Section 105 HRA Plan: Variations, Setup, and Compliance

A Section 105 HRA plan is an employer-funded health reimbursement arrangement, authorized by Section 105 of the Internal Revenue Code, that pays employees back for qualified medical expenses and insurance premiums without the reimbursements counting as taxable income. The employer deducts what it pays out as a business expense; the employee receives the money free of federal income tax, Social Security tax, and Medicare tax. That two-sided tax treatment is why these plans exist.

How the Tax Benefit Actually Works

Section 105(a) starts with a general rule that any payment an employee receives through an employer health plan is taxable. Section 105(b) then excludes reimbursements specifically for medical care from the employee’s gross income.¹ That single exclusion is the engine behind every Section 105 HRA. Reimbursements that qualify are not subject to federal income tax, Social Security, or Medicare.

For the employer, the money paid through the HRA is an ordinary business expense, fully deductible under Section 162.² The employer also avoids the payroll tax it would owe if the same dollars went out as wages.

One rule is absolute: only the employer funds the HRA. Employees cannot contribute their own money. The account works like a line of credit earmarked for medical expenses, not a bank account the employee owns. When the employee leaves, any remaining balance generally stays with the employer unless the plan says otherwise or COBRA applies.

What the Plan Can Reimburse

The outer boundary of “medical care” comes from Section 213(d), which covers diagnosis, treatment, and prevention of disease, along with insurance premiums for those services.³ Employers are not required to cover that full range. Most plans narrow it to categories like deductibles, copays, prescription drugs, dental, or vision.

Over-the-counter medications and health products became reimbursable without a prescription in 2020 under the CARES Act, and that change is permanent for HRAs.⁴ Pain relievers, allergy medication, and first-aid supplies qualify as long as the plan document permits them.

Employers also decide what happens to unused funds at year-end. Two options:

Carryover: unused amounts roll into the next plan year, building a larger available balance over time.
Forfeit: any remaining balance at year-end disappears (a use-it-or-lose-it design).

Whichever the employer picks has to be written into the plan document before the plan year starts. Changing the policy mid-year isn’t allowed.

Who Cannot Participate

Section 105 HRAs are for common-law employees only. Self-employed individuals, sole proprietors, partners in a partnership, and LLC members taxed as partners are all ineligible, because Section 105(b) limits the income exclusion to employees and the tax code does not treat self-employed people as their own employees for this purpose.

The same restriction catches S-corporation shareholders who own more than 2% of the company. The IRS treats these owners as self-employed for health benefit purposes, so reimbursements they receive through an HRA cannot be excluded from income under Section 105(b).⁵ This is a common trap for small business owners who set up a plan expecting to participate alongside their staff. C-corporation shareholder-employees are treated as regular employees and can participate fully.

Setting Up the Written Plan Document

An HRA must be established through a formal written document. Federal regulations define a self-insured medical reimbursement plan as “a separate written plan for the benefit of employees which provides for reimbursement of employee medical expenses.”⁶ Without that document in place before benefits begin, the IRS can treat every reimbursement as taxable wages. It is the most straightforward way for a small employer to lose the entire tax benefit.

At a minimum, the plan document should cover:

Eligibility rules, including which employees qualify and any waiting periods.
The annual allowance, expressed as a maximum dollar amount per plan year.
The specific categories of medical expenses the plan will reimburse.
The claims procedure employees must follow.
The 12-month plan year used for tracking benefits.
The carryover or forfeiture policy.

The document must be signed and dated by someone authorized to act for the company before the plan’s effective date. Employers subject to ERISA (most private-sector employers) must also produce and distribute a Summary Plan Description in plain language.

Modern Variations You Can Choose From

The basic Section 105 framework has been adapted into several regulated models, each designed for a different employer situation and each structured to comply with Affordable Care Act rules.

Individual Coverage HRA (ICHRA)

An ICHRA lets employers of any size reimburse employees tax-free for individual health insurance premiums and other medical expenses, as an alternative to offering traditional group coverage.⁷ The employee must be enrolled in an individual health insurance policy, purchased on or off the Marketplace, to use the benefit. The employer cannot offer both a traditional group plan and an ICHRA to the same class of employees.

There is no statutory cap on how much the employer can contribute. Within an employee class, the allowance can vary by age and number of dependents, but the age-based variation cannot exceed a 3-to-1 ratio between the oldest and youngest participants.⁷ Employers can also segment the workforce into permitted classes (full-time versus part-time, salaried versus hourly, different locations, employees under a collective bargaining agreement) and offer the ICHRA to some classes while keeping traditional group coverage for others. Classes cannot be drawn by health status.

One wrinkle for employees: if your employer offers you an ICHRA, you generally cannot claim the Premium Tax Credit for Marketplace coverage unless the ICHRA is considered unaffordable and you opt out of it entirely.⁸ Affordability is measured against the lowest-cost silver plan in the employee’s area, with the threshold falling around 9% of household income after the ICHRA allowance is applied.

Qualified Small Employer HRA (QSEHRA)

The QSEHRA is for small businesses with fewer than 50 full-time equivalent employees that do not offer any group health plan.⁹ It has statutory contribution caps. For 2026, the maximum is $6,450 for self-only coverage and $13,100 for family coverage.¹⁰ These limits are adjusted annually.

Reimbursements are tax-free only if the employee maintains minimum essential coverage. An employee without qualifying insurance who receives QSEHRA reimbursements must include those amounts in taxable income. The QSEHRA amount also reduces any Premium Tax Credit dollar for dollar.

Employers must give every eligible employee a written notice at least 90 days before the start of each plan year, and new hires must receive the notice when they first become eligible.⁹ The notice must state the annual benefit amount and remind the employee to report the allowance to the Marketplace if they receive a Premium Tax Credit.

Excepted Benefit HRA (EBHRA)

The Excepted Benefit HRA is a smaller supplemental arrangement offered alongside a traditional group health plan. It reimburses expenses like dental, vision, copays, and short-term limited-duration insurance premiums. For plan years beginning in 2026, the maximum annual contribution is $2,200.¹¹ The employer must offer traditional group coverage in conjunction with the EBHRA, though employees are not required to enroll in the group plan to use it.¹² The EBHRA cannot reimburse individual health insurance premiums or group plan premiums other than COBRA.

How HRAs Interact with Health Savings Accounts

This is where employers who offer both a high-deductible health plan and an HRA frequently get into trouble. A standard HRA that reimburses general medical expenses before the employee has satisfied the HDHP deductible counts as disqualifying coverage for HSA purposes.¹³ An employee with that kind of HRA cannot contribute to an HSA even if enrolled in a qualifying high-deductible plan.

Three HRA designs preserve HSA eligibility:

Post-deductible HRA, which only reimburses expenses incurred after the employee has met the statutory minimum HDHP deductible ($1,700 self-only or $3,400 family in 2026).¹³
Limited-purpose HRA, covering only dental and vision, which count as permitted coverage.
Preventive-care-only HRA, covering only preventive services that HDHPs are already allowed to provide at first dollar.

Getting this wrong isn’t just administrative. Employees who contribute to an HSA while covered by a disqualifying HRA face a 6% excise tax on the excess contributions for every year those amounts stay in the account.

Nondiscrimination Testing

Self-insured HRAs must pass nondiscrimination tests under Section 105(h). The rules prevent an employer from funneling disproportionate benefits to highly compensated individuals. There are two prongs: an eligibility test asking whether rank-and-file employees can participate on terms comparable to executives, and a benefits test asking whether highly compensated individuals receive richer reimbursements.¹⁴

A “highly compensated individual” for these purposes means any of the five highest-paid officers, any shareholder owning more than 10% of the company’s stock, or anyone in the top 25% of all employees by compensation.¹⁴ If the plan fails either test, only those individuals lose their tax exclusion. Rank-and-file employees keep tax-free treatment regardless.

The ICHRA has its own nondiscrimination framework built into the class rules, so traditional 105(h) testing doesn’t apply. QSEHRAs must be offered on the same terms to all eligible employees, which satisfies nondiscrimination by design. Traditional 105(h) testing matters most for standard HRAs and EBHRAs offered alongside group coverage.

Substantiation, COBRA, and HIPAA

Every reimbursement must be backed by documentation showing the expense qualifies. Acceptable proof includes an explanation of benefits from an insurance carrier or a detailed receipt from a provider showing the date, the service, and the amount owed. A credit card statement or cancelled check alone does not qualify, because neither identifies what the payment was for. The administrator must also verify the expense hasn’t been reimbursed by another source, such as an insurance plan, an FSA, or a second HRA. When substantiation breaks down across the plan, the IRS can retroactively reclassify all reimbursements as taxable wages.

Because an HRA is a group health plan, employers with 20 or more employees must offer COBRA continuation coverage when an employee has a qualifying event like job loss, a reduction in hours, or divorce.¹⁵ The obligation extends to the HRA balance even if the employer also offers COBRA on its insured medical plan. The COBRA premium for the HRA can be calculated from past utilization or an actuarial estimate, plus up to 2% for administration.

Administering claims means handling protected health information under HIPAA. The employer must develop written privacy policies, designate a privacy official, and train staff who access participant medical data.¹⁶ The plan document must certify that the employer will not use PHI received through the HRA for employment decisions or for any other benefit plan. Small employers often delegate claims administration to a third-party administrator to create a firewall between the employer and employees’ medical details.

Annual Reporting Obligations

Running an HRA creates a handful of annual filings that vary by plan type and size.

For a QSEHRA, the employer reports the total permitted benefit for each employee on Form W-2 in Box 12 with Code FF.¹⁰ The reported amount is the benefit the employee was entitled to receive for the year, not the amount actually reimbursed. If the plan offered $6,000 but the employee claimed $2,000, the W-2 still shows $6,000.

Every HRA sponsor pays the Patient-Centered Outcomes Research Institute (PCORI) fee annually on IRS Form 720. For plan years ending between October 2025 and September 2026, the fee is $3.84 per covered life.¹⁷ Form 720 is due by July 31 of the year after the plan year ends. The fee is small per person, but skipping it invites IRS scrutiny and late-payment penalties.

If the HRA is subject to ERISA, the employer may also need to file Form 5500 with the Department of Labor. Plans with 100 or more participants at the start of the plan year file as large plans and include a financial audit. Smaller plans may qualify for simplified filing or an exemption when the plan is unfunded or fully insured.¹⁸ QSEHRAs are generally exempt from ERISA and therefore exempt from Form 5500.

1
Office of the Law Revision Counsel. 26 USC 105 – Amounts Received Under Accident and Health Plans
2
Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses
3
Office of the Law Revision Counsel. 26 USC 213 – Medical, Dental, Etc., Expenses
4
Internal Revenue Service. IRS Outlines Changes to Health Care Spending Available Under CARES Act
5
Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues
6
eCFR. 26 CFR 1.105-11 – Self-Insured Medical Reimbursement Plan
7
HealthCare.gov. Individual Coverage Health Reimbursement Arrangements
8
Internal Revenue Service. Updates to Questions and Answers About the Premium Tax Credit
9
HealthCare.gov. Health Reimbursement Arrangements (HRAs) for Small Employers
10
Internal Revenue Service. 2026 General Instructions for Forms W-2 and W-3
11
Internal Revenue Service. Revenue Procedure 2025-19 – Inflation Adjusted Items for HSAs and Excepted Benefit HRAs
12
CMS Agent and Broker FAQ. What Is an Excepted Benefit Health Reimbursement Arrangement
13
Internal Revenue Service. Expanded Availability of Health Savings Accounts Under the One, Big, Beautiful Bill Act
14
Internal Revenue Service. Section 105(h) Nondiscrimination Guidance
15
U.S. Department of Labor. Continuation of Health Coverage (COBRA)
16
U.S. Department of Health and Human Services. Summary of the HIPAA Privacy Rule
17
Internal Revenue Service. Patient Centered Outcomes Research Trust Fund Fee Questions and Answers
18
U.S. Department of Labor. 2024 Instructions for Form 5500