105 HRA Plan: How to Set Up and Use It

A Section 105 Health Reimbursement Arrangement (HRA) is an employer-funded health benefit plan governed by Section 105 of the Internal Revenue Code. It is designed to reimburse employees for out-of-pocket medical costs and health insurance premiums. For many small business owners, this plan provides a structured way to pay for family medical expenses through the business. This process converts personal health costs into fully deductible business expenses. The arrangement is entirely funded by the employer, and employees cannot contribute, which gives business owners control over health benefit costs.

Eligibility and Coverage Requirements

The ability for a business owner to benefit from a Section 105 HRA depends on the business’s legal structure and the owner’s employment status. For C-Corporations, the business is a distinct legal entity, and an owner who receives a salary is considered an employee. This allows the owner-employee to participate directly in the plan and receive tax-free reimbursements for their family’s medical expenses. The rules are different for business structures where the owner is not a W-2 employee, such as sole proprietorships and partnerships. In these cases, the owner cannot directly participate.

A common strategy for sole proprietors and partners is to legitimately employ their spouse. The plan can then cover the employee-spouse, who can claim reimbursements for the entire family’s medical expenses, including those of the business owner. For this arrangement to be valid, the spouse must be a “bona fide employee,” a status the IRS scrutinizes. A bona fide employment relationship requires the spouse to perform meaningful services, have defined duties, and receive reasonable compensation for that work, separate from HRA reimbursements.

S-Corporation owners face unique rules. An owner holding more than 2% of the company’s shares is not eligible to receive tax-free reimbursements, as any reimbursements are treated as taxable income. Unlike with sole proprietorships, employing a spouse does not work around this limitation for S-Corp owners. The plan can provide benefits to employees and their dependents, including children up to age 26.

Qualified Medical Expenses

A Section 105 HRA can only reimburse qualified medical expenses as defined under Internal Revenue Code Section 213. The definitive guide for these expenses is IRS Publication 502, which defines them as costs for the diagnosis, cure, mitigation, treatment, or prevention of disease. Common examples of reimbursable expenses include payments for health and dental insurance premiums, deductibles, and copayments. Costs for prescription medications, doctor visits, hospital services, and diagnostic fees are also eligible. The definition extends to dental treatments like fillings and braces, vision care such as eye exams and prescription glasses, and even chiropractic services and acupuncture.

Costs that are merely beneficial to general health, such as vitamins or health club dues, are not reimbursable. Cosmetic surgery is excluded unless it is necessary to improve a deformity arising from a congenital abnormality, an accident, or a disfiguring disease. Other non-qualified expenses include non-prescription drugs (with the exception of insulin), maternity clothes, and teeth whitening.

Establishing the Plan

A business must formally establish the Section 105 HRA by creating a written plan document. This document is required for compliance with IRS and Department of Labor regulations and must be in place before the plan’s start date and before any claims are paid.

The plan document must contain specific components, including:

• The name of the plan administrator
• Eligibility requirements for employees
• The plan’s effective date and duration
• The reimbursement amounts or limits
• The process for submitting claims

For business owners using the employee-spouse strategy, formally documenting the employment relationship is also required. This involves creating a clear job description, setting a reasonable wage, and maintaining standard employment records like Form I-9, Form W-4, and regular payroll filings. Keeping timesheets that document the hours worked provides further evidence of a bona fide employment arrangement.

The Reimbursement Process

The employee is responsible for paying the medical expense first, using their personal funds. They must then submit a claim for reimbursement to the employer, providing documentation that substantiates the expense. This proof consists of a receipt from the provider or an Explanation of Benefits (EOB) from an insurance company.

The employer reviews the submitted claim to verify that the expense is a qualified medical expense according to the plan’s terms and that the employee has not exceeded their available reimbursement limit. Proper documentation is required for every claim. After approving the claim, the employer issues a reimbursement payment to the employee from the business’s bank account. This reimbursement must be a separate payment from the employee’s regular wages.

For compliance, the business must maintain records of each transaction. This includes copies of the employee’s claim form, the supporting receipts or EOBs, and proof of the reimbursement payment.

Tax Reporting and Implications

For the employer, all reimbursements paid to employees under the plan are considered a business expense. The total amount reimbursed throughout the year is 100% tax-deductible, reducing the business’s taxable income. This deduction is reported on the business’s annual tax return, such as on Schedule C (Form 1040) for a sole proprietorship, Form 1065 for a partnership, or Form 1120-S for an S-Corporation.

For the employee, all reimbursements received for qualified medical expenses are 100% tax-free. This money is not considered part of the employee’s taxable wages and is not subject to federal income tax, state income tax, or FICA taxes. Consequently, the reimbursement amounts are not reported on the employee’s Form W-2 at the end of the year.