IRC Section 105: Taxable Rules, Exceptions, and Self-Insured Plans

Under IRC Section 105, amounts you receive through an employer-funded accident or health plan are included in your gross income by default, but the same section carves out three exceptions that make many of those payments tax-free: reimbursements for actual medical expenses, payments for permanent bodily injury or disfigurement, and certain other statutory benefits. Whether a specific payment ends up on your W-2 turns on who paid the premiums, what the money is actually paying for, and, for self-insured arrangements, whether the plan meets federal nondiscrimination standards.¹

The Default Rule Is Taxable

Section 105(a) opens with a broad inclusion. If your employer paid the premiums, or if the plan is otherwise funded with employer contributions that were never included in your wages, then any amount the plan pays you goes into gross income.¹ The clearest example is wage-replacement sick pay. If the plan cuts you a check while you’re out sick, the money is taxed the same as the paycheck it substitutes for. Everything that doesn’t fit one of the specific exceptions below stays taxable.

Who Paid the Premium Changes the Math

The split between employer and employee funding matters more than most people expect. When the employer funds the plan entirely, every benefit dollar runs through Section 105(a). When you pay part of the premium with after-tax dollars, only the employer-funded share of any benefit is subject to Section 105. The portion traceable to your own after-tax contributions is excluded from income under Section 104(a)(3).²

The allocation is proportional. If your employer pays two-thirds of the annual premium and you pay the remaining third from after-tax wages, then two-thirds of each benefit payment falls under Section 105(a) and the other third is tax-free. That distinction can meaningfully change what you owe if you receive disability or sick-pay benefits from a contributory plan.

Tax-Free Reimbursements for Medical Expenses

The exception most people rely on is Section 105(b). It excludes from income amounts a plan pays to reimburse you for actual medical expenses. The reimbursement has to be for “medical care” as defined in Section 213(d), which covers costs for diagnosing, treating, or preventing disease, and care that affects any structure or function of the body. Transportation essential to medical treatment and qualified long-term care services also count.³

The operative word is reimburse. The plan has to pay you back for expenses you actually incurred. A flat payment triggered by a diagnosis, with no requirement that you spend anything on treatment, doesn’t qualify. That kind of payment stays taxable under the default rule.

Family Members Covered

The 105(b) exclusion isn’t limited to your own medical bills. Tax-free reimbursements extend to expenses for your spouse, your tax dependents, and any of your children who have not turned 27 by the end of the tax year.¹ The under-27 rule is useful because the child doesn’t need to qualify as your tax dependent. A 25-year-old who files independently and earns their own income can still be covered.

For divorced or separated parents, the statute treats a child subject to the custodial-parent rules under Section 152(e) as a dependent of both parents for purposes of this exclusion.¹ Either parent’s plan can reimburse the child’s medical expenses tax-free.

Watch the Double-Benefit Trap

If you claimed a medical expense as an itemized deduction under Section 213 in a prior year and then get reimbursed for that same expense, the reimbursement cannot be excluded under Section 105(b).¹ You don’t get to benefit from the same expense twice.

Tax-Free Payments for Permanent Injury or Disfigurement

Section 105(c) provides a separate exclusion for payments tied to permanent bodily harm. A payment from your employer’s plan for the permanent loss or loss of use of a body part or function, or for permanent disfigurement, is tax-free if two conditions are met:⁴

The harm must be permanent, not temporary.
The payment amount must be determined by the nature of the injury, not by how long you’re out of work.

That second requirement is the line between this exclusion and ordinary sick pay. If a plan pays $50,000 for the loss of a hand under a schedule tied to the injury itself, the payment is excludable. If the same plan pays $1,000 a week for every week you’re absent after losing that hand, those weekly checks are wage replacement and taxable under Section 105(a). The exclusion covers the injury, not the absence. It applies to permanent injuries suffered by you, your spouse, or your dependents.

What Counts as a Plan

The threshold for an “accident and health plan” under Section 105 is lower than most people expect. The plan does not need to be in writing. It does not need to be legally enforceable. It does not need to be underwritten by an insurance company. Under Treasury Regulation 1.105-5, the arrangement only has to be a plan, program, policy, or established custom that provides for payments to employees in the event of personal injury or sickness.⁵

There is a practical requirement, though. The employee has to have had notice or knowledge that the plan existed before becoming sick or injured. An employer who decides after the fact to reimburse one employee’s medical bills as a one-time favor hasn’t established a plan for Section 105 purposes. The arrangement needs to be in place before the triggering event, and the employee needs to have reasonably known about it.⁵ A written plan document isn’t strictly required, but without one, proving to the IRS that a legitimate plan existed before the expense arose becomes much harder.

Nondiscrimination Rules for Self-Insured Plans

When an employer self-funds a medical reimbursement plan rather than buying insurance from a commercial carrier, Section 105(h) layers on nondiscrimination requirements. The rules exist to stop employers from setting up tax-free reimbursement plans that benefit only their highest-paid people.⁴

Who Is a Highly Compensated Individual

Section 105(h) uses its own definition, distinct from the “highly compensated employee” definition used for retirement plan testing. Under Section 105(h)(5), a highly compensated individual is anyone who is one of the five highest-paid officers of the company, a shareholder who owns more than 10% of the company’s stock under constructive ownership rules, or among the highest-paid 25% of all employees.¹

The Two Tests

A self-insured plan has to pass both an eligibility test and a benefits test to preserve the Section 105(b) exclusion for its highly compensated participants.

The eligibility test can be met one of two ways: the plan benefits at least 70% of all employees, or it benefits at least 80% of eligible employees where at least 70% of all employees are eligible. Alternatively, the plan can use an employee classification the IRS does not treat as discriminatory. Certain workers can be excluded from the count without penalty, including those with fewer than three years of service, those under 25, part-time or seasonal workers, and employees covered by a collective bargaining agreement.⁴

The benefits test is simpler. Every benefit available to highly compensated individuals also has to be available to all other plan participants. A plan offering $10,000 annual reimbursements to executives but only $2,000 to everyone else fails.

What Failure Costs

When a self-insured plan fails either test, the tax consequence falls on the highly compensated individuals alone. Their reimbursements become “excess reimbursements” that must be included in gross income. Rank-and-file employees keep excluding their benefits under Section 105(b) as usual.⁶

Self-Employed Individuals Are Excluded

Section 105(g) states outright that a self-employed individual is not treated as an employee for purposes of this section.¹ Sole proprietors, partners, and S-corporation shareholders who own more than 2% of the company can’t receive tax-free medical reimbursements under Section 105(b) through their own business’s plan. Other benefits, such as the self-employed health insurance deduction under Section 162(l), may still be available, but the Section 105 exclusion isn’t.

How Section 106 Fits In

Section 105 handles the employee’s tax treatment of benefits coming out. Section 106 handles the employer’s contributions going in. Under Section 106(a), employer contributions to an accident or health plan are excluded from the employee’s gross income.⁷ The employer can fund the plan by paying premiums, contributing to a trust, or paying benefits directly.

The interplay is what makes employer-sponsored health coverage so tax-efficient. The contribution goes in tax-free under Section 106, and if the benefits come back out as qualifying medical expense reimbursements, they leave tax-free under Section 105(b). The money never hits the employee’s taxable income at either end.

1
Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans
2
eCFR. 26 CFR 1.105-1 – Amounts Attributable to Employer Contributions
3
Office of the Law Revision Counsel. 26 U.S. Code 213 – Medical, Dental, Etc., Expenses
4
Office of the Law Revision Counsel. 26 USC 105 – Amounts Received Under Accident and Health Plans
5
GovInfo. 26 CFR 1.105-5 – Accident and Health Plans
6
eCFR. 26 CFR 1.105-11 – Self-Insured Medical Reimbursement Plan
7
eCFR. 26 CFR 1.106-1 – Contributions by Employer to Accident and Health Plans