S-corporations offer many tax advantages for small business owners. However, when it comes to medical reimbursement through a Section 105 plan, S-corp owners face a serious limitation. The IRS does not allow owners to receive tax-free benefits under a Section 105 plan. This restriction leaves many owners searching for a workaround.
The good news is that we have a solution!
In this post, we will discuss the #1 way to structure section 105 plans for S-Corp owners. In addition, we will provide some set up tips. Let’s jump in!
Some Background
Some of the benefits that they offer include limited liability for business owners and shareholders and pass-through taxation. This means that all profits are distributed to owners and taxed on an individual basis according to the individual’s personal income tax bracket.
However, one of the distinct disadvantages of the S-Corporation structure is that it does not allow shareholders or owners of the business with an ownership percentage of 2% or more to receive the tax-free benefits of Section 105 plans.
Under current tax law, spouses and children of a shareholder with an ownership percentage larger than 2% are also treated as shareholders, even if they do not participate in the business at all.
Why S-Corp Owners Are Excluded
Under current IRS rules, S-corp shareholders who own more than 2% of the company are not considered employees for the purposes of Section 105. This means any reimbursement they receive from a Section 105 plan is treated as taxable income—not a tax-free benefit.
While S-corp owners can deduct some health insurance premiums through their wages or Form 1040, they cannot access the full range of tax-free reimbursements allowed under Section 105. This includes items like dental care, vision expenses, co-pays, and out-of-pocket medical costs.
As a result, many S-corp owners miss out on a valuable benefit that’s available to C-corp owners and employees. This creates a major incentive to restructure part of the business to regain access.
The Solution: Create a C-Corp for the 105 Plan
One of the most effective strategies is to create a management C-corporation that performs services for the S-corporation. The C-corp becomes a separate legal and tax entity, capable of sponsoring its own Section 105 medical reimbursement plan.
Here’s how it works:
- The S-corporation enters into a legitimate service agreement with the new C-corp.
- The S-corp pays the C-corp for management, consulting, administrative, or other services.
- The owner becomes an employee of the C-corp and receives wages through payroll.
- The C-corp establishes a Section 105 plan and reimburses the owner (as an employee) for eligible medical expenses.
- Reimbursements are tax-free to the owner and fully deductible to the C-corp.
This strategy is 100% legal when structured correctly. The C-corp must operate as a legitimate business, provide actual services, and maintain proper documentation.
Key Compliance Considerations
To implement this strategy successfully, you must follow certain IRS and corporate governance rules. First, the C-corp must be treated as a real business—not just a pass-through for medical deductions. It should have its own:
- EIN and bank account
- Corporate records and bylaws
- Payroll system and W-2 reporting
- Invoices for services performed
Second, the owner must receive reasonable compensation from the C-corp in order to qualify as an employee. That wage can be modest but must be consistent and run through proper payroll.
Third, the C-corp must establish a written Section 105 plan document that outlines:
- Reimbursement limits
- Covered expenses
- Claim procedures
- Eligible participants
Finally, the plan must maintain compliance with IRS substantiation rules. All reimbursed expenses must be supported by receipts or detailed records. Improper or undocumented reimbursements can lead to disallowed deductions or penalties.
Why This Strategy Works
This structure works because C-corporation owners are treated as employees for federal tax purposes. That makes them eligible for tax-free benefits under a properly structured Section 105 plan. It also allows the business to deduct those expenses as a corporate fringe benefit.
By combining the income-splitting flexibility of an S-corp with the fringe benefit advantages of a C-corp, owners get the best of both worlds. They can reduce personal healthcare costs while maintaining a lean tax structure.
For small business owners with significant out-of-pocket medical expenses, this approach can generate thousands in annual tax savings. When executed correctly, it’s a highly effective—and fully legal—method to maximize health benefit deductions.
S-corp owners are often surprised to learn they can’t personally benefit from a section 105 plan. But with a little restructuring, they can fix the problem. By forming a C-corp to handle management services and adopting a medical reimbursement plan there, owners can legally reimburse themselves tax-free. With proper documentation and compliance, this strategy offers one of the most powerful fringe benefit opportunities available to small business owners today.
Section 105 S-Corporation: Rules
Owners and their families are still eligible to set up a Section 105 plan even if the business is structured as an S-Corporation. The cost of their premiums will be passed through as taxable wages on Form 1120S. They can then claim a deduction for the cost of the premiums on page one of their Form 1040. This will allow them to reclaim any federal and state tax dollars that were paid on monies that were used for health insurance premiums.
However, they are still subject to FICA taxes of 15.3% – to a maximum of $16,479.60 – in 2019. It should also be noted that the deduction for the health insurance premiums and out of pocket expenses on Form 1040 cannot exceed the amount of earned income derived by the taxpayer from the business.
To avoid federal and state taxation on the payment of health insurance premiums, the business must pay the premiums for the plan directly, unless there is only one sole shareholder with a greater than 2% ownership in the company.
| Benefit | Description |
|---|---|
| Tax-Free Reimbursements | Employees receive reimbursements for medical expenses without paying federal income tax. |
| 100% Business Deduction | Employers can deduct all qualified reimbursements as a business expense. |
| Covers a Wide Range of Expenses | Includes medical, dental, vision, insurance premiums, prescriptions, and more (IRC §213(d)). |
| Flexible Plan Design | Employers choose which expenses to cover and set annual reimbursement limits. |
| Works for Small Businesses | Especially effective for C-corps, sole proprietors (spouse employee), and family-run businesses. |
| No Insurance Required | The plan can exist with or without a group health insurance policy. |
| Helps Attract & Retain Talent | Adds a valuable benefit for employees without the high cost of traditional insurance. |
| Reduces Payroll Taxes | Benefits are not subject to Social Security or Medicare taxes for the employee. |
| Scalable With Business Growth | Plans can be adjusted as the business grows or employee count increases. |
| Customizable Eligibility | Employers define which employees are eligible based on consistent, documented rules. |
Can an S-Corp offer an HRA?
If there are multiple shareholder that pay for their premiums directly and do not receive any reimbursement from the business, then the shareholders can only claim the premiums as a medical expense deduction if they exceed 10% of the shareholder’s adjusted gross income.
In addition, considerations on reimbursement of health care premiums should be made considering the Affordable Care Act (ACA) of 2014. The ACA introduced a ban on employers for reimbursing employees for individual health insurance premiums.
However, there is some confusion on the reimbursement of multiple shareholders with a greater than 2% ownership in S-corporations and on how the ban impacts the reimbursement of policies for owners’ spouses.
Current guidance suggests taking a conservative view – ensure that the health insurance plan is purchased through the company, under the company’s name and premiums are paid directly by the company.
The ban also introduced penalties of $100 per day for employees that are reimbursed for health insurance plans that are not directly paid for by the company. In short, it is best to ensure that health insurance premiums are paid directly by the company to avoid any confusion or non-compliance issues.
Final Thoughts
S-corp owners are often surprised to learn they can’t personally benefit from a Section 105 plan. But with a little restructuring, they can fix the problem. By forming a C-corp to handle management services and adopting a medical reimbursement plan there, owners can legally reimburse themselves tax-free. With proper documentation and compliance, this strategy offers one of the most powerful fringe benefit opportunities available to small business owners today.
