6.5 MIN READ
Most businesses start small, and many stay small by design. If you’re the owner of a small business where things start and end with you, you should know about Section 105 plans.
A properly structured Section 105 medical reimbursement plan is an effective way to save money on taxes when used appropriately, allowing business owners to reimburse themselves, tax free, for medical expenses.
These plans are a way to offer health benefits to employees without the headache, hassle, and cost of group health insurance. Additionally, many business owners use a Section 105 plan to increase their personal tax savings.
But what if you are your only employee? As a business owner, are you eligible to participate in a Section 105 plan?
The short answer is yes.
Business owners can participate in their business’s Section 105 plan.
But whether or not you are eligible to receive tax-free reimbursements depends on your owner status and how you file taxes.
What is a Section 105 Plan?
Similar to a business expense account, a Section 105 plan provides employees an allowance to use on health insurance. This medical reimbursement plan is aptly named after Section 105 of the IRS code, which allows an employer to reimburse employees, and their dependents, for their out-of-pocket medical costs and health insurance premiums under an employer-sponsored health plan.
A Section 105 plan is not health insurance. Rather, it is a means to reimburse employees for medical and individual health insurance expenses.
Section 105 Plan Requirements
Your ability to deduct medical expenses via a Section 105 plan as a business owner depends on a few major requirements.
First, the plan must be fully employer-funded. No portion of the plan can be funded through employee salary deduction.
Second, you can only reimburse eligible and substantiated medical expenses and health insurance premium amounts. If an expense is not included on the list of standard pre-approved expenditures, then a physician’s note documenting the medical necessity of the expense may be required.
Third, you must be considered an employee of your business, meaning you must draw a regular W-2 salary or wages from the business in order to qualify as an employee in the eyes of the IRS. If you are not legally considered an employee of your business, but you can legitimately employ your spouse as an employee, you may be able to take advantage of the Section 105 plan. More on that later.
Lastly, your ability as a business owner to reimburse yourself, tax free, for your medical expenses depends on your owner status (as dictated by business structure/tax filing status).
Let’s dig into that last piece.
Section 105 Plan Eligibility by Owner Status
C Corp owners who receive a regular salary from their business are considered employees and can fully participate in Section 105 plans and receive all reimbursements 100% tax free, just like non-owner employees.
In this situation, the “corporation” (your business) is considered the employer, and the business owner (you) is legally considered a salaried employee. Any qualified health insurance expenses incurred by you or your family members can be reimbursed tax free via the Section 105 plan.
Sole Proprietorships & Partnerships
If you are a sole proprietor, you cannot establish a Section 105 medical reimbursement plan solely for yourself and have your business reimburse you for out-of-pocket medical expenses on a tax-free basis— reimbursements are subject to state and federal income tax withholding.
However, if you can legitimately employ your spouse as a W-2 employee of your business, you can receive the benefit tax free. In this situation, the plan would be set up in your spouse’s name, and you would be listed as a dependent.
The key word here is “legitimately.” You can’t just put your spouse “on the books” to reap the tax advantages. Merely calling your spouse an “employee” is not sufficient. They must be a bona fide employee, meaning they must perform significant business duties and provide meaningful services to the business (part-time work, so long as it’s legitimate and non-trivial, counts). The IRS scrutinizes spousal employment, and you must be able to prove your spouse is actually a regular employee if the IRS comes knocking at your door.
The same holds true for businesses structured as partnerships. The additional restriction here is that your spouse cannot be a partner in the business. If you and your spouse are both partners in the business, neither of you are eligible to participate in a Section 105 plan.
S Corp business owners who own less than 2% of the business’s shares and who are active in the business qualify for a Section 105 plan without spousal employment.
S Corp business owners who own more than 2% of the business’s shares can technically participate in the Section 105 plan, but, as is the case with sole proprietorships and partnerships, reimbursements are not tax free. They are subject to state and federal income tax withholding. (They are not, however, subject to FICA—Federal Insurance Contributions Act—taxes.)
Unfortunately, the spouse-as-an-employee workaround does not work in this situation. Family members—spouses and children included—who do not have ownership in the business are treated as if they did and are therefore ineligible to receive the benefits on a tax-free basis.
Because 2% or greater owners of S Corps (and any family members, including spouses and dependents) are not allowed to deduct state or federal income taxes, the appeal of a Section 105 plan is largely negated.
If your business is structured as an LLC, then the rules around your participation in a Section 105 plan vary based on how you file your taxes—as a partnership, sole proprietorship, or corporation. The appropriate rules outlined based on filing status above apply.
Section 105 medical reimbursement plans continue to grow in popularity and are commonly used by small business owners as a health insurance solution that cuts down on costs and complications. It has been estimated that Section 105 plans save small business owners an average of $5,000 per year on their taxes.