Self-Insured Medical Reimbursement Plan: Tax Rules and Section 105(h)

A self-insured medical reimbursement plan is an arrangement in which an employer pays employees’ medical expenses directly from company funds rather than buying coverage from an insurance carrier. Reimbursements that meet Internal Revenue Code Section 105 come out of the employee’s pocket tax-free and out of the employer’s books as a deductible business expense.¹ The trade-off is that the employer, not an insurer, carries the financial risk of every claim, and the plan has to satisfy federal nondiscrimination and compliance rules to keep its tax-favored status.

How the Plan Works

No insurance company sits in the middle. The employer funds claims as they come in, drawing from a trust, a dedicated account, or general business assets. In a light-claims year the employer keeps the savings. In a heavy-claims year the employer absorbs the higher cost. That volatility is the main drawback and the reason most mid-to-large self-insured employers pair the arrangement with stop-loss insurance.

Most employers hire a third-party administrator (TPA) to process claims, issue reimbursements, communicate with employees, and run compliance tests. The TPA handles paperwork without taking on financial risk. Covered expenses typically include deductibles, copayments, coinsurance, and prescription drug costs, though the employer has broad discretion to define what the plan reimburses.

Tax Treatment for Employers and Employees

Amounts the employer pays under the plan are deductible as ordinary business expenses. On the employee side, reimbursements for qualified medical expenses are excluded from gross income under IRC Section 105(b), so the money arrives tax-free.¹ Those same reimbursements are excluded from wages for FICA purposes, so neither party owes Social Security or Medicare tax on them.²

Compare that to a straight raise. Hand an employee an extra $5,000 in salary to cover medical bills and both sides pay payroll taxes and the employee pays income tax. Run the same $5,000 through a compliant plan and all of those taxes disappear. The exclusion applies to medical care as defined in the tax code, which covers hospital stays, surgery, prescription drugs, dental work, and more. It also extends to reimbursements for the employee’s spouse, dependents, and children under age 27.¹

Business Owners Who Can’t Take Tax-Free Reimbursements

This is where small-business owners trip up. The Section 105(b) exclusion is available only to common-law employees, and the statute says self-employed individuals do not count as employees for this purpose.¹ Three categories of owners are shut out:

Sole proprietors. You own the business, so you are not your own employee. Reimbursements to yourself through the plan are not excludable.
Partners in a partnership. Partners are self-employed for tax purposes and face the same restriction.
S-corporation shareholders owning more than 2%. The IRS treats these individuals the same as self-employed persons and bars them from participating in an HRA or other self-insured arrangement on a tax-free basis.³

A sole proprietor or partner whose spouse is a legitimate W-2 employee of the business can sometimes work around this. The spouse enrolls as the employee, and the plan’s family coverage reimburses expenses for the owner-spouse as a dependent. The employment has to be genuine, with real duties and reasonable pay, not a paper position created for the tax benefit. If you fall into one of these owner categories, get professional guidance before assuming reimbursements will come to you tax-free.

Nondiscrimination Testing Under Section 105(h)

The tax exclusion is not automatic. The plan must pass two annual tests under Section 105(h), both designed to prevent employers from giving their highest earners better coverage than everyone else. If the plan fails, the consequences fall on the highly compensated individuals (HCIs), not on rank-and-file employees, who continue to receive their reimbursements tax-free.⁴

An HCI is anyone in at least one of three categories: one of the five highest-paid officers, a shareholder who owns more than 10% of the employer’s stock, or someone among the highest-paid 25% of all employees.¹

The Eligibility Test

The eligibility test looks at who is allowed to participate. A plan passes if it covers at least 70% of all employees, or at least 80% of eligible employees when at least 70% are eligible. The employer can exclude several categories from the count:¹

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

The Benefits Test

The benefits test looks at what participants actually receive. Every benefit available to an HCI must be available on the same terms to all other plan participants. Reimburse executives up to $10,000 a year while capping everyone else at $5,000 and the plan fails. Cover certain procedures only for HCIs and it fails.

What Failure Costs

Failure doesn’t blow up the plan for everyone. Rank-and-file employees keep their tax-free reimbursements. The damage lands on HCIs, who must include their “excess reimbursement” in taxable income for that year. If the plan failed the benefits test, the excess reimbursement equals the full amount of the discriminatory benefit the HCI received. If the plan failed the eligibility test, it’s a proportional share based on the ratio of total HCI benefits to total plan benefits. Failing both compounds the result.

ACA, COBRA, and HIPAA Requirements

Self-funding does not exempt an employer from most Affordable Care Act market reforms. Self-insured plans must:

Impose no annual or lifetime dollar limits on essential health benefits.⁵
Cover adult children up to age 26 on a parent’s plan.
Cover evidence-based preventive care with no cost-sharing.
Satisfy mental health parity: limitations on mental health and substance use disorder benefits cannot be stricter than those applied to medical and surgical benefits.

Self-insured plans are generally exempt from state insurance mandates because ERISA preempts state regulation of employer-sponsored plans. The federal requirements above apply regardless of funding.

Employers with 20 or more employees must offer COBRA continuation coverage when a qualifying event occurs, such as job loss or a reduction in hours. COBRA applies to any group health plan that provides medical care, whether insured or self-funded.⁶ The departing employee pays the full cost plus up to a 2% administrative fee, but the employer administers the continuation and provides required notices.

A self-insured plan is a covered entity under HIPAA.⁷ If a TPA or other vendor handles protected health information, a written business associate agreement must be in place. The employer must also establish safeguards to keep claims data and medical records separate from employment decisions.

Stop-Loss Insurance

The biggest fear with self-funding is a catastrophic claims year. One cancer diagnosis or one premature birth can generate hundreds of thousands of dollars in claims. Stop-loss insurance caps that exposure, and most self-insured employers carry both types.

Specific stop-loss protects against any single person’s claims exceeding a set attachment point. If the attachment point is $50,000 and one employee generates $200,000 in claims, the stop-loss carrier reimburses the employer for the $150,000 above the threshold.

Aggregate stop-loss protects against total plan claims exceeding a ceiling for the year, typically set around 125% of expected annual claims. If the employer expected $1 million in claims and the aggregate attachment point is $1.25 million, the carrier covers everything above $1.25 million.

Carrying both is standard. Specific handles the shock of one extraordinarily expensive case. Aggregate handles a year where many employees file moderate-to-large claims that individually stay below the specific threshold but collectively blow past the budget.

Setting Up the Plan

ERISA requires a formal written plan document that defines eligibility rules, covered benefits, claims procedures, and funding methods. This is the legal foundation, and ambiguities in it turn into disputes later. Alongside the plan document, the employer must give each participant a summary plan description (SPD) written in plain language, at no charge.⁸ Both documents need periodic review as regulations change.

Hiring a TPA is not legally required but is practically essential for any employer that isn’t in the business of processing medical claims. The TPA handles claims adjudication, employee communications, provider network access, and annual nondiscrimination testing. The employer retains the financial obligation and final decision-making authority.

Form 5500

ERISA generally requires annual filing of Form 5500 through the DOL’s EFAST2 system.⁸ Welfare benefit plans that cover fewer than 100 participants and are unfunded or fully insured are exempt.⁹ Because a self-insured plan funded from general assets is considered “unfunded” for ERISA reporting purposes, many smaller employers fall into this exemption. Larger plans must file annually.

PCORI Fee

Self-insured plan sponsors owe the Patient-Centered Outcomes Research Institute (PCORI) fee each year. For plan years ending between October 1, 2025 and September 30, 2026, the fee is $3.84 per covered life. Sponsors report and pay it on IRS Form 720, due by July 31 of the year following the plan year’s end.¹⁰ The amount adjusts annually.

QSEHRAs and ICHRAs as Alternatives

Self-insured medical reimbursement is a broad category, and several specific plan types fall inside it. All health reimbursement arrangements (HRAs) are employer-funded reimbursement plans operating under Section 105. Two newer HRA types have made the model accessible to small employers that couldn’t previously absorb the administrative load.

A Qualified Small Employer HRA (QSEHRA) is available to employers with fewer than 50 full-time employees that don’t offer a group health plan. The employer sets a reimbursement allowance up to annual IRS-set limits. For 2026 those limits are $6,450 for self-only coverage and $13,100 for family coverage. Employees use the allowance to buy individual health insurance or pay qualified medical expenses. The Section 105(h) nondiscrimination rules do not apply to QSEHRAs, which simplifies administration considerably.

An Individual Coverage HRA (ICHRA) is available to employers of any size and has no cap on the reimbursement amount. Employees must be enrolled in individual health insurance to participate. The employer can vary allowance amounts by employee class (full-time versus part-time, geography, age) but must offer the same terms to everyone within a class.

Both give employers a defined-contribution route: a fixed budget per employee instead of open-ended claims risk. For smaller businesses, they deliver the tax advantages of Section 105 without the exposure that makes conventional self-insurance impractical.

1
Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans
2
Office of the Law Revision Counsel. 26 U.S. Code 3121 – Definitions
3
Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues
4
eCFR. 26 CFR 1.105-11 – Self-Insured Medical Reimbursement Plan
5
Centers for Medicare & Medicaid Services. Health Insurance Market Reforms
6
U.S. Department of Labor. An Employee’s Guide to Health Benefits Under COBRA
7
HHS.gov. Covered Entities and Business Associates
8
U.S. Department of Labor. Plan Information
9
U.S. Department of Labor. Instructions for Form 5500
10
Internal Revenue Service. Patient-Centered Outcomes Research Institute Fee