A self-insured medical reimbursement plan is an arrangement in which an employer pays employees’ medical costs directly out of company funds rather than buying coverage from an insurance carrier, and under Internal Revenue Code Section 105 those reimbursements are excluded from the employee’s taxable income.1Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans The appeal is tax efficiency and benefit design flexibility. The cost is that the employer takes on the claims risk an insurer would normally carry, and the plan has to clear federal nondiscrimination, ERISA, ACA, COBRA, and HIPAA requirements to keep its tax-favored status.
How the Plan Actually Works
No insurance company sits in the middle. When an employee incurs a covered medical expense, the employer pays it out of a trust, a dedicated account, or general business assets. In a light-claims year, the employer keeps the money that would otherwise have gone to premiums. In a heavy year, the employer absorbs the higher cost.
Covered expenses typically include deductibles, copayments, coinsurance, and prescription drug costs, and the employer has broad discretion to define what gets reimbursed. Most employers hire a third-party administrator (TPA) to process claims, issue reimbursements, communicate with employees, and run the annual compliance tests. The TPA handles the paperwork; it does not take on any of the financial risk.
Stop-Loss Insurance
Because one serious diagnosis can produce hundreds of thousands of dollars in claims, most self-insured employers buy stop-loss insurance. There are two kinds, and they protect against different scenarios.
Specific (individual) stop-loss covers any single person’s claims above a chosen 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 covers total plan claims above a ceiling for the whole year, often set at 125% of expected annual claims. Carrying both is standard: specific handles one catastrophic case, aggregate handles a year where many moderate claims collectively exceed the budget.
The Tax Treatment
The tax rules are what make these plans attractive. Amounts paid under the plan are deductible as ordinary business expenses for the employer. For the employee, reimbursements for qualified medical expenses are excluded from gross income under Section 105(b).1Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans Those reimbursements are also excluded from wages for FICA purposes, so neither side owes Social Security or Medicare tax on them.2Office of the Law Revision Counsel. 26 U.S. Code 3121 – Definitions
Compare that to a raise. If an employer gives an employee an extra $5,000 in salary to help with medical bills, both sides pay payroll tax and the employee pays income tax. Running the same $5,000 through a compliant plan eliminates all of those taxes. The exclusion also extends to reimbursements for the employee’s spouse, dependents, and children under age 27.1Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans
Which Owners Can’t Take Tax-Free Reimbursements
This is where many small-business owners miscalculate. The Section 105(b) exclusion is available only to common-law employees. Self-employed individuals are not employees for Section 105 purposes.1Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans Three categories of owners are out:
- Sole proprietors. You own the business, so you are not your own employee. Reimbursements to yourself are not excludable.
- Partners in a partnership. Partners are self-employed for tax purposes.
- S-corporation shareholders owning more than 2%. The IRS treats them the same as self-employed persons and bars them from participating in an HRA or other self-insured arrangement on a tax-free basis.3Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues
A sole proprietor or partner whose spouse is a legitimate W-2 employee of the business can sometimes work around this by enrolling the spouse in family coverage that reimburses the owner-spouse as a dependent. The employment has to be genuine, with real duties and reasonable compensation, not a paper role created for the tax benefit. If you’re in one of these categories, get professional guidance before setting up the plan.
Nondiscrimination Testing
The tax exclusion is not automatic. A self-insured plan must pass two annual nondiscrimination tests under Section 105(h), both aimed at keeping employers from giving highly compensated individuals better coverage than rank-and-file workers.4eCFR. 26 CFR 1.105-11 – Self-Insured Medical Reimbursement Plan
A highly compensated individual (HCI) is anyone who is one of the five highest-paid officers, a shareholder owning more than 10% of the employer’s stock, or among the highest-paid 25% of all employees.1Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans
The Eligibility Test
A plan satisfies the eligibility test if it covers at least 70% of all employees, or at least 80% of eligible employees when at least 70% of all employees are eligible. When counting, the employer can leave several categories of workers out of the denominator: employees with fewer than three years of service, employees under age 25, part-time or seasonal workers, employees under a collective bargaining agreement where health benefits were part of good-faith bargaining, and nonresident aliens with no U.S.-source earned income from the employer.1Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans
The Benefits Test
Every benefit available to an HCI must be available on the same terms to all other plan participants. A plan that reimburses executives up to $10,000 and caps everyone else at $5,000 fails. The same goes for covering certain procedures only for HCIs.
What Failure Costs
Failure doesn’t blow up the plan. Rank-and-file employees keep their tax-free reimbursements regardless. The damage lands entirely on the HCIs, who must include their “excess reimbursement” in taxable income for the year. The calculation differs depending on which test the plan failed, and failing both at once compounds the problem.
Federal Compliance Beyond the Tax Code
Employers sometimes assume that self-funding exempts them from the Affordable Care Act’s market reforms. It does not. Self-insured plans are subject to most of the same rules as traditional group health plans, including:
- No annual or lifetime dollar limits on essential health benefits.5Centers for Medicare & Medicaid Services. Health Insurance Market Reforms
- Coverage for adult children up to age 26.
- Preventive care with no cost-sharing for evidence-based services.
- Mental health parity: limits on mental health and substance use benefits cannot be stricter than those on medical and surgical benefits.
Self-insured plans are generally exempt from state insurance mandates because ERISA preempts state regulation of employer-sponsored plans, but the federal requirements above apply regardless of funding structure.
COBRA continuation coverage applies to employers with 20 or more employees whenever a qualifying event (such as job loss or reduced hours) ends an employee’s coverage. The rule covers any group health plan that provides medical care, whether insured or self-funded.6U.S. Department of Labor. An Employee’s Guide to Health Benefits Under COBRA
HIPAA treats a self-insured plan as a covered entity, which triggers obligations to protect employees’ health information.7HHS.gov. Covered Entities and Business Associates If a TPA or other vendor handles protected health information, a written business associate agreement must be in place. The employer also has to keep claims data separate from employment decision-making.
Setting Up and Running the Plan
ERISA requires a formal written plan document defining eligibility rules, covered benefits, claims procedures, and funding methods. Ambiguities in it become disputes later, so a one-page memo won’t do. Alongside the plan document, the employer must give each participant a summary plan description written in plain language, at no charge, explaining how the plan works and how to file a claim.8U.S. Department of Labor. Plan Information
A TPA is not legally required, but any employer that isn’t in the business of processing medical claims will want one for claims adjudication, employee communications, provider network access, and the annual 105(h) testing.
ERISA generally requires an annual Form 5500 filing, but welfare benefit plans covering fewer than 100 participants that are unfunded or fully insured are exempt.9U.S. Department of Labor. Instructions for Form 5500 A self-insured plan funded from general assets counts as “unfunded” for ERISA reporting purposes, so many smaller employers fall into the exemption. Larger plans must file annually, and late filings carry penalties.8U.S. Department of Labor. Plan Information
Self-insured sponsors also owe the Patient-Centered Outcomes Research Institute (PCORI) fee. For plan years ending between October 1, 2025 and September 30, 2026, the fee is $3.84 per covered life, reported and paid on IRS Form 720 by July 31 of the year following the plan year’s end.10Internal Revenue Service. Patient-Centered Outcomes Research Institute Fee The amount adjusts annually, so check the current rate each year.
HRAs, QSEHRAs, and ICHRAs
A self-insured medical reimbursement plan is a broad category. Health reimbursement arrangements (HRAs) are the most common form, all operating under Section 105 as employer-funded reimbursement vehicles. Two newer HRA types have made self-insured reimbursement workable for small employers that previously couldn’t absorb the administrative load or the open-ended claims risk.
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 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 insurance or pay for qualified medical expenses. The 105(h) nondiscrimination rules do not apply to QSEHRAs, which simplifies administration.
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 coverage to participate. The employer can vary allowances by employee class (full-time versus part-time, geography, age) but must offer the same terms to everyone within a class.
Both arrangements give employers a defined-contribution path: a fixed budget per employee instead of the unpredictable claims costs of a traditional self-insured plan. For small businesses especially, they deliver the Section 105 tax advantages without the open-ended downside that makes conventional self-insurance impractical.