with less.

The Two Tests Every Employer Must Pass

The IRS requires two separate tests. The eligibility test checks whether the plan covers a broad enough group of employees — not just executives and owners. The benefits test checks whether all the benefits available to HCIs are also available to every other participant.

A plan passes the eligibility test if it meets at least one of these conditions: it covers 70% or more of all employees, it covers 80% or more of eligible employees (provided 70% of all employees are eligible), or the eligible class of employees is determined by the IRS to be nondiscriminatory.

What Happens When Your Plan Fails

If a plan fails either test, the consequences fall on highly compensated individuals — not on rank-and-file employees. HCIs lose the tax exclusion under Section 105(b) and must include their excess reimbursements as taxable income. The exact amount depends on which test was failed.

Failing the eligibility test means all reimbursements to HCIs become taxable. Failing only the benefits test means HCIs are taxed on the excess reimbursements that non-HCIs did not receive. Either way, the business may face additional scrutiny and possible penalties.

What the IRS Requires Before You Reimburse a Single Dollar

Setting up a Section 105 plan is not as simple as writing a check for an employee’s medical bill. The IRS has specific documentation requirements, and failing to meet them can cost you the entire deduction.

Written Plan Documents Are Non-Negotiable

Every Section 105 plan must have formal written plan documents. These documents define which expenses are eligible, the maximum reimbursement amount, employee eligibility rules, and how claims are submitted. The IRS considers a plan without written documents to be invalid, meaning all reimbursements become taxable to employees and non-deductible to the employer.

Expense Documentation Must Be Airtight

Employees must submit proper documentation to verify every reimbursement claim. This includes receipts, invoices, Explanation of Benefits statements, and in some cases, letters from healthcare providers. The IRS requires employers to keep this supporting documentation on file for ten years.

Spousal Employment Requires Real Proof

For sole proprietors and partnerships using the spousal employment strategy, the IRS demands evidence that the employment relationship is genuine. The National Society of Tax Professionals recommends maintaining the following:

A written employment agreement between the business and the spouse
A log of hours worked by the employee-spouse
An established cash compensation schedule with regular payments
Insurance policies in the employee’s name where possible
Separate checking accounts for business and personal expenses
Documentation of all medical expenses paid by the employee from their personal account

Three Real-World Scenarios: How Employers Use Section 105 Plans

Scenario 1: The Sole Proprietor With a Spouse Employee

Marcus owns a landscaping business as a sole proprietorship. He earns $120,000 per year. His wife, Dana, works part-time managing the business books and scheduling — about 15 hours per week. Their family health insurance premiums are $1,400/month ($16,800/year), and they spend about $3,000/year on out-of-pocket medical costs for themselves and their two children.

Marcus sets up a Section 105 plan and hires Dana as a legitimate employee with a written employment agreement. Her total compensation includes $12,000 in cash wages plus reimbursements under the Section 105 plan.

What Marcus Does	What It Saves
Pays Dana $12,000/year in wages	Creates a deductible business expense
Reimburses $16,800 in insurance premiums through the 105 plan	Deducts the full amount; Dana pays zero income or FICA tax on it
Reimburses $3,000 in out-of-pocket medical expenses	Deducts the full amount; bypasses the 7.5% AGI floor for personal medical deductions
Total Section 105 deductions: $19,800	Estimated tax savings: $5,000–$7,000/year depending on tax bracket

Without the Section 105 plan, Marcus could only deduct health insurance premiums through the self-employed health insurance deduction on his personal return — and he could not deduct out-of-pocket medical expenses unless they exceeded 7.5% of his adjusted gross income.

Scenario 2: The Small Business With 12 Employees

Rachel owns a marketing agency structured as an LLC (taxed as a C-corp) with 12 full-time employees. She wants to offer health benefits but cannot afford traditional group health insurance, which would cost her over $7,000 per employee per year.

Rachel sets up a QSEHRA. She offers each employee $500/month ($6,000/year) toward individual health insurance premiums and medical expenses — within the 2026 QSEHRA limits.

What Rachel Does	What It Saves
Reimburses 12 employees up to $6,000/year each through QSEHRA	Total annual cost: $72,000 (fully deductible)
Avoids buying a group health plan at $7,000+/employee	Saves $12,000+/year compared to group plan costs
Employees purchase their own individual plans on the marketplace	Employees pick plans that fit their doctors and families
Reimbursements are tax-free to employees	Employees keep more take-home pay

Rachel’s business deducts the full $72,000. Her employees receive tax-free reimbursements. She avoids the complexity and cost of a group plan. The QSEHRA gives her predictable, controlled healthcare spending each month.

Scenario 3: The Large Employer Switching to ICHRA

TechForward Inc. employs 300 people across three states. The company has been offering a group health plan, but premiums rose 12% last year and employee satisfaction with the plan dropped. The HR team explores an ICHRA as an alternative.

TechForward creates three employee classes: full-time salaried ($600/month allowance), full-time hourly ($400/month allowance), and part-time ($200/month allowance). Because the ICHRA has no annual contribution limits, TechForward can set these amounts based on budget and employee needs.

What TechForward Does	What It Achieves
Offers ICHRA with class-based allowances	Employees choose individual plans that fit their needs in each state
Eliminates the group health plan	Removes the unpredictable annual premium increases
Sets a fixed monthly budget per employee class	Total annual healthcare spend is predictable and controlled
All reimbursements are tax-deductible	FICA savings on every dollar reimbursed

For Applicable Large Employers (ALEs) like TechForward, the ICHRA must meet ACA affordability standards. For 2026, an employee’s post-reimbursement cost for the lowest-cost silver plan cannot exceed 9.96% of their household income. If it does, the coverage is considered unaffordable, and the employer may face ACA penalties.

The Shellito Case: What Happens When the IRS Audits Your Section 105 Plan

One of the most important court cases involving a Section 105 plan is Shellito v. Commissioner. Milo and Sharlyn Shellito, a Kansas farm couple, hired Sharlyn as an employee of their farm business and set up a Section 105 plan. The IRS audited the plan and initially denied the business deduction for medical expense reimbursements.

The Tax Court sided with the IRS. The Shellitos appealed to the Tenth Circuit Court of Appeals, which unanimously reversed the Tax Court’s decision. The appellate court found that the Shellitos had properly documented the employment relationship — they had a written employment agreement, the spouse was qualified to perform the work, the Section 105 plan was established in writing, and reimbursements had a reasonable annual cap.

The court stated the Shellitos “crossed all of the t’s and dotted all of the i’s with respect to the employment relationship.” This case confirmed that Section 105 plans are a legitimate tax-planning tool — but only when employers follow every IRS requirement.

Five Key Takeaways From the Shellito Ruling

The spouse had a written employment agreement that described job duties
The Section 105 plan was established in writing with reimbursements designated as compensation
Reimbursements had an annual cap that kept total compensation reasonable
The spouse submitted adequate documentation for all medical expenses
The employment relationship was genuine — the spouse performed real work for the business

Mistakes to Avoid With Your Section 105 Plan

Calling Your Spouse an “Employee” Without Proof

The single most common mistake is creating a fake employment relationship. Sole proprietors sometimes list their spouse as an employee on paper without the spouse doing any actual work. The IRS treats this as a red flag and will deny the deduction. The consequence is all reimbursements become taxable, and the employer loses the business deduction — plus potential penalties and interest.

Operating Without Written Plan Documents

Some employers start reimbursing medical expenses without ever creating formal plan documents. The IRS requires written plan documents that define the plan’s terms, eligibility, and covered expenses. Without them, the plan is considered nonexistent in the eyes of the IRS. Every reimbursement becomes taxable income to the employee.

Failing the Section 105(h) Nondiscrimination Tests

Employers who offer better benefits to executives and owners than to other employees will fail the 105(h) nondiscrimination tests. The penalty is that all reimbursements to highly compensated individuals become taxable. This mistake is common among small businesses where the owner wants maximum benefits for themselves while keeping costs low for other employees.

Ignoring the 2% S-Corp Shareholder Rule

S-corp shareholders who own more than 2% of the company cannot receive tax-free reimbursements. Some S-corp owners set up Section 105 plans and treat their reimbursements as tax-free, which is wrong. The IRS will reclassify those reimbursements as taxable income on audit.

Not Keeping Expense Records for Ten Years

The IRS requires employers to maintain all reimbursement documentation for a full decade. Employers who throw away receipts, invoices, or claim forms after one or two years leave themselves exposed in an audit. Without documentation, the IRS can disallow every reimbursement for the years in question.

Setting Unreasonable Compensation for a Spouse Employee

Even when spousal employment is real, the total compensation (wages plus Section 105 reimbursements) must be reasonable for the work performed. Paying a spouse $10,000 in wages while reimbursing $40,000 in medical expenses for 10 hours of weekly bookkeeping will raise IRS scrutiny. The annual reimbursement cap should align with the value of the work.

Pros and Cons of a Section 105 Plan

Pros	Cons
Full tax deduction for the employer on all reimbursements — reduces taxable business income	S-corp owners (2%+ shareholders) cannot receive tax-free reimbursements — benefits are taxable income
Tax-free reimbursements for employees — no federal income tax or FICA tax on amounts received	Written plan documents are required — operating without them makes the entire plan invalid
Cost control — the employer sets the reimbursement amount and budget, with no surprise premium hikes	Nondiscrimination rules under Section 105(h) restrict plans that favor highly compensated employees
Flexibility — employers can choose QSEHRA, ICHRA, Integrated HRA, or EBHRA based on their needs	Administrative burden — employers must track claims, verify documentation, and retain records for 10 years
Broad eligible expenses — covers premiums, copays, deductibles, dental, vision, prescriptions, and more	Spousal employment risk — sole proprietors and partnerships face IRS scrutiny on the employment relationship
No employer size requirement for ICHRA — works for businesses with 1 employee or 10,000 employees	QSEHRA has annual limits — $6,450 self-only and $13,100 family in 2026, which may not cover full costs
Employees choose their own plans (with QSEHRA and ICHRA) — better satisfaction and personalized coverage	ACA affordability rules apply to ALEs using ICHRA — employers must meet the 9.96% income threshold in 2026

Do’s and Don’ts for Section 105 Plans

Do’s

Do create written plan documents before making any reimbursement — the IRS considers undocumented plans invalid, and you will lose your deduction in an audit
Do hire your spouse as a real employee if you are a sole proprietor — assign genuine duties, keep time logs, and pay regular wages to pass IRS scrutiny
Do run Section 105(h) nondiscrimination tests annually — failing these tests means your HCIs lose their tax exclusion on reimbursements
Do keep all receipts and claim documentation for 10 years — the IRS can request proof of every reimbursement going back a full decade
Do set an annual reimbursement cap that keeps total spousal compensation reasonable — the Shellito case proved this protects your plan in court
Do consult a tax professional to match the right Section 105 plan type to your business structure — using the wrong plan creates unnecessary tax liability

Don’ts

Don’t operate a husband-wife partnership and expect to qualify — the IRS specifically bars this arrangement from Section 105 plans
Don’t allow 2%+ S-corp shareholders to claim tax-free reimbursements — these amounts are taxable income, and misreporting triggers penalties
Don’t reimburse expenses without verifying documentation — paying claims based on verbal requests or incomplete receipts puts your plan at risk
Don’t offer different benefit levels to executives and rank-and-file employees without understanding 105(h) nondiscrimination rules — the penalty falls on your highest-paid people
Don’t skip the annual QSEHRA contribution limit check — the IRS updates limits each year, and exceeding them creates taxable events for employees
Don’t treat the Section 105 plan as a “set it and forget it” benefit — compliance changes, limits change, and employee eligibility changes require annual review

Section 105 Plans vs. Other Health Benefit Options

Employers often ask whether a Section 105 plan is better than other options. The answer depends on business size, budget, and goals.

State-Level Nuances That Can Trip Up Employers

Federal law governs Section 105 plans, but state tax rules add another layer. Most states follow federal tax treatment, meaning reimbursements that are tax-free federally are also tax-free at the state level. A few states have rules worth knowing.

California does not conform to all federal health benefit exclusions in the same way. Employers with California employees should verify that their Section 105 plan reimbursements qualify for state tax exclusion, because California has historically been selective about which IRC provisions it follows.

New Jersey taxes certain employer-provided health benefits that other states do not. Employers operating in New Jersey should work with a state tax advisor to confirm how Section 105 reimbursements interact with the state’s Gross Income Tax Act.

States with no income tax — including Texas, Florida, Wyoming, Nevada, Washington, Alaska, and South Dakota — give employers and employees the full federal tax benefit without any state-level complications. Section 105 plans in these states produce the maximum possible tax savings.

How Much Does It Cost to Set Up a Section 105 Plan?

The cost depends on complexity. A one-person Section 105 HRA (sole proprietor with a spouse employee) can be set up through plan document templates for as little as $100–$300. Some third-party administrators charge a low monthly subscription — often $20–$75/month — to manage claims, compliance, and documentation.

A QSEHRA for a small business with 10–49 employees typically costs $200–$400 to set up with proper plan documents, plus $15–$40 per employee per month for administration through a third-party platform. An ICHRA for a larger employer may cost more in setup and administration, but the savings from dropping a group health plan almost always outweigh the fees.

These costs are themselves deductible as business expenses. The administration fees you pay to run your Section 105 plan reduce your taxable income on top of the reimbursement deductions.

Eligible Expenses That Employers Can Reimburse

The list of qualifying expenses under Section 105 is broader than most employers realize. Any expense that qualifies as a medical expense under IRC Section 213(d) is eligible for reimbursement through a Section 105 plan.

Health, dental, and vision insurance premiums
Qualified long-term care insurance premiums
Medicare Part A, Part B, and supplemental premiums
Prescription drugs and medications
Out-of-pocket copays, deductibles, and coinsurance
Physical therapy and speech therapy
Medical devices (hearing aids, reading glasses, contact lenses)
Laboratory fees and medical X-rays
Infertility treatment costs
Mental health counseling and therapy
Organ transplant expenses
Acne medications and dermatological treatments

The plan documents must specify which categories of expenses are covered. Employers can choose to cover all Section 213(d) expenses or limit reimbursements to specific categories (like insurance premiums only). The key is that whatever the plan covers must be applied consistently to all eligible employees.

QSEHRA vs. ICHRA: Which Section 105 Plan Fits Your Business?

This is the most common question employers ask after deciding to move forward with a Section 105 plan. Both are HRAs authorized under Section 105, but they serve different employers.

Small employers who want simplicity and have modest budgets should start with a QSEHRA. Growing businesses and larger employers who want flexibility and higher contribution amounts should choose the ICHRA.

FAQs

Can a sole proprietor participate in their own Section 105 plan?

No. A sole proprietor is not their own employee under IRS rules. They can benefit indirectly by employing their spouse and covering the family through the spouse’s plan.

Does a Section 105 plan require a group health insurance policy?

No. A QSEHRA and ICHRA operate as standalone plans without group coverage. An Integrated HRA, however, must pair with a group health plan to function.

Are Section 105 plan reimbursements subject to FICA taxes?

No. Qualified reimbursements under a Section 105 plan are exempt from both FICA and federal income taxes for eligible employees.

Can a 2% S-corp shareholder receive tax-free Section 105 benefits?

No. Reimbursements to shareholders owning more than 2% of an S-corp are subject to federal and state income tax, though they are exempt from FICA.

Is there a minimum number of employees required for a Section 105 plan?

No. Both QSEHRA and ICHRA plans can be set up with as few as one eligible employee, including a spouse working for a sole proprietor.

Does the IRS require annual nondiscrimination testing?

Yes. Self-insured health plans must pass Section 105(h) eligibility and benefits tests each year to maintain tax-free treatment for highly compensated individuals.

Can an employer offer both group insurance and an ICHRA?

No. An employer cannot offer both to the same class of employees. They can offer group coverage to one class and ICHRA to a different class.

Can Section 105 plans reimburse over-the-counter medications?

Yes. Since the CARES Act of 2020, over-the-counter medications and menstrual care products qualify as eligible medical expenses under Section 213(d) without a prescription.

How long must an employer keep Section 105 plan records?

Ten years. The IRS requires all supporting documentation for reimbursement claims to be stored and accessible for a full decade.

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

No. The IRS does not allow husband-wife partnerships to qualify. One spouse must be the sole owner, and the other must be a bona fide employee.

Related reading