How to Set Up a Section 105 Medical Reimbursement Plan

Setting up a Section 105 medical reimbursement plan takes six moves in order: confirm your business entity lets the people you want to cover actually participate, adopt a written plan document before any reimbursement is paid, choose the HRA structure that fits your size and insurance setup, define covered expenses and reimbursement limits, satisfy the Section 105(h) nondiscrimination tests, and stand up the ongoing compliance and administration the plan requires from that point forward. Get those in the right sequence and every dollar reimbursed comes out of the employee’s paycheck tax-free and off the employer’s books as an ordinary business deduction.

Confirm Your Entity Type Allows the Owners to Participate

Before anything else, look at how the business is organized for tax purposes. Section 105(g) of the Internal Revenue Code excludes self-employed individuals from the definition of “employee,” and that single exclusion decides who actually gets the tax break.¹

C-Corporation owners who work in the business are common-law employees and receive tax-free reimbursements on the same terms as any other participant.
S-Corporation shareholders owning more than 2% of the stock are treated as partners for fringe benefit purposes under Section 1372, which makes them self-employed for this rule and ineligible for tax-free Section 105 reimbursements. The S-Corp can still pay their health insurance premiums, but the premiums go in Box 1 of the W-2 as wages, and the shareholder claims an above-the-line deduction on their personal return.²
Sole proprietors and partners are self-employed by definition and cannot participate.

Where the owner is ineligible, a spouse who is a genuine common-law employee of the business, with real duties, regular hours, and W-2 wages, can participate and cover family members through their benefit. The employment relationship has to be real. A spouse on payroll with no schedule and no duties is the kind of arrangement the IRS unwinds.

Draft and Adopt the Written Plan Document

Federal regulations require the plan to be “a separate written plan for the benefit of employees,” and the document must exist before the first reimbursement. Pay a claim without one and every payment is taxable wages, with no way to fix it retroactively.³

At a minimum, the document needs to spell out:

The effective date. Expenses incurred before this date are not reimbursable.
Eligibility rules, including which employee categories are excluded.
The specific medical expenses the plan will reimburse.
The annual or monthly reimbursement cap per participant.
The claims procedure: how employees file, what documentation they submit, and the deadline.
A statement that the plan is intended to qualify under Section 105(b).

Adoption is formal. Corporations use a board resolution; other entities use an equivalent written action. The signed, dated resolution and plan document go into the business’s permanent records. Third-party administrators often provide templates, but the employer is still the party that legally adopts the plan.

Choose the HRA Structure That Fits Your Situation

Section 105 is the legal framework. The Health Reimbursement Arrangement is the vehicle. Which HRA works depends mostly on whether you already offer group health insurance and how many employees you have. A standalone HRA that reimburses medical expenses up to a cap without integration into one of these categories violates ACA market reform rules, because HRAs are group health plans subject to the ban on annual dollar limits for essential health benefits and to preventive care requirements.⁴⁵

Integrated HRA

If you already offer employer-sponsored group health insurance, an integrated HRA is the simplest choice. It reimburses out-of-pocket costs like deductibles and copays that the group plan doesn’t cover, and it satisfies ACA rules automatically through its pairing with qualifying group coverage.

Qualified Small Employer HRA (QSEHRA)

A QSEHRA works for employers with fewer than 50 employees that do not offer group health insurance. Employees use the reimbursement toward individual coverage they buy on their own. For 2026, the maximum annual reimbursement is $6,450 for employee-only coverage and $13,100 for family coverage.⁶ A QSEHRA must be offered on the same terms to all eligible employees, and employees need minimum essential coverage to receive reimbursements tax-free.

Individual Coverage HRA (ICHRA)

An ICHRA is available to employers of any size and has no cap on employer contributions.⁷ Employees must have their own individual health insurance to use the funds. The flexibility is in how you can set contributions by employee class (full-time versus part-time, salaried versus hourly, different geographic areas), provided everyone within a class gets the same terms. You cannot offer the same class a choice between an ICHRA and a traditional group plan.

Define Covered Expenses and Reimbursement Limits

Section 105(b) ties the income exclusion to expenses that qualify as “medical care” under Section 213(d). The definition is broad: amounts paid for diagnosing, treating, or preventing disease, and for affecting any structure or function of the body.⁸ Doctor visits, prescriptions, hospital stays, dental, vision, mental health treatment, long-term care, and, since 2020, over-the-counter medications and menstrual care products without a prescription all fall inside.

The plan document specifies which of these the plan actually covers. Most employers cover the full range, but you can narrow it. What you can’t do is vary the covered categories by employee. Whatever you cover has to be available on the same terms to every participant.

Every plan needs a defined annual limit per participant. A flat dollar amount works, and so does varying by coverage tier (employee-only versus employee-plus-family), because that variation relates to scope of coverage rather than compensation. What breaks the plan is giving higher limits to highly compensated employees. Within each coverage tier, the cap has to be uniform across all participants. There is no federally set maximum for a standard Section 105 plan integrated with group health insurance; the employer picks what it can afford. QSEHRA and ICHRA have their own limit rules described above.

Pass the Section 105(h) Nondiscrimination Tests

Section 105(h) blocks plans that only benefit the people at the top. Fail these tests and the tax-free treatment disappears for highly compensated individuals, though rank-and-file employees keep theirs.¹

Who Counts as a Highly Compensated Individual

A highly compensated individual (HCI) falls into one of three groups: the five highest-paid officers of the company regardless of title; anyone owning more than 10% of the employer’s stock, with family and related-entity attribution under Section 318; or the top 25% of all employees by compensation, after excluding the categories below.

Employees You Can Exclude When Testing

When you run the tests, you can leave several groups out of the employee count:⁹

Employees under age 25
Employees with fewer than three years of service
Part-time and seasonal employees
Employees covered by a collective bargaining agreement where health benefits were part of good-faith negotiations
Nonresident aliens with no U.S.-source earned income

These exclusions apply to the testing calculation, not to who you can cover. You can extend the plan to part-time workers, but you don’t have to count them when checking whether enough non-HCI employees benefit.

The Two Tests

The eligibility test asks whether enough non-HCI employees actually benefit. It offers two paths: cover at least 70% of all non-excludable employees, or make at least 70% eligible and cover at least 80% of those eligible. A third alternative allows the plan to pass if it benefits a classification of employees the IRS finds nondiscriminatory.

The benefits test asks whether HCIs and non-HCIs get the same deal. Every benefit available to a highly compensated participant has to be available to all other participants on the same terms. A plan that reimburses HCIs up to $10,000 and non-HCIs up to $5,000 fails.

Failure doesn’t blow up the plan. Only HCIs lose their tax-free treatment on the excess amount, and the employer must include the excess in the HCI’s W-2 wages for that year. Non-HCI employees are unaffected either way.

Handle the Ongoing Compliance Obligations

Once the plan is running, several federal obligations attach and stay attached.

COBRA

If your business employed 20 or more workers on more than half of its typical business days in the prior calendar year, the Section 105 plan is subject to COBRA.¹⁰ Employees who lose coverage in a qualifying event get the right to continue the HRA benefit at their own expense. Both full-time and part-time employees count toward the 20-employee threshold, with part-time counted as a fraction of a full-time schedule. Address COBRA in the plan document even if you’re currently below the threshold, because crossing it mid-year is easy to miss.

PCORI Fees

Section 105 HRAs are self-insured health plans and owe the Patient-Centered Outcomes Research Institute fee each year. For plan years ending between October 1, 2025, and September 30, 2026, the fee is $3.84 per covered life.¹¹ Report and pay on IRS Form 720, due July 31 following the plan year’s end. The amount is small; the penalty for missing the filing is not.

Form 5500

A self-insured, unfunded medical reimbursement plan (benefits paid from the employer’s general assets) that covers fewer than 100 participants at the start of the plan year is exempt from Form 5500.¹² At 100 participants, annual filing starts. Employers with multiple welfare benefit plans under a single plan document need to aggregate participants across them when counting.

HIPAA

Because the plan is a group health plan, HIPAA privacy obligations attach. How heavy those obligations are depends on the employer’s size, whether a TPA processes claims, and whether protected health information moves electronically. Self-insured, self-administered plans at employers with fewer than 50 employees that don’t transmit PHI electronically may qualify for reduced requirements. Larger employers or those using a TPA generally need a Notice of Privacy Practices, safeguards for health information, and periodic reminders to employees of their privacy rights. First-time self-insured plan sponsors should get a benefits attorney or compliance specialist to map their specific obligations.

Set Up Claims Processing, Records, and Tax Reporting

A plan that reads well on paper can still lose its tax status through weak administration.

Every eligible employee gets a Summary Plan Description explaining what the plan covers, the reimbursement limit, and how to file a claim. Distribute it at enrollment and again when the plan changes. Beyond satisfying disclosure obligations, this creates a paper trail showing the plan was actually offered to the full eligible workforce.

Employees submit claims with documentation showing the expense was incurred and what it was for: an EOB from an insurer, a provider invoice, or a pharmacy receipt with the date of service and amount paid. The employer or TPA verifies the expense qualifies under the plan and under Section 213(d) before approving reimbursement. Reimbursements can’t be paid for expenses that haven’t been incurred yet, and expenses already covered by insurance don’t qualify.⁸ TPAs charge a per-employee monthly fee and handle adjudication, substantiation, and recordkeeping. Self-administration is possible for very small plans, but the administrative load and HIPAA exposure make outsourcing worth considering past a handful of participants.

Keep the signed plan document, every version of the SPD, and each year’s nondiscrimination testing results. Keep individual claim records showing what was submitted, the documentation, the verification decision, and the amount paid. Standard practice is retention for at least seven years, with some practitioners keeping plan documents permanently.

Qualifying reimbursements are excluded from the employee’s gross income under Section 105(b) and don’t appear as wages on the W-2. The employer deducts total reimbursements under Section 162 as an ordinary business expense.¹³ If nondiscrimination testing turns up excess reimbursements to HCIs, those amounts get added to the HCI’s W-2 income for the year. Reporting errors in either direction cost money: taxing amounts that should have been tax-free costs employees, and leaving discriminatory excess unreported exposes the employer to penalties.

1
Office of the Law Revision Counsel. 26 USC 105 – Amounts Received Under Accident and Health Plans
2
Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues
3
eCFR. 26 CFR 1.105-11 – Self-Insured Medical Reimbursement Plan
4
U.S. Department of Labor. FAQs about Affordable Care Act Implementation, Part 37
5
Internal Revenue Service. IRS Notice 2013-54 – Application of Market Reform and Other Provisions of the Affordable Care Act to HRAs, Health FSAs, and Certain Other Employer Healthcare Arrangements
6
Internal Revenue Service. Revenue Procedure 2025-32 – Inflation Adjusted Items for 2026
7
HealthCare.gov. Individual Coverage Health Reimbursement Arrangement
8
Office of the Law Revision Counsel. 26 USC 213 – Medical, Dental, Etc., Expenses
9
Internal Revenue Service. Technical Assistance Request – Section 105(h) Nondiscrimination Rules
10
U.S. Department of Labor. FAQs on COBRA Continuation Health Coverage for Workers
11
Internal Revenue Service. Patient-Centered Outcomes Research Trust Fund Fee Questions and Answers
12
U.S. Department of Labor. Form 5500 Instructions – 2025
13
Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses