The reimbursements are 100% deductible to the business. Employees do not pay income tax on the medical benefits received. This creates a significant tax advantage for both employer and employee. However, all reimbursements must meet specific IRS guidelines.
This article explores the most important Section 105 plan limits. These include contribution restrictions, eligibility requirements, benefit caps, and reimbursement procedures. Each plays a vital role in plan administration.
The Basics of Section 105 Plans
Section 105 plans are employer-sponsored medical reimbursement arrangements authorized by the Internal Revenue Code. They allow tax-free reimbursement of medical expenses for employees. These plans are often used by small business owners, especially sole proprietors with employed spouses. Tax savings can be substantial when plans are properly structured.
Section 105 plans can be customized. Employers define eligible employees, reimbursable expenses, and maximum annual limits. The plan must be documented in writing to be valid. Failure to document disqualifies the tax benefits.
These plans are highly flexible but must be carefully managed. Not every expense qualifies, and not every structure is allowed. Section 105 plans are subject to certain federal rules. Understanding those limits is essential to maintain compliance.
Limits on Eligible Expenses
Section 105 plans only allow reimbursement for qualified medical expenses. These are defined by IRS Publication 502 and Section 213(d) of the tax code. Expenses must be primarily for medical care. They must be legal, necessary, and not cosmetic.
Examples of allowable expenses include doctor visits, prescriptions, surgeries, and dental care. Other eligible items include insurance premiums, eyeglasses, and mental health services. Transportation costs for medical care may also qualify. Expenses must be for the employee, spouse, or dependents.
Cosmetic procedures are generally excluded. Examples include teeth whitening and elective plastic surgery. These are considered non-medical and are not reimbursable. Reimbursing these can violate plan rules.
All reimbursed expenses must be documented. Receipts, invoices, and proof of payment are required. Claims without documentation should be denied. This helps maintain IRS compliance.
Employers can customize the list of reimbursable expenses. But they cannot expand it beyond what the IRS allows. Limits must be clearly defined in the plan document. This ensures consistency and transparency.
Limits on Who Can Participate
Not every individual qualifies to participate in a Section 105 plan. The IRS limits eligibility to common law employees. Sole proprietors, partners, and more-than-2% S-corp shareholders are excluded. They cannot directly benefit from the plan.
There is an exception for sole proprietors employing a spouse. If the spouse is a legitimate employee, they can participate. The plan can reimburse the spouse’s family medical costs. That includes expenses for the sole proprietor.
The spouse must perform real work for the business. This must be regular, necessary, and documented. Casual or undocumented help does not qualify. Wages should be reasonable and reported.
Plans with multiple employees must offer nondiscriminatory benefits. You cannot favor highly compensated or key employees. Discrimination can result in taxable benefits for all. The rules follow Section 105(h) of the code.
Employers must apply eligibility rules consistently. The plan document must define eligibility criteria. Changes in eligibility must be reflected in writing. Inconsistent application creates audit risk.
Limits on Benefit Amounts and Contributions
Section 105 plans do not have fixed IRS-mandated contribution limits like HSAs. However, employers typically impose reasonable annual caps. This protects against abuse and helps manage benefit costs. Annual caps are written into the plan document.
The amount must be reasonable and consistent with business needs. It cannot be excessive or arbitrary. Amounts must reflect ordinary and necessary business expenses. Otherwise, the IRS may challenge the deduction.
Plans often reimburse only what is submitted. Unused portions do not carry over. They revert back to the employer at year-end. There is no vested account like an HSA.
Some employers set monthly or quarterly caps. Others use an annual limit per employee or per family. This adds budget control and simplifies recordkeeping. Caps must be applied uniformly to all eligible employees.
Employers cannot discriminate in contribution levels. Highly compensated employees cannot receive higher benefit amounts. All participants must be treated equally. This maintains compliance with nondiscrimination rules.
Administrative and Procedural Limits
Reimbursements must follow strict administrative rules. Employees must submit valid claims with supporting documentation. Employers must review and approve each claim. No automatic payments are allowed.
Reimbursement requests must be submitted within the plan year. Some plans allow a brief grace period. But most expenses must be incurred during the coverage period. Late claims should be denied.
Employers must retain all plan records. This includes claims, receipts, plan documents, and communications. The IRS may request these during an audit. Proper documentation supports the plan’s legitimacy.
Payments must be made directly to the employee. Employers should avoid paying providers directly. This keeps the arrangement clean and consistent. It also simplifies bookkeeping and auditing.
Employers may use third-party administrators (TPAs). TPAs help manage documentation, compliance, and recordkeeping. This reduces risk and administrative burden. However, employers are still responsible for compliance.
| Requirement | Details |
|---|---|
| Written Plan Document | Must outline eligibility, covered expenses, reimbursement procedures |
| Employee Status | Participant must be a W-2 employee |
| Recordkeeping | Receipts, claim forms, payroll, and reimbursement logs must be kept |
| Nondiscrimination | If the plan is not a one-person plan, it must not discriminate in favor of highly compensated employees |
| Proper Tax Reporting | Reimbursements for 2% S-Corp owners must be reported on W-2 (Box 1 only) |
Bottom Line
Section 105 plans are powerful tools for reducing healthcare costs and tax liabilities. They offer flexibility, control, and significant savings. But those benefits depend on proper plan design and administration. Understanding plan limits is essential.
Limits on eligible expenses ensure that only valid medical costs are reimbursed. Documentation is necessary to prove legitimacy. Employers must stick to IRS definitions and rules. Straying from these limits can cause problems.
Participation rules must be followed exactly. Only qualified employees can receive benefits. Owner-employees must structure participation carefully. Violations can lead to lost deductions.
Benefit amounts should be capped reasonably. They must reflect ordinary business practices. No discrimination is allowed in benefit levels. Consistency and fairness are required.
Administrative procedures matter just as much as legal structure. Timely documentation and reimbursements are critical. Employers must follow internal deadlines and retain records. TPAs can provide helpful support.
When used correctly, Section 105 plans offer tremendous value. They make health expenses tax-deductible and help attract employees. But only if limits are understood and respected. Compliance always comes first.
