Is Section 105 Reimbursement Taxable Income? (w/Examples) + FAQs

No — Section 105 reimbursements are not taxable income in most cases. Under IRC Section 105(b), amounts an employer pays to reimburse an employee for qualified medical expenses are excluded from the employee’s gross income. The reimbursement must come through a formal, written employer-sponsored plan, and only cover expenses defined as medical care under Section 213(d) of the tax code.

The catch is that several rules can flip a tax-free reimbursement into taxable wages. Section 105(h) imposes nondiscrimination requirements on self-insured plans, and the IRS closely scrutinizes whether a legitimate plan even exists. Over 60% of small businesses now explore alternatives to traditional group health insurance, making Section 105 plans one of the fastest-growing employer health benefits in the country.

Here’s what you’ll learn:

• 💰 When Section 105 reimbursements are tax-free — and the exact rules that keep them that way
• ⚠️ The specific triggers that turn a tax-free reimbursement into taxable income on your W-2
• 🏢 How your business structure (C-Corp, S-Corp, sole proprietorship, partnership) changes the tax treatment
• 📋 Step-by-step plan setup requirements and the forms you need to stay compliant
• ⚖️ Real court cases where taxpayers lost their Section 105 exclusion — and how to avoid the same mistakes

What IRC Section 105 Actually Says

Section 105(a) of the Internal Revenue Code starts with a general rule of inclusion. It says that amounts an employee receives through an employer-funded accident or health plan are included in gross income. This surprises many people because they assume all health plan payments are automatically tax-free.

The tax-free treatment comes from exceptions carved out in subsections (b) and (c). Section 105(b) excludes reimbursements for medical care expenses — things like doctor visits, prescriptions, dental work, health insurance premiums, and other costs defined under Section 213(d). Section 105(c) excludes payments for permanent injury or disfigurement — but that applies to a narrower set of situations.

The critical word in Section 105(b) is reimbursement. The IRS has made clear through Revenue Ruling 2005-24 that a payment must be specifically tied to an actual medical expense the employee incurred. If the plan pays out money regardless of whether a medical expense occurred — such as unused reimbursement amounts paid as cash — the exclusion does not apply, and the entire amount becomes taxable.

How a Section 105 Plan Works Day-to-Day

A Section 105 plan operates through a straightforward reimbursement process. The employer creates a formal written plan document that spells out which expenses are eligible, how much the employer will contribute, and the rules for submitting claims. Employees pay for qualified medical expenses out of pocket, then submit receipts or documentation to get reimbursed.

The employer (or a third-party administrator) reviews each claim for eligibility. Once approved, the reimbursement is paid to the employee tax-free — meaning no federal income tax, no FICA tax, and no FUTA tax applies. The employer also benefits because the reimbursement is deductible as a business expense.

There are a few non-negotiable rules:

• The plan must be funded entirely by the employer — employee salary deductions are not permitted
• Employees must provide substantiation (receipts, explanation of benefits) for every expense
• The plan must have a written plan document on file before any reimbursements are made
• Only expenses incurred during the coverage period qualify for reimbursement

When Section 105 Reimbursements Stay Tax-Free

A properly structured Section 105 plan keeps reimbursements completely out of an employee’s taxable income. The employee does not report the reimbursement on their tax return, and the employer does not include it in Box 1 of the W-2. For this to happen, three conditions must be met simultaneously.

First, the reimbursement must pay for medical care under Section 213(d). This includes doctor and hospital bills, prescription drugs, dental and vision care, mental health treatment, health insurance premiums, long-term care insurance (with limits), and COBRA premiums. Cosmetic surgery that is not medically necessary does not qualify.

Second, the payment must be a true reimbursement. The employee must have already incurred and paid the expense. The IRS ruled in Revenue Ruling 2003-43 that employer-provided payments made regardless of whether medical expenses exist are not excludable — even if the employee later uses the money for medical care.

Third, the plan must satisfy all applicable federal requirements — including the Section 105(h) nondiscrimination rules for self-insured plans, ACA mandates, ERISA rules, HIPAA privacy requirements, and COBRA (if applicable). A plan that fails any of these tests can cause reimbursements to become taxable for certain employees.

The 5 Triggers That Make Section 105 Reimbursements Taxable

A Section 105 reimbursement becomes taxable income when certain rules are violated. Understanding these triggers is the difference between a legitimate tax-free benefit and an unexpected tax bill.

Trigger 1: No Written Plan Document Exists

The IRS requires a formal written plan document before any reimbursement is made. In Larkin v. Commissioner, two brothers who each owned 50% of a corporation claimed Section 105 exclusions for medical reimbursement payments. The court found there was no written evidence of a corporate program for medical benefits. The reimbursements were reclassified as taxable dividends, and the corporation lost its deduction.

Without a written plan, the IRS treats the payment as ordinary compensation — or worse, a constructive dividend. The plan document must exist before any reimbursements occur, not after an audit begins.

Trigger 2: Payments Not Tied to Actual Medical Expenses

The IRS has drawn a hard line: a payment qualifies for exclusion only when it reimburses a specific, documented medical expense. Revenue Ruling 2005-24 examined plans that gave employees the option to receive unused reimbursement amounts as cash. The IRS held that all amounts paid under such plans — including amounts that did reimburse medical expenses — were taxable.

This means if your plan has a “cash-out” feature, it poisons the entire arrangement. Every dollar paid under the plan becomes includable in the employee’s gross income.

Trigger 3: The Plan Fails Section 105(h) Nondiscrimination Testing

Self-insured plans (including most HRAs) must pass the Section 105(h) nondiscrimination tests. These rules exist to prevent employers from creating health plans that only benefit the highest-paid people in the company. A “highly compensated individual” (HCI) under Section 105(h) includes anyone who is one of the five highest-paid officers, a shareholder owning more than 10% of the company’s stock, or among the highest-paid 25% of all employees.

There are three tests the plan must pass:

Test	What It Requires
Eligibility Test	The plan must benefit at least 70% of all employees, or 80% of eligible employees if at least 70% are eligible
Benefits Test	All benefits available to HCIs must also be available to all other plan participants
Operational Test	The plan must not discriminate in actual operation — not just on paper

If the plan fails any test, the reimbursements paid to HCIs become excess reimbursements and are included in their gross income. Non-HCI employees keep their tax-free treatment. The penalty only falls on the highly compensated individuals.

Trigger 4: The Employee Is a 2% S-Corporation Shareholder

A more-than-2% shareholder of an S-Corporation is not treated as an employee for purposes of Section 105(b). Under IRC Section 1372(a), an S-Corporation is treated like a partnership for fringe benefit purposes, and a 2% shareholder is treated like a partner. Partners and sole proprietors are classified as self-employed — and self-employed individuals cannot exclude health plan reimbursements under Section 105(b).

The reimbursement must be included on the shareholder’s W-2 as Box 1 taxable income and is subject to federal income tax withholding. It is not subject to FICA or FUTA taxes, as long as the payments are made under a plan for employees. The S-Corporation can still deduct the cost, and the shareholder may be able to claim the self-employed health insurance deduction on their Form 1040.

Trigger 5: The Business Owner Is a Sole Proprietor or Partner

Sole proprietors and partners face the same limitation as 2% S-Corp shareholders — they are considered self-employed and are not “employees” for Section 105 purposes. A sole proprietor cannot exclude reimbursements received from their own business plan. The same rule applies to a partner receiving reimbursements from a partnership.

The workaround many sole proprietors use is the employee-spouse strategy. By hiring a spouse as a bona fide employee, the spouse can be covered under a Section 105 plan with family coverage that includes the business-owner spouse. This approach has been upheld by the IRS and Tax Court — but the employment relationship must be real and documented.

How Business Structure Changes Everything

The tax treatment of Section 105 reimbursements depends heavily on how the business is organized. The same medical expense can be fully tax-free, partially taxable, or completely taxable depending on the entity type.

Business Type	Tax Treatment of Owner’s Reimbursement
C-Corporation	Owner-employee receives tax-free reimbursements like any other employee
S-Corporation (2%+ shareholder)	Reimbursement is taxable income on W-2 (Box 1), but exempt from FICA; shareholder may deduct on Form 1040
Sole Proprietorship	Owner cannot directly participate; must use employee-spouse strategy for tax-free treatment
Partnership	Partners cannot exclude reimbursements; same employee-spouse workaround applies
LLC	Follows rules of the entity’s tax filing status (sole proprietorship, partnership, or corporation)

C-Corporations offer the cleanest path. The owner-employee is simply treated as an employee, and all Section 105 plan benefits flow tax-free — as long as the plan satisfies nondiscrimination rules. There is no need for the employee-spouse strategy.

S-Corporations create the most confusion. The reimbursement is deductible by the company and reported on the shareholder’s W-2, but it is not a tax-free benefit. The shareholder can claim a self-employed health insurance deduction on Line 17 of Schedule 1 (Form 1040), but that only offsets the income tax — not the fact that it was included in wages.

The Employee-Spouse Strategy for Sole Proprietors

This is one of the most powerful — and most scrutinized — uses of a Section 105 plan. A sole proprietor hires their spouse as a legitimate employee and offers a Section 105 HRA with family coverage. Because the spouse is the employee, and the business-owner is the spouse’s family member, the reimbursement covers the entire family’s medical expenses tax-free.

Example: Henry runs a Schedule C business and employs his wife, Sarah. Henry sets up a Section 105 HRA that reimburses Sarah for family medical expenses. Sarah submits $22,000 in receipts — $12,000 for health insurance premiums and $10,000 for out-of-pocket medical costs. Henry reimburses Sarah tax-free through the plan. Henry’s business deducts the full $22,000. If Henry is in the 25% federal bracket with 15.3% self-employment tax and 8% state tax, the plan saves him over $10,000 per year.

Without the Section 105 plan, Henry would only get a partial deduction through itemized medical expenses on Schedule A — and only for amounts exceeding 7.5% of his adjusted gross income. The difference in tax savings is dramatic.

What Makes the Spouse Employment Legitimate

The IRS has challenged employee-spouse arrangements in multiple cases. The Tax Court has upheld these plans when the spouse performs real, substantial work — such as bookkeeping, customer service, fieldwork, or administrative tasks. To survive an audit:

• The spouse must perform actual services essential to the business
• The spouse must receive reasonable compensation (cash wages + benefits combined)
• Standard employment documents must exist — W-4, I-9, timesheets, job description
• Payroll taxes must be withheld and reported properly
• The written plan document must be in place before any reimbursements are made

Three Real-World Scenarios

Scenario 1: A Qualifying Tax-Free Reimbursement

Rachel works as a marketing manager at a C-Corporation with 30 employees. The company offers an ICHRA that reimburses employees for individual health insurance premiums up to $500 per month. Rachel buys a plan on the marketplace for $450/month and submits proof of enrollment. She receives $450/month tax-free.

What Rachel Does	Tax Result
Purchases individual health insurance for $450/month	Expense qualifies under Section 213(d)
Submits proof of coverage to employer’s ICHRA administrator	Meets substantiation requirement
Receives $450/month reimbursement from employer	Excluded from gross income under Section 105(b)
Does not claim premium tax credit	Required because ICHRA is considered affordable

Scenario 2: Reimbursement Becomes Taxable Due to Plan Flaw

Tom owns 60% of an S-Corporation and is the company’s CEO. The company creates a self-insured medical reimbursement plan and reimburses Tom $15,000 for health insurance and dental expenses. Tom assumes the reimbursement is tax-free.

What Tom Does	Tax Result
Owns more than 2% of S-Corp stock	Classified as self-employed for fringe benefit purposes under IRC §1372
Receives $15,000 in medical reimbursements	Must be included in Box 1 of his W-2 as taxable wages
Expects FICA exemption	Correct — the $15,000 is exempt from FICA and FUTA
Claims self-employed health insurance deduction on Form 1040	May offset some of the income tax, but does not make the benefit tax-free

Scenario 3: Discriminatory Plan Penalizes the Highly Compensated

A tech startup with 20 employees creates a self-insured HRA. The plan reimburses the three founders (all HCIs) up to $10,000/year, but only reimburses other employees up to $2,000/year. The plan fails the Section 105(h) benefits test because the benefits available to HCIs are not available to all other participants.

Who Is Affected	Tax Result
Three founders (HCIs) receiving $10,000 each	The excess reimbursement ($8,000 per founder) is included in their gross income
17 non-HCI employees receiving $2,000 each	Their reimbursements remain tax-free under Section 105(b)
The company	Still deducts all reimbursements as a business expense

Types of Section 105 Plans Compared

Several types of plans fall under the Section 105 umbrella. Each has different rules for employer size, contribution limits, and employee classes.

Feature	Key Rule
QSEHRA	Only for employers with fewer than 50 FTEs; 2026 limits are $6,450 (individual) and $13,100 (family); must offer the same allowance to all eligible employees
ICHRA	No employer size limit; no contribution cap; employers can offer different amounts to up to 11 employee classes
Integrated HRA (GCHRA)	Must be offered alongside a group health plan; cannot reimburse individual premiums
Excepted Benefit HRA (EBHRA)	Limited to $2,150/year (2026); can be offered alongside group coverage; covers limited expenses
Medical Expense Reimbursement Plan (MERP)	Broad category; subject to full Section 105(h) nondiscrimination testing

QSEHRA plans require employers to report allowance amounts on each employee’s W-2 in Box 12 using Code FF. Employees with a QSEHRA must reduce their premium tax credit by the allowance amount — even if they don’t use the full allowance.

ICHRA plans require the employer to file Forms 1095-B and 1094-B instead. Employees cannot collect premium tax credits and participate in an ICHRA — they must choose one or the other. If the ICHRA is considered “unaffordable” under ACA rules, the employee can waive it and keep the credits.

Mistakes to Avoid

These are the most common errors that turn a perfectly good Section 105 plan into a tax liability.

Mistake 1: Running a plan without a written document. The IRS will reclassify reimbursements as taxable wages — or constructive dividends — if no written plan exists. The Larkin court confirmed this when two shareholder-employees lost their exclusion because there was no documented plan.

Mistake 2: Allowing cash-outs of unused amounts. If your plan lets employees take leftover funds as cash or other non-medical benefits, the entire plan fails. All reimbursements — including those tied to real medical expenses — become taxable.

Mistake 3: Assuming S-Corp shareholders get tax-free treatment. A more-than-2% S-Corp shareholder is not an employee for Section 105 purposes. Reimbursements must be included on their W-2 as taxable income.

Mistake 4: Failing nondiscrimination testing. If your self-insured plan gives better benefits to owners and executives than to rank-and-file employees, the excess reimbursements to HCIs are taxable. Many small employers overlook this because they think the rules only apply to large companies.

Mistake 5: Not substantiating expenses. Every reimbursement must be backed by documentation — receipts, EOBs, or other proof. Without substantiation, the IRS can reclassify the payment as taxable compensation and impose penalties.

Mistake 6: Fabricating a spouse employment relationship. The IRS heavily scrutinizes employee-spouse arrangements. If the spouse does not perform real, substantial work, the entire Section 105 plan can be disqualified by the Tax Court.

Key Court Rulings You Should Know

Larkin v. Commissioner (1968)

Two brothers who each owned 50% of a corporation received medical reimbursement payments and excluded them from income under Section 105. The Second Circuit affirmed the Tax Court’s ruling that the payments were taxable. The court found there was no bona fide plan for employees — just informal arrangements benefiting only the two owner-shareholders. The payments were reclassified as constructive dividends.

Speltz v. Commissioner (2006)

A married couple ran a daycare business. The wife was the owner; the husband worked as an employee. They established a Section 105 medical benefits plan. The Tax Court ruled in the taxpayers’ favor, finding that a genuine employer-employee relationship existed and the husband’s activities were essential to business operations. The medical reimbursements were properly excluded from gross income.

Caplin v. United States (1983)

A taxpayer received a lump-sum disability payment and attempted to exclude it under Section 105(c), which covers payments for permanent disfigurement or loss of bodily function. The Second Circuit held that the payment was taxable because the amount was calculated based on length of service — not on the nature or severity of the injury. Section 105(c) requires a direct connection between the payment amount and the specific physical condition.

Do’s and Don’ts of Section 105 Plans

Do	Don’t
Do create a written plan document before making any reimbursements — the IRS requires it	Don’t reimburse expenses that occurred before the plan’s effective date — they are not eligible
Do require employees to submit receipts and documentation for every claim — substantiation is mandatory	Don’t allow employees to receive unused funds as cash — it makes the entire plan taxable
Do run Section 105(h) nondiscrimination testing annually if you have a self-insured plan — failure penalizes HCIs	Don’t assume your plan is nondiscriminatory just because it is “open to all” — the benefits test looks at actual operation
Do include the reimbursement on a 2%+ S-Corp shareholder’s W-2 as taxable wages — it’s required by law	Don’t treat a 2%+ S-Corp shareholder the same as a regular employee for Section 105 — they are classified as self-employed
Do ensure the employee-spouse performs real work with documented hours and duties — the IRS will check	Don’t set up a “phantom” spouse employment arrangement just for the tax benefit — the Tax Court will disqualify it
Do keep all plan records, receipts, and documentation for at least 10 years — the IRS requires it	Don’t fund the plan through employee salary reductions — Section 105 plans must be 100% employer-funded

Pros and Cons of Section 105 Plans

Pros	Cons
Reimbursements are tax-free for eligible employees — no income tax, FICA, or FUTA	Some business owners (sole proprietors, partners, 2%+ S-Corp shareholders) cannot receive tax-free reimbursements directly
Employers get a full business expense deduction for all reimbursements paid	Plans must comply with IRS, ERISA, HIPAA, COBRA, and ACA rules — which adds administrative burden
Employers have complete cost control — they set the allowance amount and only pay for documented expenses	The Section 105(h) nondiscrimination rules can make reimbursements taxable for highly compensated individuals if the plan is discriminatory
Employees get flexibility to choose their own doctors, insurance plans, and how to use their allowance	Employees unfamiliar with HRAs may find the reimbursement process confusing compared to traditional group insurance
Unused funds stay with the employer — unlike an HSA, the employer does not lose unspent dollars	A plan without proper documentation, substantiation, or a written plan document can be entirely disqualified by the IRS
Can be combined with other benefits — such as a group plan (GCHRA) or offered as a standalone benefit (ICHRA, QSEHRA)	QSEHRA plans have strict annual contribution limits ($6,450 individual / $13,100 family in 2026) that may not cover all costs

State-Level Nuances That Catch People Off Guard

Federal law governs the core tax treatment of Section 105 reimbursements, but states add their own layers. Most states follow the federal exclusion — meaning if a reimbursement is tax-free under federal law, it’s tax-free under state law too. But there are important exceptions.

California does not conform to all federal health benefit exclusions in every situation. Employers operating in California should verify that their specific Section 105 plan structure qualifies for the state income tax exclusion. California also has its own nondiscrimination framework that can affect how benefits are treated at the state level.

New Jersey is known for its aggressive treatment of employer-provided health benefits. While most Section 105 reimbursements are excluded from New Jersey gross income, certain fringe benefits — particularly for S-Corp shareholders — can be treated differently than under federal law. New Jersey does not recognize S-Corporation status for state tax purposes, which can create unexpected taxable income.

Pennsylvania does not tax most employer-provided health benefits, but it has a flat income tax structure and unique rules around what qualifies as compensation. Employers should confirm that the specific plan design aligns with Pennsylvania’s definition of excludable benefits.

The safest approach is to confirm your state’s conformity with federal Sections 105 and 106 before setting up a plan. A state-specific tax advisor can prevent expensive surprises.

Step-by-Step: Setting Up a Section 105 Plan

Step 1: Choose the Right Plan Type

Decide whether you need a QSEHRA, ICHRA, integrated HRA, or another Section 105 arrangement. The choice depends on your company size, whether you offer group insurance, and how much flexibility you want in setting allowance amounts.

Step 2: Draft the Written Plan Document

This is non-negotiable. The document must include the plan’s effective date, eligible employees, covered expenses, allowance amounts, claims procedures, and plan year. Many employers use a third-party plan document provider to ensure IRS compliance.

Step 3: Create the Summary Plan Description (SPD)

Under ERISA, every Section 105 plan must have an SPD that is distributed to each participant. The SPD explains the plan in plain language — what’s covered, how to file claims, and what happens when employment ends.

Step 4: Set Up a Reimbursement Process

Establish how employees will submit claims and how you will verify and pay them. Many small employers use benefits administration software. Larger employers often hire a third-party administrator (TPA). Every claim must include substantiation — a receipt, EOB, or other documentation.

Step 5: Handle Tax Reporting

For QSEHRAs, report the allowance amount in Box 12 of each employee’s W-2 using Code FF. For ICHRAs, file Forms 1094-B and 1095-B annually. For 2%+ S-Corp shareholders, include the reimbursement amount in Box 1 of the W-2 and withhold federal income tax.

Step 6: Run Annual Nondiscrimination Testing

If your plan is self-insured, perform Section 105(h) testing each plan year. Check the eligibility test, benefits test, and operational test. If the plan fails, correct it immediately — or the excess reimbursements to HCIs become taxable.

Step 7: Maintain Records for 10 Years

Keep all plan documents, SPDs, employee claims, receipts, and testing results. The IRS can audit Section 105 plans going back several years, and the absence of records is treated the same as noncompliance.

FAQs

Is Section 105 reimbursement taxable for regular employees?

No. Reimbursements for qualified medical expenses under a properly structured Section 105 plan are excluded from a regular employee’s gross income, FICA, and FUTA.

Is Section 105 reimbursement taxable for S-Corp owners?

Yes. A more-than-2% S-Corp shareholder must include Section 105 reimbursements as taxable wages on their W-2, though FICA and FUTA do not apply.

Can a sole proprietor use a Section 105 plan?

Yes, but only indirectly. A sole proprietor can hire a spouse as a bona fide employee and offer family coverage through the plan.

Does a Section 105 plan need a written document?

Yes. The IRS requires a formal written plan document before any reimbursements are made. Without one, all payments become taxable.

Can Section 105 reimburse health insurance premiums?

Yes. Individual health insurance premiums, COBRA premiums, Medicare premiums, and dental and vision insurance premiums all qualify under Section 213(d).

What happens if the plan fails nondiscrimination testing?

Yes, there is a penalty. Reimbursements paid to highly compensated individuals become taxable “excess reimbursements.” Non-HCI employees keep their tax-free treatment.

Can I have a Section 105 plan and an HSA?

Yes. Special rules apply to which expenses the Section 105 plan can reimburse when an HSA-qualified high deductible health plan is in place.

Are Section 105 reimbursements subject to FICA tax?

No. Properly excluded Section 105 reimbursements are not subject to Social Security or Medicare taxes for either the employer or the employee.

Is there a contribution limit on ICHRAs?

No. Unlike QSEHRAs, Individual Coverage HRAs have no federal cap on how much an employer can contribute per employee per year.

Can I offer different amounts to different employees under an ICHRA?

Yes. Employers can create up to 11 different employee classes and offer different allowance amounts to each class under an ICHRA.

Does a QSEHRA affect premium tax credits?

Yes. Employees must reduce their premium tax credit by the QSEHRA allowance amount, even if they do not use the full allowance.

Can a C-Corp owner participate in a Section 105 plan?

Yes. A C-Corporation owner-employee is treated like any other employee and receives fully tax-free reimbursements under the plan.

What is an “excess reimbursement” under Section 105(h)?

Yes, it’s a specific term. An excess reimbursement is the amount paid to a highly compensated individual under a plan that fails nondiscrimination testing — and it’s taxable.

Can a partnership offer a Section 105 plan?

Yes. A partnership can offer a Section 105 plan to employees, but the partners themselves cannot receive tax-free reimbursements directly.

Is a Section 105 plan the same as an FSA?

No. An FSA is employee-funded through salary reductions, while a Section 105 reimbursement plan is funded entirely by the employer.