Section 105(h)

Introduction to Section 105(h)

If you offer a health benefit that reimburses medical expenses pre-tax, there’s a good chance Section 105(h) applies to you. And if you’ve never heard of it before, you’re not alone.

Section 105(h) is a part of the Internal Revenue Code that governs nondiscrimination rules for self-insured medical reimbursement plans. In plain English? It’s designed to make sure employers don’t unfairly favor highly compensated employees when offering certain health benefits.

As a small business owner or HR manager, you don’t need to become a tax attorney. But you do need to understand how this rule affects your reimbursement arrangements, especially if you’re offering an HRA, including an ICHRA or QSEHRA. Employees should understand it too, because it impacts whether their reimbursements remain tax-free.

Let’s break it down step by step.

What Is Section 105(h)?

Section 105(h) is a federal tax rule that applies to self-insured medical reimbursement plans. These are plans where the employer pays medical claims directly rather than buying a fully insured group health policy.

According to the Internal Revenue Code (26 U.S. Code § 105(h)), these plans cannot discriminate in favor of highly compensated individuals (HCIs) with respect to:

• Eligibility to participate
• Benefits provided under the plan

If a plan fails these nondiscrimination tests, the consequence isn’t that the entire plan is illegal. Instead, the highly compensated employees lose the tax-free status of their reimbursements. Their benefits become taxable income.

That’s a big deal.

What Counts as a Self-Insured Plan?

A self-insured plan includes:

• Health Reimbursement Arrangements (HRAs)
• Certain employer payment plans
• Medical reimbursement arrangements funded directly by the employer

It does not include traditional fully insured group health plans for purposes of Section 105(h) income tax rules (though ACA nondiscrimination rules may still apply separately).

If you’re offering an HRA, Section 105(h) is front and center.

Who Is a Highly Compensated Individual?

Section 105(h) defines a highly compensated individual (HCI) as someone who is:

• One of the five highest-paid officers
• A shareholder who owns more than 10% of the company’s stock
• Among the top 25% of all employees ranked by compensation

For small businesses, this often includes:

• Founders
• Executives
• Owner-employees
• Senior leadership

If you’re running a startup and reimbursing yourself more generously than your team, this rule is especially relevant.

The Two Section 105(h) Nondiscrimination Tests

Section 105(h) includes two primary tests:

1. The Eligibility Test
2. The Benefits Test

You must satisfy both.

1. The Eligibility Test

This test looks at who is allowed to participate in the plan.

Your plan must benefit:

• At least 70% of all employees, or
• At least 80% of eligible employees if 70% are eligible, or
• A classification of employees that the IRS considers nondiscriminatory

You can exclude certain groups, such as:

• Employees with less than three years of service
• Part-time or seasonal workers
• Employees under age 25
• Union employees (in some cases)

But here’s the catch: your eligibility structure can’t be designed to primarily benefit highly compensated individuals.

If most non-HCI employees are excluded while leadership participates, that’s a red flag.

2. The Benefits Test

Even if everyone is technically eligible, the benefits themselves can’t favor HCIs.

This means:

• The same reimbursement limits must apply to all participants within a class.
• You can’t provide richer benefits (like higher reimbursement caps) only to executives unless it’s structured within permitted employee classes under applicable HRA rules.

For example, if your CEO receives $1,000 per month in reimbursements and staff receive $300 without a legitimate, compliant class-based structure, you may fail the benefits test.

How Section 105(h) Applies to HRAs

Now let’s bring this home.

Most small employers today use HRAs instead of traditional self-insured group health plans. Common types include:

• QSEHRA (Qualified Small Employer HRA)
• ICHRA (Individual Coverage HRA)

Both are employer-funded and self-insured by definition. That means Section 105(h) matters.

QSEHRA and Section 105(h)

QSEHRAs are only available to small employers with fewer than 50 full-time equivalent employees and no group health plan.

The good news? QSEHRAs are designed to avoid discrimination issues because:

• They must be offered on the same terms to all eligible employees.
• Annual contribution limits are set by the IRS.

This structure typically keeps employers aligned with nondiscrimination principles.

ICHRA and Section 105(h)

ICHRA offers more flexibility. Employers can vary reimbursement amounts by:

• Employee classes (e.g., full-time vs. part-time)
• Age (within ACA limits)
• Family size

Because of this flexibility, careful design is critical.

While ICHRA must comply with ACA rules (see healthcare.gov and IRS guidance), employers must also consider how class structures interact with nondiscrimination principles under Section 105(h).

If you’re increasing reimbursements for executives without a defensible class-based structure, you could create taxable consequences for those individuals.

What Happens If You Fail Section 105(h)?

Here’s what doesn’t happen:

• The plan isn’t automatically void.
• The employer doesn’t typically face a corporate penalty.

Here’s what does happen:

• Highly compensated individuals must include excess reimbursements in taxable income.
• That means federal income tax and potentially payroll tax consequences.

For an executive receiving $12,000 per year in reimbursements, losing tax-free status could cost thousands in additional taxes.

No one likes surprise tax bills.

Best Practices for Small Businesses

If you’re offering or considering an HRA, here’s how to stay on the right side of Section 105(h):

1. Design clear employee classes upfront
2. Apply reimbursement limits consistently within each class
3. Avoid special executive-only arrangements
4. Document eligibility rules carefully
5. Conduct periodic nondiscrimination reviews

And perhaps most importantly—don’t DIY complex compliance.

Even well-intentioned employers can trip over technical rules.

Why Employees Should Care

You might be thinking, “Isn’t this just an HR issue?”

Not quite.

If you’re a highly compensated employee and your employer’s plan fails Section 105(h), your reimbursements may become taxable income. That could affect:

• Your take-home pay
• Your year-end W-2
• Your overall tax liability

Understanding the structure of your benefits isn’t just smart—it protects you financially.

Staying Compliant with SimplyHRA

Section 105(h) can feel like alphabet soup mixed with tax code fine print. But at its core, it’s about fairness and proper plan design. For small businesses offering HRAs, compliance isn’t optional—it’s essential.

At SimplyHRA, we help small business owners and HR managers structure ICHRA and QSEHRA plans with compliance built in from day one. Our platform supports proper employee classification, standardized reimbursement rules, automated documentation, and audit-ready reporting—so you’re not left guessing whether your plan meets Section 105(h) requirements. Employees get clarity, tax-free reimbursements when eligible, and 24/7 support.

If you’d like help reviewing your current HRA or setting up a compliant plan, email us at info@simplyhra.com or schedule a consultation at https://www.simplyhra.com/contact. Let’s make your health benefits simple, fair, and fully compliant.

Common Section 105(h) Mistakes Small Businesses Make

Even well-meaning employers can unintentionally run afoul of Section 105(h). In my experience working with startups and growing companies, the issue isn’t bad intent—it’s misunderstanding how technical the rule can be.

Here are a few common pitfalls I see:

• Informal executive carve-outs. A founder reimburses their own family’s premiums at a higher amount “just for now.”
• Overly narrow eligibility rules. Only salaried leadership qualifies, while hourly staff are excluded.
• Mid-year plan tweaks that disproportionately benefit top earners.
• No written plan document. Yes, you need one. The IRS expects formal documentation.

Section 105(h) compliance isn’t about checking a single box. It’s about designing the plan thoughtfully from the beginning and monitoring it over time.

The Role of Plan Documentation Under Section 105(h)

Why Written Plan Documents Matter

The IRS requires that self-insured medical reimbursement arrangements be established and maintained pursuant to a written plan document. This isn’t just bureaucratic busywork.

A compliant plan document should clearly define:

• Eligibility criteria
• Benefit limits
• Reimbursement procedures
• Employee classes (if applicable)
• Effective dates

If your reimbursement arrangement lives in a few scattered emails or payroll notes, that’s risky. During an IRS review, the absence of a formal document can undermine your ability to demonstrate compliance with Section 105(h).

Substantiation and Claims Procedures

Another overlooked piece? Proper substantiation.

Under IRS guidance (see IRS Publication 502 and related Section 105 regulations), medical reimbursements must be substantiated with documentation showing:

• The expense was for medical care as defined under IRC Section 213(d)
• The amount of the expense
• The date incurred

Reimbursing employees without reviewing proper documentation can jeopardize the tax-advantaged status of the entire arrangement. It’s not just a Section 105(h) issue—it’s a core HRA compliance requirement.

Section 105(h) and Controlled Groups

If you own multiple businesses or have related entities, pay close attention here.

Section 105(h) applies on a controlled group basis. That means if your companies are treated as a single employer under IRS controlled group rules (IRC Sections 414(b), (c), and (m)), employees across those entities may need to be considered together when testing nondiscrimination.

For example:

• You own 100% of Company A and 80% of Company B.
• Only Company A offers an HRA benefiting senior leadership.
• Rank-and-file employees sit mostly in Company B.

The IRS may view both companies as one employer for testing purposes. Suddenly, what looked compliant inside one entity could fail when evaluated across the group.

This is especially important for:

• Franchise operators
• Family-owned business structures
• Real estate holding companies with operating subsidiaries
• Startup founders with multiple ventures

When ownership overlaps, nondiscrimination testing becomes more complex.

How Section 105(h) Interacts with Owners

C-Corporation Owners

If your business is taxed as a C-corporation, owner-employees are generally treated as employees for purposes of Section 105(h). That means:

• They can participate in the HRA.
• Their benefits are subject to nondiscrimination testing.

If the plan disproportionately benefits owner-employees, the tax-free treatment of their reimbursements could be lost.

S-Corporation and Other Pass-Through Owners

More nuance comes into play with S-corporations and partnerships.

Under IRS rules, more-than-2% S-corp shareholders and partners are generally not treated as employees for certain fringe benefit purposes. Their health benefits are handled differently for tax reporting.

While Section 105(h) technically applies to self-insured plans, the broader tax treatment of owner benefits can differ significantly depending on entity type. This is an area where business owners should coordinate with both a benefits advisor and a CPA.

Too often, I see founders assume, “It’s my company—I can reimburse myself however I want.” From a tax standpoint, that’s rarely true.

Operational Compliance Throughout the Year

Section 105(h) isn’t just about how the plan is written. It’s also about how it operates.

You could have a perfectly drafted plan document—and still fail if day-to-day administration favors highly compensated individuals.

Examples include:

• Fast-tracking reimbursements for executives but delaying others.
• Allowing exceptions to documentation rules for leadership.
• Quietly increasing reimbursement limits mid-year for a small group.

Operational consistency matters. The IRS evaluates how the plan actually functions, not just what the paperwork says.

Testing Timing and Practical Review Tips

While Section 105(h) doesn’t mandate a specific annual filing like Form 5500 (for small unfunded HRAs), employers should internally review compliance at least annually.

Here’s a practical checklist:

1. Review your employee census and compensation rankings.
2. Identify who qualifies as a highly compensated individual.
3. Confirm eligibility percentages meet one of the IRS thresholds.
4. Compare reimbursement limits across classes.
5. Ensure documentation procedures are applied uniformly.

Growing companies should repeat this review whenever:

• Compensation structures shift
• New executive roles are added
• Workforce composition changes significantly

A plan that passed testing two years ago might not pass today if your team makeup has evolved.

Why Fairness and Transparency Matter Culturally

Beyond taxes and technicalities, there’s a cultural component here.

When benefit structures heavily favor leadership without transparency, employees notice. Even if technically compliant, poorly communicated disparities can erode trust.

On the other hand, thoughtfully designed class-based reimbursements—where differences are tied to objective factors like full-time status, geography, or family size—tend to feel more defensible and understandable.

Section 105(h) pushes employers toward equity. And in today’s workforce, that’s not a bad thing.

Building a Compliant Health Benefit Strategy with SimplyHRA

Section 105(h) is detailed, technical, and easy to overlook—especially for small businesses without in-house benefits counsel. But with the right structure, it’s entirely manageable.

At SimplyHRA, we help small business owners and HR managers design ICHRA and QSEHRA plans with nondiscrimination principles built into the framework. Our platform supports compliant employee classifications, standardized reimbursement structures, substantiation workflows, and audit-ready documentation—so your plan operates consistently throughout the year, not just on paper.

Employees benefit from transparent rules, tax-advantaged reimbursements when eligible, and real-time support when questions arise. Employers gain cost control and peace of mind knowing Section 105(h) considerations are addressed proactively.

If you’d like guidance reviewing your current arrangement or setting up a compliant HRA, reach out to us at info@simplyhra.com or schedule a call at https://www.simplyhra.com/contact. We’re here to help you offer health benefits that are fair, compliant, and built to scale with your business.

Frequently Asked Questions (FAQs) about Section 105(h):

Q: Does Section 105(h) apply to fully insured small group health plans?

A: Technically, Section 105(h) applies to self-insured medical reimbursement plans, not fully insured group health insurance policies. However, the Affordable Care Act (ACA) includes separate nondiscrimination provisions that were intended to apply to insured plans as well, though enforcement has been delayed pending federal guidance. If you offer an HRA alongside a fully insured plan, the HRA itself is still subject to Section 105(h), even if the group policy is not.

Q: Are there penalties filed with the IRS if we fail Section 105(h)?

A: There is no specific excise tax or penalty form triggered solely by failing Section 105(h). Instead, the consequence is tax-related: highly compensated individuals must include the discriminatory portion of their reimbursements in gross income. That amount becomes subject to federal income tax and potentially employment taxes. Employers may also need to correct payroll reporting if issues are discovered after year-end.

Q: How is “discriminatory benefit” calculated under Section 105(h)?

A: If a plan fails the benefits test, the excess reimbursement received by a highly compensated individual over what a non-highly compensated participant could receive becomes taxable. The IRS regulations under 26 CFR §1.105-11 outline how to determine the taxable portion. Generally, it’s not the entire reimbursement that becomes taxable—only the portion considered discriminatory.

Q: Can we exclude new hires from our HRA without violating Section 105(h)?

A: Yes, but only within permitted parameters. Section 105(h) allows employers to exclude employees with less than three years of service. Many employers apply shorter waiting periods, such as 30 or 60 days, to stay competitive. The key is that eligibility rules must be applied consistently and cannot disproportionately exclude non-highly compensated employees.

Q: Does Section 105(h) apply differently if we reimburse only health insurance premiums versus all medical expenses?

A: No. Section 105(h) applies to self-insured medical reimbursement plans broadly, whether you reimburse only individual insurance premiums or also reimburse out-of-pocket medical expenses under IRC Section 213(d). The nondiscrimination rules focus on eligibility and benefit structure—not the specific types of medical expenses covered.

Q: If our company grows quickly, when should we re-test Section 105(h) compliance?

A: You should revisit nondiscrimination testing whenever there’s a material change in workforce composition, ownership, or compensation structure. Rapid hiring, executive compensation increases, or restructuring into new employee classes can all affect whether the eligibility and benefits tests are satisfied. Annual review is a best practice, even if no major changes occur.

Q: Are part-time employees required to be included for Section 105(h) purposes?

A: Not necessarily. Employers may exclude part-time or seasonal employees under certain conditions. However, exclusions cannot be designed in a way that disproportionately favors highly compensated individuals. For example, if most non-highly compensated employees are classified as part-time while executives are full-time and eligible, that structure may create compliance concerns.

Q: Is Section 105(h) the same as ERISA nondiscrimination requirements?

A: No. Section 105(h) is part of the Internal Revenue Code and focuses on tax treatment of self-insured medical reimbursements. ERISA, enforced by the U.S. Department of Labor, governs reporting, disclosure, and fiduciary obligations for benefit plans. Many HRAs are subject to both tax rules under the IRS and ERISA requirements under the DOL. Compliance in one area does not automatically ensure compliance in the other.

Q: Can an employer correct a Section 105(h) failure mid-year?

A: In some cases, yes. Employers may adjust plan terms prospectively to restore nondiscriminatory treatment. However, reimbursements already paid that are considered discriminatory may still need to be treated as taxable income to the affected highly compensated individuals. Employers should coordinate with tax advisors and benefits counsel when making corrections.

Q: Where can employers find official guidance on Section 105(h)?

A: Authoritative sources include the Internal Revenue Code at 26 U.S. Code § 105(h), Treasury Regulations at 26 CFR §1.105-11, and related IRS publications available at irs.gov. Reviewing primary sources—or working with a knowledgeable benefits administrator—helps ensure interpretations are aligned with federal guidance.

Q: Does Section 105(h) apply to dental and vision reimbursement arrangements?

A: Yes, if the dental or vision benefits are provided through a self-insured reimbursement arrangement funded directly by the employer, they are generally subject to Section 105(h). Even though dental and vision coverage are often considered “excepted benefits” under certain ACA rules, the nondiscrimination requirements for self-insured medical reimbursement plans can still apply if the employer is reimbursing those expenses on a pre-tax basis.

Q: If only one highly compensated employee participates, can the plan still fail Section 105(h)?

A: Yes. The number of highly compensated individuals doesn’t determine compliance. If that one individual receives disproportionately favorable eligibility or benefits compared to non-highly compensated employees, the plan can fail the applicable test. The focus is on structure and fairness, not headcount.

Q: Does offering different reimbursement amounts based on geographic location violate Section 105(h)?

A: Not automatically. Geographic-based classifications can be permissible if they are reasonable, applied consistently, and not designed to favor highly compensated individuals. For example, higher reimbursements in high-cost states may be defensible if tied to objective cost differences. Documentation explaining the business rationale is important in case of IRS scrutiny.

Q: How does Section 105(h) affect bonuses used to offset medical expenses?

A: If an employer provides taxable bonuses instead of using a formal reimbursement plan, Section 105(h) typically does not apply because the payments are treated as taxable wages. However, those payments lose their tax-advantaged status. Some employers mistakenly try to “work around” nondiscrimination rules this way, but doing so increases payroll taxes and eliminates the pre-tax benefit for employees.

Q: Are COBRA participants included in Section 105(h) testing?

A: COBRA qualified beneficiaries are generally not counted as active employees for purposes of eligibility testing. However, if the reimbursement arrangement continues for COBRA participants and disproportionately benefits highly compensated former employees, it may raise broader compliance considerations under tax and ERISA rules.

Q: If an HRA is integrated with an ICHRA, does Section 105(h) testing still matter?

A: Yes. Even when structured as an ICHRA, which is designed to comply with ACA integration requirements, the arrangement is still employer-funded and self-insured. That means nondiscrimination principles under Section 105(h) remain relevant, particularly when designing employee classes and reimbursement amounts.

Q: Can a startup exclude international employees from an HRA without violating Section 105(h)?

A: Potentially, yes. Employees who are not subject to U.S. income taxation or who do not receive U.S.-based health coverage may reasonably be excluded. However, the classification must be based on legitimate employment distinctions, not compensation level. Employers with global teams should carefully evaluate how U.S. tax rules apply to different categories of workers.

Q: Does Section 105(h) apply to reimbursements made through payroll without a formal HRA?

A: If an employer is reimbursing medical expenses on a pre-tax basis, even informally, the IRS may treat that arrangement as a self-insured medical reimbursement plan subject to Section 105(h). Simply running reimbursements through payroll does not eliminate nondiscrimination requirements. In fact, informal setups often increase compliance risk.

Q: Can a company rely on safe harbors to automatically satisfy Section 105(h)?

A: There is no broad “safe harbor” that automatically guarantees compliance. However, structuring eligibility to cover a large percentage of employees and applying uniform benefit formulas within legitimate classes can reduce risk. Employers should periodically review workforce data to confirm ongoing compliance rather than assuming prior structure remains compliant indefinitely.

Q: If reimbursements become taxable to highly compensated individuals, does that affect non-highly compensated employees?

A: Generally, no. The tax consequence typically applies only to the highly compensated individuals who received discriminatory benefits. Non-highly compensated employees usually retain their tax-free treatment. However, a failed test may indicate broader structural issues that the employer should correct to prevent future complications.

A Smarter Way to Stay Compliant with Section 105(h)

Section 105(h) isn’t just a technical tax rule buried in the Internal Revenue Code—it’s a guardrail that ensures fairness in employer-funded health benefits. For small businesses offering HRAs or other self-insured medical reimbursement plans, the stakes are real. Missteps can turn tax-free reimbursements into taxable income for highly compensated employees, create payroll reporting headaches, and strain internal trust. The good news? With thoughtful plan design, consistent administration, and proper documentation, compliance is entirely manageable.

At SimplyHRA, we’ve worked with founders, HR managers, and growing teams who didn’t set out to create discriminatory benefit structures—they just needed clarity and the right tools. We’ve been in those shoes. Our platform helps businesses design compliant ICHRA and QSEHRA plans with clear employee classes, consistent reimbursement rules, built-in substantiation workflows, and audit-ready reporting. That means fewer surprises at tax time, less back-and-forth with payroll, and more confidence that your plan aligns with Section 105(h) requirements. Employees get transparency and reliable, tax-advantaged reimbursements. Employers get cost control and peace of mind.

If you’re unsure whether your current arrangement complies with Section 105(h), or you’re ready to build a health benefits program that’s fair, flexible, and compliant from day one, let’s talk. Email us at info@simplyhra.com or schedule a consultation at https://www.simplyhra.com/contact. We’d be honored to help you simplify your health benefits and protect what you’ve worked so hard to build.