No. A Section 105 plan is not tax avoidance — it is a legitimate, IRS-recognized tax strategy built directly into the Internal Revenue Code. Congress created Section 105 to let employers reimburse employees for medical expenses on a tax-free basis. The IRS itself distinguishes between tax avoidance and tax evasion, confirming that using the tax code to minimize taxes is legal and encouraged.
A sole proprietor using a Section 105 medical reimbursement plan can save over $10,000 per year in federal, state, and self-employment taxes on medical expenses alone, according to the Bradford Tax Institute. The plan has survived IRS audits, Tax Court challenges, and even a Tenth Circuit Court of Appeals ruling that unanimously sided with the taxpayer.
Here’s what you’ll learn:
- 💡 What a Section 105 plan is and why the IRS considers it legal
- ⚖️ The difference between tax avoidance and tax evasion under Section 105
- 🚫 Mistakes that turn a legal plan into an IRS red flag
- 🏗️ How Section 105 works for sole proprietors, S-corps, C-corps, and partnerships
- 📋 Real court cases where the IRS challenged — and lost — Section 105 deductions
What Section 105 Actually Says
Section 105 of the Internal Revenue Code allows employers to set up written plans that reimburse employees for medical expenses. These reimbursements are tax-free to the employee and tax-deductible for the employer. The plan covers health insurance premiums, co-pays, dental, vision, and out-of-pocket costs defined under IRC Section 213.
There are several variations of the Section 105 plan. These include Health Reimbursement Arrangements (HRAs), Medical Expense Reimbursement Plans (MERPs), Health Flexible Spending Arrangements (FSAs), and self-insured medical reimbursement plans. Each version follows the same core rule: the employer pays for medical costs, and those payments are excluded from the employee’s gross income under Section 105(b).
How The Money Flows
The employer funds the plan. The employee submits proof of a qualifying medical expense. The employer reimburses the employee. That reimbursement is not treated as taxable wages. The business deducts it as an ordinary and necessary business expense under IRC Section 162(a).
This structure is backed by Revenue Ruling 71-588 and Letter Ruling 9409006. Both confirm that a self-employed individual who employs a spouse can offer that spouse a medical benefits package that covers the entire family — including the business owner.
Why Section 105 Is Not Tax Avoidance
Tax avoidance means using legal provisions in the tax code to reduce what you owe. The IRS has stated clearly that tax avoidance is “perfectly legal and encouraged.” Tax evasion, on the other hand, involves deliberately hiding income or claiming false deductions — a federal crime punishable by up to five years in prison and $250,000 in fines.
Section 105 doesn’t fall into either category when used properly. It isn’t tax avoidance in the negative sense because Congress intentionally designed it to give employers a tax benefit for covering employee medical costs. It’s a feature of the tax code, not a loophole.
Tax Avoidance vs. Tax Evasion Under Section 105
| Legal Use of Section 105 | Illegal Misuse of Section 105 |
|---|---|
| Hiring your spouse as a bona fide employee and reimbursing documented medical expenses | Putting your spouse “on the books” without any real job duties to claim deductions |
| Maintaining written plan documents, receipts, and W-2s | Failing to keep records or fabricating expense documentation |
| Paying reasonable total compensation (wages + benefits) | Claiming reimbursements that exceed what a reasonable salary would be |
| Following nondiscrimination rules under §105(h) for larger employers | Designing a plan that only benefits the owner or highly compensated employees |
| Reimbursing only IRS-qualifying medical expenses under Section 213 | Reimbursing personal, non-medical expenses through the plan |
How Section 105 Works Across Business Types
Not every business structure gets the same tax treatment under Section 105. The entity type determines who qualifies as an employee, how deductions are taken, and what limitations apply. Here’s how each one works.
Sole Proprietorships: The Spouse-Employee Strategy
A sole proprietor is not considered an employee for purposes of a medical plan under federal tax law. This means the business owner cannot directly deduct personal medical expenses on Schedule C. The workaround is hiring a spouse as a legitimate employee and offering that spouse a Section 105 medical reimbursement plan.
The plan covers the employee, the employee’s spouse (the business owner), and dependents. The business deducts the reimbursements as an ordinary business expense. The employee-spouse receives the benefits tax-free — no federal income tax, no state income tax, and no FICA tax.
The catch: the spouse must perform real, meaningful work. The IRS closely scrutinizes spousal employment and will deny the deduction if the relationship is fabricated. Part-time work counts, but it must be genuine and non-trivial.
C-Corporations: The Simplest Path
C-corporation owners have the easiest setup. The owner-employee can be covered directly by the plan without needing a spouse on the payroll. The corporation deducts the reimbursements as a business expense, and the owner-employee receives tax-free benefits. The plan must still comply with written documentation requirements and, if other employees exist, the §105(h) nondiscrimination rules.
S-Corporations: The 2% Shareholder Problem
S-corporations can use Section 105, but a major restriction applies. Any shareholder owning more than 2% of the company cannot receive medical reimbursements on a fully tax-free basis. These benefits are subject to federal and state income tax, though they remain exempt from FICA taxes.
Family members — including spouses and children — of a greater-than-2% shareholder are treated as if they also own more than 2%. This means the spouse-employee workaround does not work for S-corps the way it does for sole proprietorships. Employees who do not own stock in the S-corp, however, can still receive full tax-free benefits under the plan.
Partnerships: Spouse Cannot Be a Partner
A partner in a partnership operates similarly to a sole proprietor. The partner’s spouse must be a bona fide employee to qualify for the plan. A critical restriction: if both spouses are partners in the business, neither qualifies for Section 105 benefits. The plan only works when one spouse is the partner and the other is a genuine employee.
LLCs: It Depends on How You File
A Limited Liability Company’s treatment under Section 105 depends entirely on its federal tax filing status. An LLC taxed as a sole proprietorship follows sole proprietor rules. An LLC taxed as an S-corp follows S-corp rules. An LLC taxed as a C-corp follows C-corp rules. There is no separate “LLC” category for Section 105 purposes.
The Shellito Case: When The IRS Lost
The most important court case involving Section 105 is Shellito v. Commissioner. Milo and Sharlyn Shellito operated a Kansas farm. Milo employed Sharlyn as a legitimate employee and set up a Section 105 medical reimbursement plan using a commercially marketed package called AgriPlan/BizPlan.
The Shellitos deducted their family’s medical expenses — insurance premiums and out-of-pocket costs — on Schedule F as an ordinary business expense. The IRS audited them and denied the deductions for 2001 and 2002, arguing that Mrs. Shellito was essentially an unpaid employee and received no real economic benefit from the reimbursements.
The Tax Court Initially Sided With the IRS
The Tax Court upheld the IRS position. It reasoned that because the Shellitos shared a joint checking account, the reimbursement payments flowing from the joint account to Mrs. Shellito’s individual account didn’t constitute genuine economic benefit.
The Tenth Circuit Reversed the Decision
The Shellitos appealed to the Tenth Circuit Court of Appeals. A three-judge panel unanimously reversed the Tax Court. The appellate court had harsh words for the IRS, noting that the agency had failed to follow its own established caselaw and prior positions on medical reimbursement plans.
The court found that the Shellitos had “carefully followed all of the rules” for establishing a legitimate employment relationship and deducting amounts under the plan. The case was sent back to Tax Court, which then reversed its original decision and granted the Shellitos their deductions. This case remains a landmark validation of Section 105 plans for sole proprietors with a spouse-employee.
Three Real-World Scenarios
Scenario 1: Sole Proprietor With a Spouse-Employee
Sarah runs a consulting business as a sole proprietor. Her husband Tom handles bookkeeping, scheduling, and client follow-ups 15 hours per week. Sarah sets up a Section 105 medical reimbursement plan and pays Tom a total compensation package of $18,000 — $6,000 in cash wages and $12,000 in medical reimbursements.
| What Sarah Does | Tax Result |
|---|---|
| Formally hires Tom with a W-2, job description, and time records | IRS recognizes Tom as a bona fide employee |
| Creates a written Section 105 plan document | Meets IRS documentation requirements |
| Reimburses Tom for family health insurance premiums ($8,400) and out-of-pocket medical costs ($3,600) | $12,000 deducted on Schedule C as a business expense |
| Tom submits receipts and explanation of benefits for each claim | Satisfies expense documentation rules |
| Total compensation ($18,000) is reasonable for part-time bookkeeping | Passes the reasonable compensation test |
Sarah saves approximately $4,200 in taxes per year — across federal income tax, state tax, and self-employment tax — that she would have lost if she paid these medical expenses personally.
Scenario 2: S-Corp Owner Hits the 2% Wall
David owns 100% of an S-corporation. He sets up a Section 105 plan expecting tax-free medical reimbursements for his family. The plan reimburses $15,000 in medical costs.
| What David Does | Tax Result |
|---|---|
| Claims medical reimbursements as a greater-than-2% shareholder | Reimbursements are included in his W-2 wages for income tax purposes |
| His wife is also covered under the plan | She is treated as a greater-than-2% shareholder by attribution |
| Reimbursements are exempt from FICA | David saves on Social Security and Medicare taxes |
| David deducts the health insurance premiums on his personal Form 1040 | Gets a partial benefit through the self-employed health insurance deduction |
David still gets some tax savings, but the benefit is significantly reduced compared to what a sole proprietor or C-corp owner would receive. The plan is still legal — it just isn’t as powerful for S-corp majority shareholders.
Scenario 3: C-Corp Owner Maximizes the Benefit
Lisa is the sole owner and employee of a C-corporation. She establishes a Section 105 HRA and reimburses herself $20,000 for health insurance premiums, dental work, vision care, and prescription costs.
| What Lisa Does | Tax Result |
|---|---|
| Creates a written plan document specifying eligible expenses and reimbursement limits | Meets IRS and DOL requirements |
| Submits receipts for all medical expenses | Satisfies documentation rules |
| No other employees exist, so nondiscrimination rules don’t apply | No §105(h) testing needed |
| The C-corp deducts $20,000 as a business expense | Reduces corporate taxable income |
| Lisa receives $20,000 tax-free | No federal, state, or FICA tax on the reimbursements |
Lisa gets the maximum possible benefit from Section 105. The C-corp structure gives her direct access to the plan without needing a spouse-employee or dealing with the 2% shareholder restriction.
The §105(h) Nondiscrimination Rules
When a Section 105 plan covers multiple employees, it must pass three nondiscrimination tests under §105(h). These rules exist to prevent employers from designing plans that only benefit the people at the top.
Who Counts as a Highly Compensated Individual?
Under §105(h)(5), a highly compensated individual (HCI) is someone who is:
- One of the five highest-paid officers
- A shareholder who owns more than 10% of the company’s stock
- Among the highest-paid 25% of all employees
The Three Tests
Eligibility Test: The plan must benefit at least 70% of all employees, or 80% of eligible employees if at least 70% of all employees are eligible. Certain employees can be excluded from the count — those with fewer than three years of service, part-time or seasonal workers, employees under age 25, and employees covered by a collective bargaining agreement.
Benefits Test: Every benefit available to an HCI must also be available to all other plan participants. You cannot offer the CEO a $50,000 reimbursement cap while limiting other employees to $2,000.
Operational Discrimination Test: Even if the plan looks fair on paper, it must operate fairly in practice. If highly compensated individuals use plan benefits disproportionately over a period that coincides with their employment, the IRS may find discriminatory operation.
What Happens If You Fail?
If a plan fails the nondiscrimination tests, the consequences fall on the highly compensated individuals only. Their reimbursements become taxable income. The non-highly compensated employees keep their tax-free benefits. The plan itself isn’t disqualified — but the tax advantage disappears for the people at the top.
Three Plan Designs the IRS Has Flagged
The IRS issued Revenue Ruling 2005-24 identifying three specific plan designs that disqualify a Section 105 plan from tax-favored status:
- Cash-out provisions: If the plan allows employees to receive unused HRA funds as cash (directly or indirectly), all amounts paid under the plan become taxable. Section 105(b) only excludes reimbursements for actual medical expenses.
- Benefits other than medical reimbursement: A plan that provides any benefit besides the reimbursement of qualifying medical expenses loses its tax-free status entirely.
- Disguised compensation arrangements: If the IRS determines that the plan is structured primarily to deliver additional compensation — rather than to reimburse genuine medical costs — the entire arrangement fails.
Mistakes That Turn a Legal Plan Into an IRS Target
Fabricating a Spousal Employment Relationship
This is the number one reason Section 105 plans get denied on audit. Putting your spouse on the payroll without assigning real duties, tracking hours, or paying reasonable wages is not a gray area — it’s a clear violation. The IRS will deny every deduction taken under the plan and may assess penalties and interest going back multiple years.
Failing to Create Written Plan Documents
The IRS requires a formal written plan document that outlines eligible expenses, reimbursement limits, employee eligibility, and plan administration procedures. A verbal agreement or informal understanding does not satisfy this requirement. Without a written plan, every reimbursement becomes taxable.
Exceeding Reasonable Compensation
The total compensation package — cash wages plus medical reimbursements — must be reasonable for the work performed. Paying your spouse $3,000 in wages but $40,000 in medical reimbursements for occasional filing work will not survive IRS scrutiny. Your Section 105 plan should include a maximum annual reimbursement cap that keeps total compensation within a defensible range.
Not Keeping Expense Documentation
The IRS requires that employees submit proper documentation for every reimbursement claim — receipts, dates of service, descriptions of the services, and proof of payment. These records must be kept on file for ten years. Missing or incomplete documentation can result in the entire deduction being disallowed.
Ignoring the Nondiscrimination Rules
Employers with multiple employees who design a plan that only reimburses the owner or top executives will fail §105(h) testing. The result: all reimbursements to highly compensated individuals become taxable. This mistake is especially common among small businesses that grow from one employee to several but never update their plan documents.
Pros and Cons of a Section 105 Plan
| Pros | Cons |
|---|---|
| 100% tax deduction for medical expenses, premiums, and out-of-pocket costs as a business expense | Sole proprietors and partners must have a legitimate spouse-employee to qualify |
| Reimbursements are tax-free to the employee — no federal, state, or FICA tax for qualifying recipients | S-corp shareholders owning more than 2% get reduced benefits — reimbursements are subject to income tax |
| Unused amounts can carry over to future years under Revenue Ruling 2002-41, protecting against high-cost medical years | Written plan documents are mandatory — failure to maintain them voids the entire tax benefit |
| No cap on reimbursement amounts under a traditional Section 105 plan (unlike FSAs with annual limits) | IRS scrutinizes spousal employment heavily — fabricated relationships lead to denied deductions and penalties |
| Covers a wide range of expenses including dental, vision, prescriptions, co-pays, and long-term care | Nondiscrimination rules apply to businesses with multiple employees, adding compliance complexity |
| Affordable to set up — plan documents can cost as little as $199 through third-party administrators | Record retention requirement of 10 years for all expense documentation |
Do’s and Don’ts
Do:
- Do hire your spouse for real work with documented hours, a job description, and a W-2. The IRS demands a bona fide employment relationship.
- Do create a formal, written plan document before making any reimbursements. Retroactive plans are not valid.
- Do keep all receipts, explanation of benefits forms, and proof of payment for a minimum of ten years.
- Do set a maximum annual reimbursement cap that keeps total compensation within a reasonable range for the work performed.
- Do consult a tax professional before setting up the plan. The rules differ significantly by business entity type.
Don’t:
- Don’t put your spouse on the payroll as a formality. The IRS will deny your deductions if there’s no real work being done.
- Don’t reimburse non-medical expenses through the plan. This disqualifies the entire plan from tax-favored status.
- Don’t add cash-out provisions that let employees convert unused HRA funds to cash. This violates Revenue Ruling 2005-24.
- Don’t assume S-corp rules are the same as sole proprietor rules. The 2% shareholder restriction changes the math dramatically.
- Don’t forget to update your plan when you add new employees. Failing to do so can trigger §105(h) discrimination penalties.
How Section 105 Interacts With the Affordable Care Act
The Affordable Care Act (ACA) does not apply to businesses with only one employee. This is a critical detail for sole proprietors using the spouse-employee strategy with a 105-HRA. Because the ACA’s employer mandate only kicks in at 50 or more full-time equivalent employees, most small businesses using Section 105 plans are entirely exempt from ACA requirements.
For larger employers, Section 105 HRAs must coordinate with ACA rules. The Individual Coverage HRA (ICHRA) allows employers to give employees a set allowance to purchase their own individual health insurance on the marketplace. Employees cannot collect premium tax credits if the ICHRA is considered affordable. The Qualified Small Employer HRA (QSEHRA) has annual reimbursement caps and is available only to employers with fewer than 50 employees who don’t offer a group health plan.
Key IRS Forms and Documentation
Setting up a Section 105 plan requires more than just writing a check. Every element of the employment relationship and the plan itself must be documented. For the spouse-employee arrangement, the business must maintain:
- W-2 issued annually to the employee-spouse
- W-4 (Employee’s Withholding Certificate) on file
- I-9 (Employment Eligibility Verification) completed
- Written job description with specific duties
- Time records showing hours worked
- Written Section 105 plan document specifying eligible expenses, reimbursement limits, and plan terms
The plan document must be readily available to all eligible employees. Expense documentation should include the date of service, a description of the medical service, and proof of payment. The IRS requires this documentation to be saved for ten years.
FAQs
Is a Section 105 plan the same as an HRA?
No. A Section 105 plan is the broader legal framework. An HRA is one type of plan that falls under Section 105, along with FSAs, MERPs, and self-insured plans.
Can a sole proprietor use Section 105 without a spouse?
No. Sole proprietors are not considered employees under federal tax law. They must hire a bona fide spouse-employee to access Section 105 benefits.
Will the IRS audit my Section 105 plan?
Yes, it’s possible. The IRS scrutinizes spousal employment closely. Proper documentation and a real working relationship are your best protection.
Can both spouses be partners and use Section 105?
No. If both spouses are partners in the business, neither qualifies for Section 105 benefits. One must be the partner and the other the employee.
Does Section 105 cover dental and vision?
Yes. Section 105 covers all expenses defined under IRC Section 213, including dental, vision, prescriptions, co-pays, and long-term care.
Can an S-corp owner get tax-free benefits under Section 105?
No, not fully. A greater-than-2% S-corp shareholder must include reimbursements as taxable income, though they remain exempt from FICA.
Is there a maximum reimbursement limit?
No. Traditional Section 105 plans have no statutory cap on reimbursements. The limit is total reasonable compensation for the employee’s work.
Can I set up a Section 105 plan retroactively?
No. The written plan document must be established before any reimbursements are made. Retroactive plans are not recognized by the IRS.
Do I need a third-party administrator?
No. You can self-administer the plan. However, using a third-party administrator adds credibility and helps ensure compliance during an audit.
Can unused funds roll over to the next year?
Yes. Under Revenue Ruling 2002-41, unused amounts can carry over to future plan years, accumulating until the plan terminates or the employee becomes ineligible.
Related reading
- How Does a Section 105 Plan Work? (w/Examples) + FAQs
- Is Section 105 Reimbursement Taxable Income? (w/Examples) + FAQs
- Can I Deduct Section 105 Reimbursements? (w/Examples) + FAQs
- Can I Set Up a Section 105 Plan for Myself? (w/Examples) + FAQs
- Can Section 105 Reimburse Health Insurance Premiums? (w/Examples) + FAQs
- Does My Spouse Need to Do Actual Work for Section 105? (w/Examples) + FAQs