Using a Section 105 Medical Reimbursement Plan to Reduce Your Tax Bill

Using a Section 105 Medical Reimbursement Plan to Reduce Your Tax Bill

“I paid out the ears in taxes this year.  How can I reduce my tax burden?”

This is a question I’m hearing a lot from business owners recently.  And while it may not sound flashy, the best way to reduce taxes is to incorporate some smart planning into your decision making.  More often than not, business owners simply don’t have the time to research and apply the opportunities offered in the tax code.

So to make your life a little easier, today’s post will cover an often unused tax saving opportunity: the Section 105 medical reimbursement plan.


An Overview of Section 105 Health Reimbursement Plans

A section 105 health reimbursement plan is a tax-efficient way to repay your employees for their health care costs.  Rather than purchasing group coverage that your qualifying employees can opt into, you allow them to find their own coverage and then reimburse them for qualified expenses.  This can include premiums, deductibles, or a wide variety of other out of pocket costs.  (Side note, there are section 105 plans that combine traditional group coverage with reimbursement for qualified out of pocket costs, but that’s a subject for a future post).

Whereas this would not have been a popular way to offer benefits a decade ago, it’s more palatable now that individual health insurance is widely available through the state and federal marketplaces.

The main benefits of section 105 plans are the tax advantages.  Most small businesses deduct the cost of health insurance premiums for their employees, and possibly for themselves.  But when it comes to their own out of pocket health care costs, business owners normally pay for them with taxable dollars.  These expenses can be deductible at the personal level, but only when they exceed 10% of your adjusted gross income.

With a Section 105 plan you can deduct your entire family’s medical expenses with without being subject to the 10% AGI floor.  Even better, it’s a deduction from income tax at the state and federal levels, AND a deduction from payroll taxes.  For some business owners this can be a savings of thousands of dollars per year.

The tax benefits don’t apply to all types of business entities, though.  S-Corps don’t get to deduct reimbursements through section 105 plans from state or federal income tax.  And if you own a sole prop, a partnership, or an LLC you aren’t considered an employee.  That means you can’t be reimbursed by a plan, and would need to employ your spouse in order to reap the benefits.


How a Section 105 Medical Reimbursement Plan Works

Since a Section 105 plan is considered qualified, you’ll need to adopt a plan document in order to use one.  This establishes what the plan does, what your responsibilities as the employer are, and how it will be managed.  Your plan document then needs to be distributed to qualified employees.

Next, you’ll need to determine how much the plan will reimburse employees for qualified expenses during the coverage period.  The coverage period is usually annually, but can be modified for your needs.  Keep in mind here that you can’t discriminate between employees, by nature of being a qualified plan.  That means you can’t offer more reimbursement to your spouse than to other employees.  You set the annual limit for all qualified employees, and agree to reimburse them for qualified expenses up to that amount.

Then, as employees pay the premiums & other costs for their health care, they submit the expenses for reimbursement.  The business reimburses employees up to the coverage limits, which is a 100% deductible expense.  If employees don’t use their total allotment during the coverage period, the remaining amount is then typically carried over to the next period.


Here’s an Example:

Let’s say you own an LLC in California and don’t have any employees.  You gross $150,000 per year, and pay $1,500 per month in healthcare premiums.  Your plan covers you, your wife, and your two kids.

Let’s also say you usually pay about $2,000 per year out of pocket, as your kids are aspiring knuckleheads.  Let’s ignore California state disability taxes too (they won’t make a difference in this example).

Your net income after taxes and health care costs would be $89,335:

Using a Section 105 Medical Reimbursement Plan to Reduce Your Tax Bill

If you decided to establish a section 105 medical reimbursement plan, you still couldn’t take advantage of the tax benefits because you’re not considered an employee.  But what if you decided to hire your wife?  You could reimburse her, for her entire family’s health care expenses, which you’re a part of, of course.

To do so, you’d first need to establish her compensation arrangement.  Assuming her employment isn’t fabricated this shouldn’t be a problem.  This is an area that the IRS scrutinizes, so it’d be important that she actually work for a reasonable compensation.

Let’s say she keeps your books, handles order processing, arranges your travel schedule, and keeps your calendar.  Her compensation would consist of:

  1. W-2 wages of $15,000
  2. Reimbursement for medical costs of $20,000

Summing the two, her total cash compensation is $35,000.  If you utilized a Section 105 plan, you could reimburse your wife for your entire family’s health costs.  This expense would be fully deductible, and in this example boost your combined after tax income by about $3,000:

Using a Section 105 Medical Reimbursement Plan to Reduce Your Tax Bill

So, by using the Section 105 plan you’re free to deduct all your family’s healthcare expenses from your FICA taxes in addition to state and federal income taxes.  All you’d need to do is employ your spouse (legitimately), and set up the plan.


Other Considerations

There are a few other considerations when considering a Section 105 plan.  First, in order to qualify for the tax benefits neither you nor your spouse can be eligible for a workplace sponsored health plan.

Second, as I mentioned your spouse must be a bona fide employee.  You’ll also need to consider any other employees you might have.  Since Section 105 plans are considered “qualified” in the eyes of the IRS, you can’t offer more health benefits to your spouse than you do to other employees.  That would be discriminatory, which is a big no-no for qualified plans.

Finally, your business entity matters too.  The example above works with a sole proprietorship, a partnership, or an LLC .  It doesn’t work well with S-Corps, though.  With S-Corps, 2% or greater owners are allowed to deduct FICA taxes in Section 105 plans.  They aren’t allowed to deduct state or federal income taxes, though, which more than negates the appeal.  Family members, including spouses and dependents, are treated the same as owners, too.

C-Corps are able to reap the full deduction privileges, though.  And since owners are already considered employees in C-Corps, there’s no need to hire your spouse to qualify.


Spousal Employment

Like we covered above, the IRS scrutinizes spousal employment pretty closely.  Many business owners across the country like to put their spouses “on the books” to take advantage of tax benefits, even if they don’t do any actual work.

For this reason, it’s important to clearly establish the employer-employee relationship with your spouse.  If the IRS comes knocking, they’ll want you to prove that your spouse is actually a regular employee.  To do so, keep the following documents on hand & up to date:

  • A record of regular and fair wages
  • W-2
  • W-4
  • I-9
  • Other employee tax reporting forms required by the IRS
  • Log of hours worked
  • Written employment agreement


Qualified Medical Expenses

Section 105 medical reimbursement plans do have limitations on qualified expenses.  They’re listed here in Section 213 of the tax code.  Fortunately, the definition is pretty broad.  As a general rule you can use reimbursement any expense used for the diagnosis, cure, mitigation, treatment, or prevention of a disease.  This includes, but isn’t limited to:

  • Health insurance premiums
  • Deductibles
  • Physician fees
  • Prescription costs
  • Dental care fees
  • Vision care fees
  • Chiropractor fees
  • Psychiatric Care fees
  • Hospital fees
  • Laboratory fees
  • Orthodontia fees
  • Medical supplies


Administering a Section 105 Plan

Some businesses prefer to administer Section 105 plans themselves, but for most it makes more sense to hire an expert.  Since you’ll need to abide by ERISA, HIPAA, and IRS regulations, there’s a whole lot to keep track of.  At the very least, look into software that will help you stay compliant.  The law tends to change pretty frequently, and failure to abide by them can be costly and jeopardize the plan’s tax benefits.

All in all, a Section 105 medical reimbursement plan is a great way to save money on taxes when used in the right circumstance.  Just remember that your spouse’s employment must be legitimate, and operating a plan is no small task.  If you’re not sure you’re up to it, you could probably benefit from the help of an experienced professional.  If the cost of professional help to administer the plan is less than your tax savings, any for-profit business owner would be foolish not to explore the idea further.

Posted in Business Ownership, Entrepreneurship, Financial Planning, Taxes & Accounting and tagged , , , , , , , , , .


    • I don’t think the new tax bill will affect this strategy much. If the strategy was more appealing for S-corps the tax bill would make it less beneficial, given the lower tax rates for most corporations. (Lower taxes = less tax savings from deductions). But since this works best with sole props, partnerships, and LLCs, the new law doesn’t change the picture. You’ll capture the deduction on either Schedule C or a K-1, where you calculate business profits. This info is ported over to your personal 1040 above the line, meaning it goes into the calculation of adjusted gross income. In other words, it won’t affect whether you itemize or not.

  1. I have a section 105 plan and converted to an s corp this year (due to bad advise). Is it better for the scorp to calculate wages as if there was no section 105 plan, or go ahead and use the plan.

    Please provide an example of how an s copr would calculate wages and taxes if the section 105 plan is used.

    • Hi Tammy,

      Thanks for the question. It’s a lot to bite off though, and I wouldn’t know which option was better without knowing more about your business. Feel free to reach out directly if you’d like to chat about your situation.

  2. Great article!
    How is the 105 plan and a QSEHRA plan different? Or are they?
    I am a sole proprietor, with my spouse as a w-2 employee, and will be setting something up asap.

    The QSEHRA will reimburse up to 10k a year of medical premiums and expenses.
    With healthcare premiums at 20k a year, that isn’t a lot of reimbursement.

    thank you,

    • Great question. They are two different plans. The Affordable Care Act severely limited business’s ability to use HRAs (health reimbursement arrangements), which were prevalent at the time. After realizing that HRAs were important for small businesses trying to offer health care, Congress got together and created the QSEHRA. Check out IRS Notice 2013-54 for more background.

      Section 105 plans were not included on some of these limitations. In other words you can still use them, provided they comply with the ACA. My sense is that a properly structured Section 105 plan might allow you to set a limit of $20k per year, which would cover your premiums. This would be a good topic to discuss with health insurance provider though, as I’m not an ACA expert. Either way, make sure whomever you work with is good, and capable of providing adequate compliance for your plan.

  3. Why does a 105 plan not work for the LLC member (owner) if they are an employee of the LLC? I see repeatedly that the LLCs are hiring a spouse to adopt the plan for. Is there a specific disqualifier for LLC owners in the code?

    • Jeff, the owner of an LLC is never an employee of the LLC. If you are paying yourself wages (that is, you withhold taxes and give yourself a W2 at the end of the year), that is incorrect procedure because you are not an employee. If you are simply making draws from the LLC, which is correct procedure, you are not an employee. Owners can only deduct healthcare premiums as an above-the-line adjustment on the front of Form 1040, as long as your net profit is more than the premiums. Owners can not deduct them on Schedule C. Thus, you must hire spouse-employee to use Section 105.

  4. Thanks for the article and sharing this information. Like Patti, above, I too have been wondering about why people are excited about the QSEHRA when it has a paltry $10K limit to cover premiums that run much higher.

    Zane Benefits (Peoplekeep) seem to have moved away from Section 105 to the QSEHRA.

    I am trying to find a provider that can administer the Section 105 plan for me. I am a sole-shareholder and sole employee of a C Corp. It is surprising that many of the benefits providers that target small businesses seem to know nothing about this.

    One way that these plans are super helpful is for children with special needs. It seems to me that is possible through this plan to put away money for lifetime care – an unlimited amount. Am I correct in this?

    There is of course the issue of finding a lifetime care provider. Yet to find that, but this plan seems to address the dire need of many parents with children on the spectrum and other special needs to be able to put away the large amounts that will be needed for future care of their children. With this it can be done without the tax burden.

    One of my primary reasons for forming a C Corp (I am a single shareholder and employee) was this capability. Would be interested in getting your thoughts about this.

    • Arun, you are in a perfect position to provide a Section 105 plan for your single EE C-Corp. Section 105 allows for the reimbursement of LTC. We specialize in the consultation and admin for “micro-sized” biz — Tom Luker — 608-833-7526

  5. Can a sole prop owner take advantage of the section 105 HRA by paying their spouses Health Insurance premiums with out paying their spouse any W-2 wages?

    • I also would like to know the answer to this. The amount of work my spouse would be working would not be more than their high insurance premium rates per month.

  6. My spouse and I are employed in full time positions. We have health insurance through out different employer plan. I have a part-time business LLC and elect sole proprietor. My wife is an employee of the business. Can I set plan to reimburse medical expenses? Or I can’t because the employer offers a low deductible plan?

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