A Section 105 plan is usually the better choice if you want to deduct all medical expenses — including premiums, copays, and dental — as a business expense on Schedule C. An HSA is better if you want a portable, individually owned account that grows tax-free and rolls over year after year. Many business owners can actually use both at the same time with proper planning.
Under IRC Section 105, amounts an employer reimburses for medical expenses are excluded from an employee’s gross income — but only if the plan meets strict nondiscrimination rules under Section 105(h). If the plan fails those rules, highly compensated employees lose their tax-free treatment and must report reimbursements as taxable income. The average small business owner using a Section 105 plan saves more than $5,000 per year in taxes.
Here’s what you’ll learn in this article:
- 🔍 The key differences between a Section 105 plan and an HSA — and when each one wins
- 💰 Real dollar-for-dollar examples showing tax savings for sole proprietors, S-corps, and C-corps
- ⚖️ How nondiscrimination rules under IRC Section 105(h) can blow up your plan if you’re not careful
- 🚫 The most common mistakes business owners make — and how to avoid IRS penalties
- 🧩 How to legally combine a Section 105 plan with an HSA for maximum deductions
What Is a Section 105 Plan?
A Section 105 plan is an employer-funded health benefit arrangement authorized under Section 105 of the Internal Revenue Code. It allows a business to reimburse employees for qualified medical expenses — including insurance premiums, copays, deductibles, prescriptions, and vision and dental costs. The reimbursements are tax-deductible for the business and tax-free for the employee.
The IRS considers Section 105 plans to be group health plans. That means they must comply with IRS, HIPAA, COBRA, ERISA, and ACA regulations. The employer — not the employee — funds and owns the plan. Any unused funds stay with the employer if an employee leaves.
Employers must maintain written plan documents that outline eligible expenses, employer contributions, and plan specifics. Employees submit proof of medical expenses, and the employer reimburses them — typically on a monthly basis — up to a set allowance.
Types of Section 105 Plans
There are several types of plans that fall under the Section 105 umbrella. Each serves a different business size and structure.
One-Person 105 HRA. This plan works when a business has only one eligible employee. A sole proprietor can hire their spouse, make the spouse the sole employee, and reimburse all family medical expenses — including premiums — as a business deduction on Schedule C. There are no statutory caps on how much you can reimburse. The plan must satisfy Section 105(h) nondiscrimination rules, which is easy when there’s only one eligible employee.
QSEHRA (Qualified Small Employer HRA). Created by the 21st Century Cures Act, the QSEHRA is available to employers with fewer than 50 full-time employees who do not offer a group health plan. It has annual reimbursement limits set by the IRS. Employees must have minimum essential coverage to receive reimbursements.
ICHRA (Individual Coverage HRA). An ICHRA is a Section 105 plan available to businesses of all sizes. It allows employers to set different reimbursement amounts for different classes of employees. There are no annual caps on what an employer can contribute.
MERP (Medical Expense Reimbursement Plan). A MERP supplements an existing group health plan by covering expenses insurance doesn’t pay — like deductibles and coinsurance. It functions like an HRA but is designed to work alongside traditional group coverage.
| Section 105 Plan Type | Best For |
|---|---|
| One-Person 105 HRA | Sole proprietors or C-corp solo owners with no other employees |
| QSEHRA | Small employers (under 50 employees) without group health insurance |
| ICHRA | Businesses of any size wanting flexible, class-based reimbursement |
| MERP | Employers supplementing an existing group health plan |
What Is an HSA?
A Health Savings Account (HSA) is a tax-advantaged savings account that the individual owns. You can contribute pre-tax dollars, the money grows tax-free, and withdrawals for qualified medical expenses are also tax-free — creating a “triple tax advantage”. Unlike a Section 105 plan, the employee — not the employer — owns the HSA.
To contribute to an HSA, you must be enrolled in a High Deductible Health Plan (HDHP). For 2026, an HDHP must have a minimum deductible of $1,700 for self-only coverage and $3,400 for family coverage. The out-of-pocket maximum cannot exceed $8,500 for individuals or $17,000 for families.
HSA funds roll over indefinitely — there is no “use it or lose it” rule. You can also invest the funds in stocks, bonds, and mutual funds, turning the HSA into a long-term retirement savings vehicle. After age 65, you can withdraw funds for any purpose without penalty (though non-medical withdrawals are taxed as income).
2025–2026 HSA Contribution Limits
| Coverage Type | 2025 Limit | 2026 Limit |
|---|---|---|
| Self-only | $4,300 | $4,400 |
| Family | $8,550 | $8,750 |
| Catch-up (age 55+) | +$1,000 | +$1,000 |
You cannot contribute to an HSA if you are enrolled in Medicare, claimed as a dependent, or covered by a non-HDHP plan like a general-purpose FSA.
How Section 105 Plans and HSAs Are Fundamentally Different
The core difference comes down to ownership and control. A Section 105 plan is employer-owned and employer-funded. An HSA is employee-owned and portable. This single distinction creates a cascade of differences in tax treatment, flexibility, and long-term value.
A Section 105 plan reimburses expenses after they happen. An HSA lets you save and invest money before you need it. A Section 105 plan can reimburse insurance premiums. An HSA generally cannot be used for premiums except in limited situations like COBRA or long-term care insurance.
With a Section 105 plan, the employer decides which expenses qualify and how much to reimburse. With an HSA, the account holder can spend on any IRS-qualified medical expense without employer approval. The Section 105 plan has no contribution limit for most HRA types. The HSA is capped at $4,400 individual / $8,750 family for 2026.
| Feature | Section 105 Plan | HSA |
|---|---|---|
| Who owns it | Employer | Employee |
| Who funds it | Employer only | Anyone (employee, employer, family) |
| Contribution limits | None (except QSEHRA) | $4,400 / $8,750 for 2026 |
| Requires HDHP | No | Yes |
| Can reimburse premiums | Yes | Generally no |
| Funds roll over | Depends on plan design | Always |
| Portable if you leave | No | Yes |
| Tax deduction type | Business expense (Schedule C) | Above-the-line personal deduction |
| Investment option | No | Yes |
The Tax Deduction Waterfall: Why It Matters
Where your medical expense deduction falls on your tax return makes a huge difference. A Section 105 plan puts the deduction at the top of the tax waterfall — as a business expense on Schedule C. This reduces your gross business income before self-employment tax is calculated. That means you save on both income tax and self-employment tax (15.3%).
An HSA contribution is an above-the-line deduction on your Form 1040. It reduces your adjusted gross income (AGI) but does not reduce your self-employment tax. The self-employed health insurance deduction (Line 17 of Schedule 1) works the same way — it reduces federal and state income tax but not FICA/Medicare tax.
A Section 105 plan can also reimburse expenses that the self-employed deduction cannot — like copays, dental work, vision, and prescribed over-the-counter drugs. The self-employed deduction only covers insurance premiums. This gap is where a Section 105 plan adds enormous value.
Real-World Examples: Section 105 vs. HSA
Scenario 1: Sarah the Sole Proprietor
Sarah runs a freelance graphic design business on Schedule C. She’s married, and her husband doesn’t work. They have two kids. Their annual health insurance premium is $18,000, and they spend about $6,000 a year on copays, dental, and vision.
Without a Section 105 plan, Sarah takes the self-employed health insurance deduction of $18,000 on her Form 1040. She gets no deduction for the $6,000 in out-of-pocket expenses unless she itemizes and exceeds 7.5% of her AGI.
With a One-Person 105 HRA, Sarah hires her husband as a W-2 employee. He becomes the sole eligible employee. The plan reimburses the entire $24,000 — premiums plus out-of-pocket costs — as a business deduction on Schedule C. At a combined federal, state, and self-employment tax rate of 35%, Sarah saves $8,400 in taxes versus $6,300 with the self-employed deduction alone.
| Deduction Method | Amount Deducted | Estimated Tax Savings (35% rate) |
|---|---|---|
| Self-employed deduction only | $18,000 (premiums only) | $6,300 |
| One-Person 105 HRA | $24,000 (premiums + out-of-pocket) | $8,400 |
Scenario 2: Mike the C-Corp Owner
Mike is the sole employee of his C corporation. He has an HDHP with a $3,400 family deductible. His premium is $14,000/year. He contributes $8,750 to his HSA for 2026.
Mike can also set up a limited-purpose 105 HRA that reimburses only dental and vision expenses. This does not disqualify his HSA because limited-purpose HRAs are an exception to the HSA-incompatibility rule. His corporation deducts the HRA reimbursements as a business expense. Mike gets both the HSA triple tax advantage and the Section 105 deduction for dental and vision.
| Benefit | Amount | Tax Treatment |
|---|---|---|
| HSA contribution | $8,750 | Pre-tax; grows and withdraws tax-free |
| Limited-purpose 105 HRA (dental/vision) | $3,200 | Business deduction; tax-free to Mike |
| Health insurance premium | $14,000 | Corporation deducts as business expense |
Scenario 3: Lisa and Tom’s S-Corporation
Lisa and Tom each own 50% of an S corporation. As more-than-2% shareholders, they cannot participate in a Section 105 HRA because spouses of S-corp owners are attributed ownership. Their best option is to have the S corporation pay their health insurance premiums, report them as W-2 wages, and then take the self-employed health insurance deduction on their personal returns.
They can each open an HSA if they’re on an HDHP. Their three employees, however, can be offered a QSEHRA. This lets the business deduct employee health reimbursements while Lisa and Tom use HSAs for their own medical savings.
How to Legally Combine a Section 105 Plan with an HSA
You can have both a Section 105 plan and an HSA at the same time — but the Section 105 plan must be limited in scope. A general-purpose HRA that reimburses all medical expenses disqualifies you from HSA contributions. The IRS treats it as “other health coverage.”
Three types of Section 105 plans are HSA-compatible:
- Limited-purpose HRA — reimburses only dental, vision, or preventive care
- Post-deductible HRA — only reimburses expenses after the HDHP deductible is met
- Retirement HRA — only reimburses expenses after retirement or separation from service
This combination is powerful. You get the long-term investment growth of the HSA plus the immediate business deduction of the limited-purpose 105 plan. A C-corp owner-employee is in the best position to use this strategy because the corporation can fund both the HRA and contribute to the employee’s HSA.
The Section 105(h) Nondiscrimination Rules
If your Section 105 plan is self-insured (which most HRAs are), it must pass two tests under IRC Section 105(h): the eligibility test and the benefits test. Failing either test means highly compensated employees must report their reimbursements as taxable income.
The eligibility test requires that the plan not favor highly compensated individuals in who gets to participate. A plan passes automatically if it covers 70% or more of all employees, or if 80% or more of eligible employees actually participate, or if it covers a nondiscriminatory classification of employees.
The benefits test requires that the same benefits be available to all eligible employees on equal terms. If management gets $10,000 in reimbursements but line workers get $2,000, the plan is discriminatory. The penalty falls on the highly compensated employees — not the employer. There are no monetary fines for the employer, but the HCEs lose their tax-free treatment.
Problematic plan designs include:
- Longer waiting periods for lower-paid employees
- Higher reimbursement amounts for executives
- Restricting eligibility to management-level employees only
A One-Person 105 HRA sidesteps these issues because there’s only one eligible employee. Once you hire a second eligible employee, however, the nondiscrimination rules kick in with full force.
Pros and Cons: Section 105 Plan vs. HSA
| Factor | Section 105 Plan | HSA |
|---|---|---|
| Pro: Deduction power | Deducts premiums and all out-of-pocket expenses as a business expense | Triple tax advantage: pre-tax contributions, tax-free growth, tax-free withdrawals |
| Pro: Flexibility | Employer designs the plan and chooses covered expenses | Account holder spends on any IRS-qualified expense without approval |
| Pro: No contribution cap | Most types have no statutory limit on reimbursement | Funds roll over and can be invested for decades |
| Pro: Premium coverage | Can reimburse health insurance premiums | After age 65, funds can be used for any purpose |
| Pro: Self-employment tax savings | Reduces self-employment tax because it’s a Schedule C deduction | Portable — you keep it if you change jobs or retire |
| Con: Not portable | Funds stay with the employer if employee leaves | Cannot reimburse insurance premiums (with limited exceptions) |
| Con: Compliance burden | Must comply with HIPAA, COBRA, ERISA, ACA, and Section 105(h) | Requires enrollment in an HDHP — high deductibles can be a financial strain |
| Con: Administrative cost | Requires plan documents, PCORI fee, and often a third-party administrator | Annual contribution caps limit how much you can shelter |
| Con: Entity restrictions | S-corp owners (>2%) and partners cannot participate | No self-employment tax reduction — deduction is on Form 1040, not Schedule C |
| Con: Nondiscrimination risk | Failing Section 105(h) tests makes reimbursements taxable for HCEs | Non-medical withdrawals before 65 trigger a 20% penalty plus income tax |
Mistakes to Avoid
Running a Section 105 Plan Without Written Documents
The IRS requires formal, written plan documents for any Section 105 plan. Operating without them is the fastest way to have every reimbursement reclassified as taxable income. The court in Shellito v. Commissioner emphasized the importance of documentation. Keep a plan document, employment contract, and timesheets for any employee-spouse.
Forgetting the PCORI Fee
Every Section 105 HRA, QSEHRA, and ICHRA triggers an annual PCORI (Patient-Centered Outcomes Research Institute) fee. It’s a small amount per covered life, but failing to pay it can draw IRS attention. The fee is reported on IRS Form 720 and due by July 31 each year.
Using a General-Purpose HRA While Contributing to an HSA
A general-purpose HRA that reimburses all medical expenses makes you ineligible for HSA contributions. If you want both, the HRA must be limited-purpose, post-deductible, or retirement-only. Getting this wrong means the IRS can impose a 6% excise tax on excess HSA contributions for every year the money stays in the account.
S-Corp Owners Trying to Use a One-Person 105 HRA
More-than-2% S-corporation shareholders are not treated as employees for purposes of tax-free fringe benefits. Their spouses are attributed the same ownership status. Attempting to set up a One-Person 105 HRA in an S-corp will not produce the intended tax benefits and can create reporting headaches.
Not Keeping Receipts and Substantiation
Employees must substantiate every claimed expense with proper documentation — receipts, explanations of benefits, and doctor’s notes. Both employers and employees should keep records for ten years. The IRS can disallow the entire deduction if you cannot prove that reimbursements were for legitimate medical expenses.
Contributing to an HSA While on Medicare
Once you enroll in Medicare, you lose HSA contribution eligibility. You can still spend existing HSA funds tax-free on medical expenses. But new contributions after Medicare enrollment trigger the 6% excise tax. Many people miss this when they turn 65 and auto-enroll in Medicare Part A.
Which Business Structures Work Best With Each Plan?
Your business entity determines which plan — or combination — gives you the most tax savings. The rules are strict and vary significantly by entity type.
Sole Proprietors (Schedule C). You cannot participate in your own Section 105 plan because the IRS does not treat self-employed individuals as employees under Section 105(g). The workaround: hire your spouse as a W-2 employee, make them the sole eligible employee, and set up a One-Person 105 HRA. Your spouse’s plan covers the entire family. You can also open an HSA if you have an HDHP.
C Corporations. The owner-employee is an employee. The corporation can fund a One-Person 105 HRA or QSEHRA and deduct all reimbursements as a business expense. The owner receives reimbursements tax-free. A C-corp is in the strongest position to combine a limited-purpose HRA with an HSA.
S Corporations (>2% owners). Owners cannot receive tax-free benefits from a Section 105 plan. The S-corp can pay premiums and report them as W-2 wages, and the owner takes the self-employed health insurance deduction. An HSA is available if the owner has an HDHP. Employees (who are not >2% shareholders) can be offered a QSEHRA or ICHRA.
Partnerships. Partners are treated like S-corp owners for health benefit purposes. They cannot participate in the partnership’s Section 105 plan. Health insurance premiums paid by the partnership are reported as guaranteed payments. Partners can use HSAs if they have HDHPs.
| Business Entity | Section 105 Available to Owner? | HSA Available? | Best Strategy |
|---|---|---|---|
| Sole Proprietor | Yes, via employee-spouse workaround | Yes, with HDHP | One-Person 105 HRA + HSA (limited-purpose) |
| C Corporation | Yes, owner is an employee | Yes, with HDHP | 105 HRA + HSA (limited-purpose) |
| S Corporation (>2%) | No | Yes, with HDHP | Self-employed deduction + HSA |
| Partnership | No | Yes, with HDHP | Guaranteed payments + HSA |
Do’s and Don’ts
Do’s
- Do create formal written plan documents before making any reimbursements — the IRS requires them and courts have denied deductions without them
- Do pay the annual PCORI fee on time if you operate any HRA, QSEHRA, or ICHRA
- Do keep timesheets and an employment contract if you hire your spouse — the IRS needs proof of a bona fide employment relationship
- Do consult a tax professional before combining a Section 105 plan with an HSA to ensure the HRA is properly limited in scope
- Do save all medical receipts and documentation for at least ten years
Don’ts
- Don’t set up a Section 105 plan if you’re a more-than-2% S-corp shareholder — it won’t produce tax-free benefits
- Don’t operate a general-purpose HRA and contribute to an HSA at the same time — this triggers a 6% excise tax on excess HSA contributions
- Don’t reimburse yourself under a Section 105 plan as a sole proprietor — the IRS says self-employed individuals are not employees under Section 105(g)
- Don’t forget to offer COBRA continuation if you have 20 or more employees and operate a Section 105 plan
- Don’t contribute to an HSA after enrolling in Medicare Part A — even retroactive enrollment can create excess contributions
Key Entities and How They Relate
The IRS sets the rules for both Section 105 plans and HSAs. It publishes annual HSA contribution limits, defines what qualifies as a medical expense under Section 213(d), and enforces Section 105(h) nondiscrimination rules. The IRS also requires the PCORI fee from all HRA sponsors.
The Department of Labor (DOL) oversees ERISA compliance for Section 105 plans. Because HRAs are considered group health plans, ERISA’s reporting, disclosure, and fiduciary rules apply. The DOL also enforces COBRA requirements for employers with 20+ employees.
Third-Party Administrators (TPAs) handle the day-to-day management of Section 105 plans. They process employee claims, verify substantiation, manage compliance, and protect employee health information under HIPAA. Using a TPA is not legally required but is strongly recommended — especially for QSEHRAs — because employers should not handle employees’ private health data directly.
HSA Custodians — typically banks or financial institutions — hold HSA funds. They issue debit cards, process investments, and provide annual tax reporting (Form 5498-SA and Form 1099-SA). Unlike TPAs for Section 105 plans, HSA custodians do not approve or deny individual expenses.
FAQs
Can I have a Section 105 plan and an HSA at the same time?
Yes. The Section 105 plan must be a limited-purpose, post-deductible, or retirement HRA. A general-purpose HRA disqualifies HSA contributions.
Does a Section 105 plan have contribution limits?
No — for most types. One-Person 105 HRAs and ICHRAs have no statutory caps. QSEHRAs have annual limits set by the IRS that adjust each year for inflation.
Can an S-corp owner use a Section 105 plan?
No. More-than-2% S-corp shareholders cannot receive tax-free Section 105 reimbursements. Their spouses are also attributed ownership, blocking the employee-spouse workaround.
Can I use HSA funds to pay insurance premiums?
No, with limited exceptions. HSA funds can pay for COBRA premiums, long-term care insurance, and Medicare premiums — but not regular health insurance premiums.
Do I need an HDHP to open an HSA?
Yes. You must be enrolled in a qualifying HDHP with a minimum deductible of $1,700 (individual) or $3,400 (family) for 2026.
Can a sole proprietor participate in their own Section 105 plan?
No. Under Section 105(g), self-employed individuals are not employees. A sole proprietor must hire a spouse as an employee to access Section 105 benefits indirectly.
What happens to my HSA if I enroll in Medicare?
You keep the account and can spend existing funds tax-free. You just cannot make new contributions once enrolled in Medicare.
What happens if my Section 105 plan fails nondiscrimination testing?
Highly compensated employees must report their reimbursements as taxable income. There are no monetary penalties for the employer — only the HCEs bear the tax consequences.
Is an HSA better than a Section 105 plan for retirement?
Yes, for long-term savings. HSA funds can be invested and grow tax-free for decades. After age 65, withdrawals for any purpose are penalty-free, though non-medical withdrawals are taxed as income.
Do I have to pay FICA taxes on Section 105 reimbursements?
No. Section 105 reimbursements are excluded from gross income and are not subject to FICA or Medicare tax — a major advantage over simply increasing an employee’s salary.
Related reading
- Does an HSA Really Lower Your Taxable Income? – Avoid This Mistake + FAQs
- What Qualifies as Medical Expenses for HSA? (w/Examples) + FAQs
- Can You Have an HRA and HSA? (w/Examples) + FAQs
- Should I Choose an HRA or HSA? (w/Examples) + FAQs
- Are HSA Contributions Worth It? (w/Examples) + FAQs
- Does an HSA Beat a 401(k) for Retirement Savings? (w/Examples) + FAQs
- Is Section 105 Reimbursement Taxable Income? (w/Examples) + FAQs