Section 106

Section 106 Explained for Small Business Health Plans

Section 106 allows employers to provide tax-free health benefits to employees. Learn how it works and why it matters for small businesses.

Introduction to Section 106 for Small Employers

If you’ve ever wondered why employer-sponsored health insurance isn’t treated as taxable income to employees, the answer usually traces back to Section 106 of the Internal Revenue Code. It’s one of those behind-the-scenes tax rules that quietly shapes how small businesses offer health benefits in the United States.

For small business owners, HR managers, and employees who are new to benefits, Section 106 can feel abstract. But it’s actually simple at its core: it allows employers to exclude certain health plan contributions from employees’ gross income. In plain English? Employer-paid health coverage is generally tax-free to employees.

That tax treatment is a big deal. It’s the foundation for traditional group health plans and also plays a role in newer arrangements like ICHRA (Individual Coverage Health Reimbursement Arrangements).

Let’s break it down in a practical, beginner-friendly way.

What Is Section 106?

The Basic Rule

Section 106 of the Internal Revenue Code states that gross income of an employee does not include employer-provided coverage under an accident or health plan.

That means:

• If your employer pays your health insurance premium, you typically don’t pay federal income tax on that amount.
• The employer can usually deduct those contributions as a business expense.
• The benefit is excluded from wages for federal income tax purposes.

This exclusion is one of the largest tax expenditures in the federal budget, according to the U.S. Department of the Treasury and Congressional Budget Office. It’s been part of the tax code for decades and remains central to how Americans get health coverage.

Why It Matters to Employees

For employees, the impact is straightforward:

• You receive health coverage.
• You don’t pay income tax on the employer-paid portion.
• Your taxable wages are lower than they would be if that money were paid as salary.

If your employer pays $6,000 per year toward your health insurance, that’s $6,000 you don’t report as taxable income. Depending on your tax bracket, that can mean significant savings.

How Section 106 Affects Small Business Owners

Tax Advantages for Employers

From a small business owner’s perspective, Section 106 creates a win-win tax structure:

1. Employer contributions are generally deductible as an ordinary and necessary business expense under Section 162.
2. Employees don’t treat those contributions as taxable wages.
3. Payroll taxes may also be reduced when contributions are excluded from wages.

That favorable treatment is a major reason employer-sponsored insurance became the dominant coverage model in the U.S.

But here’s the catch: compliance matters. The health plan must meet certain requirements under federal laws like:

• The Affordable Care Act (ACA)
• ERISA (Employee Retirement Income Security Act)
• IRS nondiscrimination rules (where applicable)

If a plan isn’t structured correctly, the tax-favored treatment could be jeopardized.

Budget Planning and Cost Control

Small businesses often worry about unpredictable premium increases in traditional group plans. While Section 106 allows tax-free treatment, it doesn’t control rising costs.

That’s where alternative structures like ICHRA come in. When properly designed, an ICHRA still leverages Section 106 principles by allowing tax-free reimbursement of individual health insurance premiums and medical expenses—so long as employees have qualifying coverage.

Instead of being locked into one group premium, employers can:

• Set defined monthly allowances
• Create different employee classes (e.g., full-time vs. part-time)
• Cap their financial exposure

The tax treatment remains favorable, but cost control improves dramatically.

Section 106 and Health Reimbursement Arrangements

How HRAs Fit Into the Picture

Many small employers assume Section 106 only applies to traditional group insurance. That’s not the case.

Health Reimbursement Arrangements (HRAs), when structured correctly, are also built on the tax exclusion framework tied to employer-provided health coverage.

The IRS has issued guidance over the years clarifying how employer payment plans and HRAs must comply with ACA market reforms. For example:

• IRS Notice 2013-54 addressed standalone HRAs.
• The 2019 ICHRA final regulations (issued by the Departments of Treasury, Labor, and Health and Human Services) formally authorized Individual Coverage HRAs.

Under these rules:

• Reimbursements for individual health insurance premiums can be tax-free.
• Employees must be enrolled in individual coverage that meets Minimum Essential Coverage (MEC).
• Employers must follow notice and substantiation requirements.

When structured properly, reimbursements remain excluded from income under Section 106.

Common Compliance Pitfalls

I’ve seen well-meaning small business owners try to reimburse employees for health insurance informally—just adding money to payroll and calling it a “health stipend.” That’s risky.

If reimbursements aren’t part of a compliant plan:

• The payments may be treated as taxable wages.
• The arrangement may violate ACA rules.
• Employers could face penalties under IRS Code Section 4980D.

In short, casual reimbursements don’t automatically qualify for tax-free treatment. The structure matters.

What Employees Should Know About Section 106

Marketplace Tax Credits and Employer Coverage

Employees often ask: “Can I still get premium tax credits if my employer offers coverage?”

Here’s where things intersect with ACA affordability rules.

If an employer offers an ICHRA or group coverage that is considered “affordable” under ACA standards, the employee generally cannot receive Marketplace premium tax credits for those same months.

Affordability is measured by comparing:

• The employee’s required contribution for the lowest-cost silver plan (self-only coverage), minus the employer’s allowance
• Against the IRS affordability percentage threshold (updated annually)

If the coverage is unaffordable, the employee may decline it and pursue tax credits instead.

So while Section 106 provides tax exclusion for employer-sponsored coverage, employees must evaluate whether accepting the employer benefit makes financial sense.

Owner Eligibility

Business owners often assume they’re automatically eligible for the same tax treatment as employees. Not always.

Eligibility depends on business structure:

• C-corporation owners who are bona fide employees can generally participate.
• S-corporation shareholders owning more than 2% are treated differently for tax purposes.
• Sole proprietors and partners typically cannot participate as “employees” under Section 106 but may deduct health insurance under separate rules (see IRS Publication 535 and Publication 969).

This is one area where a quick conversation with a tax advisor can prevent expensive mistakes.

Section 106 in Today’s Small Business Environment

Shifting Away from One-Size-Fits-All Plans

Traditional group health plans were once the only practical way to take advantage of Section 106. Today, small businesses have more flexibility.

With tools like ICHRA:

• Employers define their budget.
• Employees choose their own individual plans.
• Tax-free treatment is preserved.
• Administrative burden can be automated.

For startups and growing companies, that flexibility is a game-changer. Instead of negotiating annual renewals and bracing for double-digit premium increases, employers can focus on predictable contributions and compliance.

Why Documentation and Administration Matter

Even though Section 106 sounds simple, proper documentation is critical:

• Written plan documents
• Employee notices
• Substantiation of coverage
• Clear reimbursement processes

Without these pieces, the tax exclusion could be challenged.

The IRS and Department of Labor expect formal structure. “Handshake agreements” don’t count when it comes to tax-favored health benefits.

Bringing Section 106 to Life with SimplyHRA

Section 106 is the backbone of tax-free employer health benefits—but making it work correctly requires structure, compliance, and ongoing administration. At SimplyHRA, we help small business owners and HR managers design compliant ICHRA plans that preserve the tax advantages of Section 106 while giving employees real choice and flexibility. We handle plan setup, documentation, reimbursements, and compliance so you don’t have to second-guess whether you’re doing it right. If you’re ready to offer meaningful, tax-advantaged health benefits without the complexity of traditional group plans, email info@simplyhra.com or schedule a call at https://www.simplyhra.com/contact. Let’s make your health benefits simple, compliant, and built for growth.

Section 106 and Nondiscrimination Rules

Why Fairness in Benefits Design Matters

Now here’s something many small employers don’t hear about until it’s too late: Section 106 ties into nondiscrimination requirements.

While the tax exclusion under Section 106 is generous, it’s not a free-for-all. Certain self-insured health plans are subject to nondiscrimination rules under Internal Revenue Code Section 105(h). These rules are designed to prevent employers from favoring highly compensated individuals (HCIs) when offering benefits.

In practical terms, a plan cannot:

• Provide better eligibility terms to executives than to rank-and-file employees.
• Offer disproportionately higher benefits to highly paid employees.
• Structure reimbursements in a way that effectively excludes lower-paid staff.

If a plan fails nondiscrimination testing:

• The highly compensated employees may lose the tax-free treatment.
• The value of discriminatory benefits may become taxable income to those individuals.

For small businesses, this often comes into play when:

• Only leadership receives reimbursement arrangements.
• Reimbursement amounts vary dramatically without a compliant employee class structure.
• Informal “executive-only” health reimbursement setups are created.

Properly structured ICHRAs allow different employee classes (such as full-time, part-time, seasonal, or salaried vs. hourly), but those classifications must follow federal regulations. This is not something you want to improvise.

Section 106 and Payroll Tax Implications

Income Tax vs. Payroll Tax Treatment

When we talk about tax-free benefits under Section 106, most people think about federal income tax. But payroll taxes matter just as much.

Generally, employer-provided health coverage that qualifies under Section 106 is excluded from:

• Federal income tax withholding
• Social Security tax (FICA)
• Medicare tax (FICA)
• Federal unemployment tax (FUTA)

That means both the employer and employee may save on payroll taxes.

For a small business, this can add up quickly. Instead of increasing wages—which triggers payroll taxes—allocating funds through a compliant health benefit structure can be more tax-efficient.

However, if a reimbursement is structured incorrectly and treated as taxable wages:

• It must be included in Box 1 of Form W-2.
• Payroll taxes apply.
• The tax advantage disappears.

That’s why documentation and correct payroll integration are essential.

Section 106 and Cafeteria Plans

How Section 125 Interacts with Section 106

You may have heard of Section 125 “cafeteria plans.” While Section 106 governs employer-provided coverage, Section 125 allows employees to pay their portion of premiums on a pre-tax basis.

Here’s how they work together:

• Section 106 excludes employer contributions from income.
• Section 125 allows employees to make pre-tax salary reduction contributions for their share.

In a traditional group health plan:

• The employer portion is excluded under Section 106.
• The employee portion can be deducted pre-tax through a Section 125 plan.

In an ICHRA setup:

• Employer reimbursements are excluded under Section 106 principles.
• If needed, a cafeteria plan can sometimes be used for certain additional benefits (though not to pay for individual marketplace premiums on a pre-tax basis outside specific exceptions).

This interplay is technical, but the big picture is simple: the tax code gives employers structured pathways to make health benefits tax-efficient. The structure just has to be done correctly.

Recordkeeping Requirements Under Section 106

What the IRS Expects

Let’s talk brass tacks. If the IRS ever audits your business, what will they look for?

Employers offering health benefits that rely on Section 106 exclusion should maintain:

• A formal written plan document.
• Summary plan descriptions (if subject to ERISA).
• Records of employer contributions.
• Documentation that employees had qualifying coverage when required.
• Reimbursement substantiation records (for HRAs).

The IRS has made clear in multiple guidance documents that substantiation is not optional. For example, HRAs must verify that reimbursed expenses qualify as medical care under Section 213(d) of the Internal Revenue Code.

For small employers managing this manually, the administrative load can be heavier than expected. Missing documentation can undermine the tax-favored treatment.

Section 106 and Remote or Multi-State Employees

Expanding Teams, Expanding Complexity

Today’s small businesses often have remote employees scattered across different states. That introduces new wrinkles.

Section 106 itself is federal tax law, but health insurance regulation also involves:

• Federal ACA requirements.
• State insurance laws.
• Marketplace plan availability by region.

Traditional group plans may:

• Be limited to certain geographic areas.
• Require minimum participation thresholds.
• Increase costs based on regional rating factors.

By contrast, individual coverage arrangements that rely on Section 106 tax treatment allow:

• Employees in different states to choose plans available in their zip code.
• Employers to maintain a uniform reimbursement structure.
• Greater flexibility without negotiating multi-state group policies.

For distributed teams, this flexibility is often the tipping point.

Economic Trade-Offs of Section 106

Salary vs. Benefits

Here’s a question business owners sometimes ask: “Why not just increase salaries and let employees buy insurance themselves?”

On the surface, it sounds simpler. But financially, it’s usually less efficient.

If you increase salary:

• The employee pays income tax on the amount.
• Both employer and employee pay payroll taxes.
• The employee then pays insurance premiums with after-tax dollars.

If you provide structured health benefits under Section 106:

• The employer contribution is excluded from income.
• Payroll taxes are generally avoided.
• The employee receives greater net value.

That tax leverage is precisely why employer-sponsored health coverage remains so prevalent in the U.S.

Still, the key is predictability. Small businesses don’t want open-ended liability. That’s why defined contribution approaches—like ICHRA—are increasingly popular. They preserve the tax efficiency of Section 106 while controlling employer cost exposure.

Audit Risk and Penalty Exposure

What Happens If It’s Done Incorrectly?

When health benefits are structured improperly, the consequences can include:

• Loss of tax exclusion for employees.
• Payroll tax liabilities.
• ACA market reform penalties (up to $100 per day per affected employee under Section 4980D).
• ERISA compliance issues.

Many small employers aren’t intentionally noncompliant—they simply don’t realize that informal reimbursements can trigger penalties.

The safest approach is to:

• Use formal plan documentation.
• Ensure reimbursements are substantiated.
• Confirm compliance with ACA requirements.
• Maintain consistent employee classifications.

It’s far less expensive to set it up correctly than to fix it later.

Section 106 as a Strategic Tool for Growing Companies

Attracting and Retaining Talent

In competitive hiring markets, benefits matter. And because Section 106 allows tax-free treatment, employers can deliver more perceived value per dollar spent.

Employees often compare offers based on:

• Base salary.
• Health coverage.
• Employer contribution amounts.
• Flexibility in plan choice.

When structured well, health benefits become a strategic asset—not just an expense line item.

Small businesses that can’t compete dollar-for-dollar on salary can still compete on smart, tax-efficient benefit design.

Making Section 106 Work Without the Headaches

Section 106 gives small businesses a powerful tax advantage—but only when the health benefit arrangement is structured and administered correctly. At SimplyHRA, we help employers design compliant ICHRA plans that preserve the tax exclusion under Section 106, automate documentation and reimbursements, and provide employees with real plan choice across states. Instead of juggling IRS rules, ACA requirements, and payroll coordination on your own, you get a streamlined platform built specifically for small teams. If you’re ready to offer tax-efficient, compliant health benefits without traditional group plan complexity, email info@simplyhra.com or schedule a call at https://www.simplyhra.com/contact. Let’s build a smarter benefits strategy together.

Frequently Asked Questions (FAQs) about Section 106:

Q: Does Section 106 apply to dental and vision benefits?

A: Yes, in most cases. Section 106 excludes employer-provided coverage under an accident or health plan, and that definition generally includes dental and vision plans. If an employer pays premiums for standalone dental or vision insurance, those employer contributions are typically excluded from the employee’s gross income. As long as the arrangement qualifies as an employer-provided health plan under IRS rules, the tax exclusion applies.

Q: Are reimbursements for family members covered under Section 106?

A: Generally, yes. If the health plan covers an employee’s spouse or dependents, employer-paid premiums or reimbursements for their coverage are usually excluded from the employee’s income under Section 106. Dependents are defined under federal tax rules, primarily in Internal Revenue Code Section 152. However, if coverage is extended to individuals who do not qualify as tax dependents, the tax treatment can become more complicated and may create imputed income.

Q: Does Section 106 have dollar limits like an HSA or FSA?

A: No, Section 106 itself does not impose annual dollar contribution limits on employer-provided health coverage. Unlike Health Savings Accounts (HSAs) or Health Flexible Spending Arrangements (FSAs), which have IRS-set annual caps, employer contributions to health insurance premiums or compliant HRAs are not capped by Section 106. That said, other rules—such as affordability standards under the Affordable Care Act—may indirectly influence contribution amounts.

Q: How does Section 106 interact with COBRA coverage?

A: If an employee elects COBRA continuation coverage after a qualifying event, the tax exclusion under Section 106 can still apply to employer-provided coverage. However, in most small business settings, COBRA premiums are paid primarily by the former employee on an after-tax basis. If an employer subsidizes COBRA premiums, that employer-paid portion may still qualify for exclusion from income, depending on how the arrangement is structured.

Q: Is Section 106 affected by whether a plan is insured or self-insured?

A: Section 106 applies broadly to employer-provided accident or health coverage, whether the plan is fully insured through an insurance carrier or self-insured by the employer. However, self-insured plans may also be subject to additional nondiscrimination testing under Section 105(h). Fully insured small group plans are generally not subject to the same 105(h) testing rules, although other ACA requirements still apply.

Q: Do part-time employees qualify for tax-free treatment under Section 106?

A: Section 106 does not limit tax exclusion based on full-time or part-time status. If a part-time employee is eligible for and enrolled in an employer-sponsored health plan, the employer’s contributions are generally excluded from that employee’s income. The real question is plan eligibility design, which the employer controls—subject to ACA employer mandate rules if the company is an applicable large employer.

Q: Can an employer offer a taxable health stipend instead of using Section 106?

A: Yes, but it changes the tax outcome. If an employer provides a flat stipend without a formal health plan structure and without compliance safeguards, the payment is typically treated as taxable wages. That means it’s subject to income and payroll taxes. While simpler on the surface, taxable stipends eliminate the tax advantages that Section 106 was designed to provide.

Q: Does Section 106 apply to retiree health benefits?

A: In many cases, yes. Employer-provided retiree health coverage may still qualify for exclusion from income under Section 106. However, retiree-only plans are treated differently under certain ACA market reform rules. Employers offering retiree health benefits should carefully structure those plans to ensure compliance with both tax and benefits regulations.

Q: Is Section 106 automatic, or does an employer need to file something with the IRS?

A: There is no separate election form filed specifically for Section 106 treatment. The exclusion applies automatically if the employer’s health plan is properly structured and compliant with federal law. However, employers must maintain appropriate documentation, ensure correct payroll reporting, and comply with applicable ACA and ERISA requirements. Failure to administer the plan correctly can jeopardize the tax-favored status.

Q: Can state taxes treat Section 106 benefits differently?

A: While Section 106 governs federal income tax treatment, most states follow federal tax rules and also exclude employer-provided health coverage from taxable income. That said, state tax conformity varies. Employers operating in multiple states should confirm whether their state fully conforms to federal exclusion rules or has unique reporting requirements.

Q: Does Section 106 apply to health benefits provided through a Professional Employer Organization (PEO)?

A: Generally, yes. If your small business uses a PEO and employees receive health coverage through the PEO’s group plan, the tax exclusion under Section 106 typically still applies. The key factor is that the coverage is considered employer-provided under a qualifying health plan. However, contractual arrangements between the PEO and your company should clearly establish co-employment status and plan sponsorship to avoid confusion about compliance responsibility.

Q: Are wellness program benefits covered under Section 106?

A: It depends on the type of benefit. If a wellness program provides medical care as defined under Internal Revenue Code Section 213(d), such as health screenings or flu shots, employer-paid costs are generally excluded from income under Section 106. However, cash rewards or gym memberships that do not qualify as medical care may be treated as taxable income unless structured carefully. The details matter here, especially with lifestyle benefits.

Q: How does Section 106 affect employees on unpaid leave?

A: If an employee remains covered under the employer’s health plan during unpaid leave and the employer continues to pay its portion of the premium, that employer-paid amount is generally still excluded from income under Section 106. However, how the employee pays their share—pre-tax or after-tax—can change depending on whether wages are available for salary reduction. Leave policies and plan documents should clearly address these scenarios.

Q: Does Section 106 apply to health benefits for domestic partners?

A: Federal tax treatment depends on whether the domestic partner qualifies as a tax dependent under IRS rules. If the partner is a qualified tax dependent under Section 152, employer-paid coverage may be excluded from income under Section 106. If not, the fair market value of the coverage provided to the domestic partner may need to be included as imputed income to the employee. Many employers overlook this nuance, which can create W-2 reporting issues.

Q: Can Section 106 benefits be offered to independent contractors?

A: No, not in the traditional sense. Section 106 applies to employees. Independent contractors are not employees for federal tax purposes, so employer-provided health coverage exclusions generally do not apply. If a business provides payments to contractors for health insurance, those payments are typically treated as taxable compensation and reported on Form 1099-NEC. Misclassification of workers can create significant tax exposure.

Q: Does Section 106 require employers to offer health benefits?

A: No. Section 106 is a tax exclusion rule, not a mandate. It explains how employer-provided health benefits are treated for tax purposes. Whether an employer must offer coverage depends on other laws, such as the Affordable Care Act’s employer mandate, which applies only to applicable large employers (generally those with 50 or more full-time equivalent employees). Small employers are not federally required to offer coverage but may choose to do so for competitive and tax advantages.

Q: How does Section 106 affect W-2 reporting?

A: Although employer-sponsored health coverage is excluded from taxable income under Section 106, employers may still be required to report the total cost of employer-sponsored coverage in Box 12 of Form W-2 using Code DD. This reporting requirement, mandated under the ACA, is informational only. It does not make the coverage taxable. Small employers under certain size thresholds may be exempt from this reporting requirement, depending on IRS guidance.

Q: Does Section 106 apply to short-term health insurance?

A: Typically, no. Short-term limited duration insurance does not qualify as comprehensive major medical coverage and may not meet the requirements necessary for tax-free reimbursement under compliant employer health arrangements. For arrangements like ICHRA, employees must be enrolled in individual coverage that qualifies as Minimum Essential Coverage (MEC). Short-term plans generally do not meet that standard, which can disqualify reimbursements from favorable tax treatment.

Q: What happens if an employer accidentally includes health benefits as taxable wages?

A: If employer-provided health coverage that should qualify under Section 106 is mistakenly treated as taxable income, corrections may be possible through amended payroll filings, such as Form 941-X. Timing matters, and corrections should be handled carefully to ensure both employer and employee payroll taxes are properly adjusted. Working with a knowledgeable payroll provider or tax advisor is strongly recommended.

Q: Can Section 106 benefits continue during a company merger or acquisition?

A: Yes, but transitions must be handled carefully. In mergers or acquisitions, responsibility for health plan sponsorship and compliance may shift. The tax exclusion under Section 106 can continue as long as the acquiring or surviving employer maintains a compliant health plan structure. Plan documents, employee notices, and payroll systems should be reviewed during due diligence to avoid unintended tax consequences or coverage gaps.

Section 106 Done Right for Growing Small Businesses

Section 106 is the quiet engine behind tax-free employer health benefits—but as you’ve seen, the real challenge isn’t understanding the concept. It’s implementing it correctly. Between nondiscrimination rules, payroll tax treatment, ACA compliance, documentation requirements, and proper reimbursement structures, even well-intentioned small businesses can stumble. And when mistakes happen, the tax advantages that make Section 106 so powerful can quickly unravel.

That’s exactly why we built SimplyHRA. We’ve been in your shoes—navigating rising premiums, confusing IRS guidance, and the pressure to offer competitive benefits without enterprise-level HR teams. Our platform helps small business owners and HR managers design compliant ICHRA plans that preserve the tax advantages of Section 106 while giving employees the flexibility to choose coverage that fits their lives. We automate reimbursements, documentation, and compliance safeguards so your team doesn’t have to second-guess whether everything is structured properly. Employees get clarity and choice. Employers get cost control and peace of mind.

If you’re offering health benefits—or thinking about it—and want to make sure you’re leveraging Section 106 the right way, let’s talk. Email info@simplyhra.com or schedule a call at https://www.simplyhra.com/contact. We’ll walk you through your options and help you build a compliant, tax-efficient health benefits strategy that supports your business and your people.