Understanding HRA Basics and Section 105
A Health Reimbursement Arrangement (HRA) allows employers to reimburse employees for qualified medical expenses on a tax-free basis. Section 105 of the Internal Revenue Code governs these plans and outlines the requirements for their proper operation. Reimbursements are fully deductible by the employer and tax-free for the employee. To maintain these tax advantages, the plan must follow IRS rules closely.
HRAs are funded entirely by the employer. Employees are not permitted to contribute under any circumstances. While there is no formal contribution limit, employers often set reasonable annual caps. Reimbursements can only be made for approved medical expenses.
There are different types of Section 105 HRAs, including individual arrangements, group plans, and HRAs integrated with group health insurance. Sole proprietors and partners are not eligible to participate. However, C-Corp employees and spouses who work in the business may be covered. Eligibility is based on IRS definitions and entity structure.
Although Section 105 HRAs are flexible, they must be carefully structured and managed. Proper documentation and adherence to procedures are essential. This article covers the key reimbursement rules, claim documentation, and compliance responsibilities. Employers must understand and follow these rules to avoid penalties.
What Expenses Are Reimbursable?
HRAs may only reimburse qualified medical expenses. The IRS defines eligible expenses in Section 213(d) of the tax code and in Publication 502. To qualify, an expense must be primarily for medical care. It cannot be cosmetic or for general wellness.
Common reimbursable expenses include insurance premiums, doctor visits, prescriptions, dental services, and vision care. Additional eligible expenses may include mental health counseling, chiropractic treatment, and lab tests. Long-term care insurance premiums are also eligible, subject to age-based IRS limits. These expenses must be clearly defined in the plan document.
Employers should use IRS guidelines to determine which expenses qualify. While customization is allowed, any limitations must be stated in writing. The plan must be applied consistently across all employees. Ambiguous or undocumented claims should not be reimbursed.
Over-the-counter medications and menstrual care products are now eligible without a prescription. This change was introduced through the CARES Act in 2020. Cosmetic procedures remain ineligible unless required due to injury or illness. Employers must ensure expenses meet IRS definitions before approval.
Plans may also reimburse costs for employee spouses and dependents. However, this must be specified in the written plan. If dependent coverage is excluded, those claims cannot be paid. Clear language in the document avoids disputes and confusion.
| Expense Category | Typically Covered | Examples | IRS Publication 502 Reference |
|---|---|---|---|
| Medical Care | Yes | Doctor visits, hospital stays, surgery | Yes |
| Prescription Drugs | Yes | Generic and brand medications | Yes |
| Dental Care | Yes | Cleanings, fillings, orthodontics | Yes |
| Vision Care | Yes | Eye exams, glasses, contact lenses | Yes |
| Mental Health | Yes | Therapy, counseling, psychiatric care | Yes |
| Alternative Medicine | Sometimes | Chiropractic, acupuncture | Yes |
| Health Insurance Premiums | Yes* | Individual or family premiums | Yes |
| Cosmetic Surgery | No | Elective cosmetic procedures | No |
How to Process Reimbursements
Reimbursements must follow procedures defined in the written plan document. Employees must submit claims through a formal process, usually involving a reimbursement form and documentation. Reimbursements should not be issued without valid paperwork. Each claim must meet the plan’s requirements.
Supporting documents include receipts, invoices, and proof of payment. Credit card statements are not sufficient unless they provide complete details. Each submission should include the date, provider name, and a description of services. Incomplete claims must be rejected and returned.
Employers should reimburse approved claims within a reasonable time frame. Many plans aim for 15 to 30 days after claim approval. Quick turnaround builds trust and keeps the process efficient. Delays can cause employee dissatisfaction and increase errors.
Reimbursement payments should go directly to the employee, not the provider. This avoids issues with double billing and simplifies the audit trail. Reimbursing employees directly also supports proper recordkeeping. This method is widely accepted and recommended.
All documentation must be retained by the employer. Plan documents and claim records should be stored for at least six years. These materials are essential during IRS audits. Proper recordkeeping supports the validity of deductions.
Common Compliance Requirements
Section 105 limited purpose HRAs must be supported by a written plan document. Verbal arrangements are not acceptable under IRS rules. The plan must outline eligibility rules, covered expenses, and claim procedures. Each provision must comply with applicable tax law.
Claims must be fully documented and submitted during the appropriate plan year. Some plans offer a grace period or run-out window. These timeframes must be clearly defined in the plan. Reimbursing claims outside those windows can create compliance risks.
Section 105(h) includes nondiscrimination rules that apply to many plans. The plan must not favor highly compensated employees. Offering better benefits to executives or managers could make all reimbursements taxable. Equal access and treatment are essential to compliance.
Reimbursements cannot be made in advance of an incurred expense. Only expenses that have already occurred and are properly documented qualify. Advance payments or estimates are not permitted. This prevents misuse and enforces accuracy.
Plans covering two or more employees may fall under ERISA. If ERISA applies, the plan must include additional disclosures and responsibilities. Employers may be required to provide Summary Plan Descriptions and maintain fiduciary standards. Professional assistance may be needed for ERISA compliance.
Errors That Trigger IRS Audits
Reimbursing undocumented expenses is a common and costly mistake. Payments without proper documentation may be reclassified as taxable income. This can result in penalties, interest, and back taxes. Documentation is not optional—it’s essential.
Another major error is allowing ineligible individuals to participate. Sole proprietors, partners, and certain S-Corp owners cannot use HRAs directly. Only W-2 common-law employees qualify for participation. Failing to follow these rules endangers the plan.
Employers also risk compliance when reimbursing nonqualified expenses. Gym memberships, cosmetic procedures, and general health items are not allowed. Reimbursing these creates taxable benefits and audit exposure. Always use IRS definitions when reviewing claims.
Many plans fail because they lack documentation or a valid plan document. Without clear procedures and defined rules, mistakes are more likely. The IRS will disallow deductions without written proof. Proper documentation supports the plan’s tax-exempt status.
Failing to update the plan document is another frequent problem. Tax laws and eligible expenses change over time. Employers must revise plan terms to reflect these updates. An outdated document can be just as risky as no document.
Best Practices for Reimbursement Compliance
Employers should use a standard reimbursement form for all claims. This form should include employee details, claim amount, and purpose. Required receipts and supporting documents must be attached. Claims without forms should not be reimbursed.
Establish a clear deadline for claim submissions. Many plans allow 60 to 90 days after the plan year ends. Late claims should be denied according to the plan terms. Deadline enforcement ensures fairness and reduces backdated errors.
Only reimburse expenses that are clearly eligible. Employers should verify receipts, confirm the nature of the service, and ensure all details are present. Bundled invoices must be itemized before approval. Attention to detail is essential.
Maintain a separate ledger for all reimbursements. This keeps financial reporting clean and supports accurate bookkeeping. It also simplifies year-end reviews and audits. Mixing records with other payroll functions should be avoided.
Consider hiring a third-party administrator (TPA) to manage your plan. TPAs provide forms, approve claims, and handle recordkeeping. They help reduce compliance risk and administrative burden. This is especially useful for businesses with multiple employees.
Final Thoughts
Health Reimbursement Arrangements under Section 105 provide valuable tax savings for both employers and employees. However, to maintain these benefits, reimbursements must follow strict IRS rules. A written plan, proper documentation, and timely processing are essential for compliance. Without these, reimbursements may be reclassified as taxable wages.
Qualified expenses must align with IRS definitions, and each claim must be fully documented. Plans must also comply with ERISA, Section 105(h), and applicable nondiscrimination rules. Reimbursing ineligible employees or improper expenses creates unnecessary risk. The IRS closely monitors these arrangements.
Common mistakes include reimbursing undocumented claims, allowing nonemployees to participate, and using outdated plan documents. These errors can trigger audits and result in back taxes. Employers should proactively monitor their plans and enforce internal procedures. Frequent plan reviews help maintain ongoing compliance.
Following best practices protects your business and your employees. Accurate records, consistent procedures, and clear documentation all support your Section 105 plan. Consider using a TPA if you need help managing the workload. Compliance is critical—and entirely achievable with the right structure.
When properly administered, an HRA is a powerful tool. It lowers tax burdens and supports employee well-being. With careful management, your business can reap the full benefits of this strategy. Section 105 plans work best when they follow the rules.
