How to Set Up a Section 105 Medical Reimbursement Plan

Setting up a Section 105 medical reimbursement plan takes seven practical steps: confirm your business entity can legally offer one, pick the right HRA structure for your size and insurance situation, draft and formally adopt a written plan document before any reimbursement is paid, define covered expenses and dollar limits, design the plan to pass the Section 105(h) nondiscrimination tests, build in ongoing compliance obligations like COBRA and PCORI, and set up clean claim processing and tax reporting. Done right, every reimbursed dollar comes out tax-free to the employee and fully deductible to the employer. Done wrong, the whole arrangement becomes taxable wages.

Step 1: Confirm Your Entity Can Offer One

Before anything else, check whether your owners and your employees can actually benefit from a Section 105 plan. Section 105(g) of the Internal Revenue Code excludes self-employed individuals from the definition of “employee,” and that one sentence drives who gets tax-free treatment.¹

C-Corporation owners who work in the business are common-law employees and participate on the same terms as anyone else.
S-Corporation shareholders owning more than 2% are treated as partners for fringe benefit purposes under Section 1372 and cannot receive tax-free Section 105 reimbursements. The S-Corp can still pay their health insurance premiums, but those premiums go in Box 1 of the shareholder’s W-2 as wages, with the shareholder claiming an above-the-line deduction personally.²
Sole proprietors and partners are self-employed by definition and are excluded entirely.

If the owner is ineligible but a spouse works as a legitimate common-law employee of the business, with documented duties, regular hours, and W-2 wages, the spouse can participate and extend coverage to family members. The IRS scrutinizes these arrangements, so the employment relationship has to be real.

Step 2: Pick the HRA Structure That Fits Your Business

Section 105 is the legal framework. The Health Reimbursement Arrangement is the vehicle that delivers the benefit. Which HRA you choose depends mostly on whether you offer group health insurance and how many employees you have. This choice shapes everything downstream, so make it before you draft the plan document.

Integrated HRA

If you already offer group health insurance, pair the HRA with that plan. The HRA reimburses out-of-pocket costs like deductibles and copays that the group plan doesn’t cover. Because the HRA is integrated with qualifying group coverage, it satisfies ACA market reform rules automatically.

Qualified Small Employer HRA (QSEHRA)

A QSEHRA fits employers with fewer than 50 employees that do not offer group health insurance. Employees use the reimbursement toward individual health coverage they buy on their own. For 2026, the maximum reimbursement is $6,450 for employee-only coverage and $13,100 for family coverage.³ The QSEHRA must be offered on the same terms to all eligible employees, and employees need minimum essential coverage to receive tax-free reimbursements.

Individual Coverage HRA (ICHRA)

An ICHRA works for employers of any size and has no cap on employer contributions.⁴ Employees must have their own individual health insurance to use the funds. The ICHRA lets you offer different contribution amounts to different classes of employees (full-time versus part-time, salaried versus hourly, employees in different geographic areas) as long as everyone within a class gets the same terms. You cannot offer the same class a choice between an ICHRA and a traditional group plan.

Structure matters because of the ACA. A standalone HRA that reimburses medical expenses up to a cap, without being integrated with group coverage and without fitting the QSEHRA or ICHRA framework, violates the prohibition on annual dollar limits for essential health benefits.⁵ The QSEHRA and ICHRA exist specifically to give employers without group insurance a compliant option.⁶

Step 3: Draft and Adopt the Written Plan Document

Federal regulations require a Section 105 plan to be a “separate written plan for the benefit of employees” before any reimbursement qualifies for the income exclusion.⁷ Without a written document adopted before the first reimbursement, every payment is taxable wages. You cannot fix this retroactively.

At minimum, the document should include:

An effective date. No expense incurred before this date is reimbursable.
Eligibility rules identifying which employees are covered and which categories are excluded.
The specific types of medical expenses the plan will reimburse.
The annual or monthly reimbursement cap per participant.
A claims procedure covering how employees submit claims, what documentation they provide, and the submission deadline.
A statement that the plan is intended to qualify under Section 105(b) of the Internal Revenue Code.

Formally adopt the plan through a board resolution for corporations or a similar written action for other entity types. The signed, dated resolution and plan document go into the permanent business records. A third-party administrator will usually supply template documents, but the employer is still the party that legally adopts the plan.

Step 4: Define Covered Expenses and Reimbursement Limits

Section 105(b) ties the income exclusion to expenses that qualify as “medical care” under Section 213(d). That definition is broad, covering amounts paid for diagnosing, treating, or preventing disease and for affecting any structure or function of the body.⁸ In practice, that means doctor visits, prescriptions, hospital stays, dental work, vision care, mental health treatment, and long-term care services. Since the CARES Act took effect in 2020, over-the-counter medications and menstrual care products also qualify without a prescription.

The plan document specifies which of these expenses the plan actually covers. Most employers cover the full range of Section 213(d) expenses, but you can narrow coverage if you prefer. The firm rule: whatever expenses you cover must be available on the same terms to every participant. You cannot offer dental reimbursement to executives while limiting rank-and-file employees to prescriptions.

Every plan needs a defined annual limit per participant. You can set a flat dollar amount for everyone, or vary it by coverage tier (employee-only versus employee-plus-family). Varying by family status is permissible because it relates to the scope of coverage. What you cannot do is give higher limits to highly compensated employees. The annual cap must be uniform within each coverage tier. A standard Section 105 plan integrated with group health insurance has no federally mandated maximum, but QSEHRAs and ICHRAs follow their own rules.

Step 5: Design the Plan to Pass the Nondiscrimination Tests

Section 105(h) prevents medical reimbursement plans from benefiting only the people at the top. If your plan fails these tests, the tax-free treatment disappears for highly compensated individuals while everyone else keeps their exclusion.¹ Design the plan to pass from the start; fixing a failure after the fact means amended W-2s.

A highly compensated individual (HCI) is anyone who falls into one of three groups: the five highest-paid officers, anyone owning more than 10% of the employer’s stock (with attribution through family members and related entities under Section 318), or the top 25% of all employees by compensation.

When running the tests, you can exclude from 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

The plan then has to pass two tests. The eligibility test offers two paths: cover at least 70% of all non-excludable employees, or make at least 70% of them eligible with the plan actually covering at least 80% of those eligible. A third alternative lets the plan pass if it benefits a classification 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 must be available to every other participant on the same terms. Different reimbursement caps by compensation level fail this test immediately.

When a test fails, only HCIs lose tax-free treatment, and the excess reimbursements get added back to their W-2 wages for the year. Non-HCI employees are unaffected either way.

Step 6: Build In the Ongoing Compliance Obligations

A Section 105 plan carries recurring federal duties beyond the setup phase. Address them in the plan document and operational calendar from the beginning.

COBRA

If your business employed 20 or more workers on more than half of its typical business days in the prior calendar year, your plan is subject to COBRA.¹⁰ Employees who lose coverage due to a qualifying event must be offered the chance to continue HRA benefits at their own expense. Full-time and part-time employees both count toward the 20-employee threshold, with part-time workers counted as a fraction of a full-time schedule. Build COBRA procedures into the plan document even if you’re currently below the threshold, since crossing it mid-year catches employers off guard.

PCORI Fees

Self-insured health plans, including Section 105 HRAs, pay the Patient-Centered Outcomes Research Institute fee annually. 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 of the year following the plan year’s end. The dollar amount is small; the penalties for missing the filing are not.

Form 5500

A self-insured medical reimbursement plan that is unfunded (benefits paid from the employer’s general assets) and covers fewer than 100 participants at the start of the plan year is exempt from Form 5500 filing.¹² Once you reach 100 participants, annual filing is required. Employers with multiple benefit plans covered by a single plan document aggregate participants across all welfare plans, so count carefully.

HIPAA

Because a Section 105 plan is a group health plan, HIPAA privacy rules can apply. The scope depends on the employer’s size, whether a third-party administrator handles claims, and whether protected health information moves electronically. Self-insured, self-administered plans at employers with fewer than 50 employees that don’t transmit protected health information electronically may have limited obligations. Larger employers, and those using a TPA, will generally need a Notice of Privacy Practices, policies for safeguarding health information, and periodic reminders of employee privacy rights. The specifics vary enough that a benefits attorney or compliance specialist is worth consulting before launch.

Step 7: Run Claims and Tax Reporting Correctly

Even a well-drafted plan loses its tax-advantaged status through sloppy administration. The daily routine matters.

Give every eligible employee a Summary Plan Description explaining what the plan covers, how much can be reimbursed, and how to file a claim. Distribute it at enrollment and whenever terms change. The paper trail shows the plan was genuinely offered to the entire eligible workforce.

Employees submit claims with documentation showing the expense was incurred and what it was for: an Explanation of Benefits from an insurer, a provider invoice, or a pharmacy receipt with date of service and amount paid. The employer or TPA verifies the expense qualifies under the plan’s terms and under Section 213(d) before approving reimbursement. No reimbursement for an expense that hasn’t yet been incurred, and nothing already covered by insurance. Many employers outsource verification to a third-party administrator, who typically charges a per-employee monthly fee and handles adjudication, substantiation, and recordkeeping. Very small plans can self-administer, but the administrative load and HIPAA exposure make outsourcing worth considering past a handful of participants.

Keep the original signed plan document, every version of the Summary Plan Description, and the results of each year’s Section 105(h) nondiscrimination testing. Keep individual claim records showing what was submitted, the documentation provided, the verification decision, and the amount reimbursed. These records support the employer’s tax deduction and prove compliance if the IRS asks. Standard practice is seven years for claim records, with plan documents often kept permanently.

On tax reporting, qualifying reimbursements are excluded from the employee’s gross income under Section 105(b) and should not appear as wages on the W-2.¹ The employer deducts total reimbursements paid during the year as a business expense under Section 162.¹³ If nondiscrimination testing turns up excess reimbursements to highly compensated individuals, those amounts get added back to the HCI’s W-2 income. Reporting errors in either direction cause problems: taxing employees on reimbursements they shouldn’t owe, or missing discriminatory excess reimbursements and exposing the business 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
Internal Revenue Service. Revenue Procedure 2025-32 – Inflation Adjusted Items for 2026
4
HealthCare.gov. Individual Coverage Health Reimbursement Arrangement
5
U.S. Department of Labor. FAQs about Affordable Care Act Implementation, Part 37
6
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
7
eCFR. 26 CFR 1.105-11 – Self-Insured Medical Reimbursement Plan
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