Internal Revenue Code 105: Where the Tax Win Breaks

Somewhere between setting up the plan and running payroll, the documentation slips. No receipts on file. No written plan document. No annual nondiscrimination testing. Then the IRS asks a question no one can answer cleanly. The frustrating part is that the underlying structure was probably sound. Internal Revenue Code 105 genuinely lets employers reimburse qualified medical expenses tax-free, cut payroll taxes, and strengthen benefits without adding to cash compensation. The problem isn't the code. It's how rarely anyone treats it as a living compliance program instead of a one-time setup.

In This Post

• What Internal Revenue Code 105 Covers
• Key Eligibility and Compliance Rules for Nonprofits
• Optimizing Section 105: Strategies for Tax Savings and Benefit Design
• Navigating Nuances, Limitations, and Advanced Considerations
• What Most Nonprofits Miss About Internal Revenue Code 105
• Work With a Benefits Advisor Who Understands Your Sector
• Frequently Asked Questions

Key Takeaways

Tax-free reimbursements	IRC 105 lets employers reimburse qualified medical expenses without those dollars becoming taxable wages, which reduces FICA obligations on both sides of the paycheck.
Ongoing compliance required	A written plan document, substantiated receipts for every reimbursement, and annual nondiscrimination testing are recurring requirements. Setting it up once and walking away is the most common way this goes wrong.
HRA and HSA conflict	A general-purpose HRA disqualifies employees from contributing to an HSA. If you want to offer both, the plan design has to account for that from the start, not after the conflict surfaces.
Private inurement risk	For 501(c)(3) organizations, a benefit structure that disproportionately rewards senior leadership, even by accident, creates private inurement risk. The IRS has pursued it. This is not a hypothetical.

What Internal Revenue Code 105 Covers

IRC 105 is the foundational rule that determines whether employer-provided medical reimbursements reach employees tax-free or show up as taxable income. Get it right and both sides benefit. Get it wrong and you've handed a tax bill to the people you were trying to help.

Internal Revenue Code 105 governs amounts received under accident and health plans, and the IRS applies it to several plan types employers commonly use:

• Health Reimbursement Arrangements (HRAs): Employer-funded accounts that reimburse employees for qualified medical expenses.
• Individual Coverage HRAs (ICHRAs): Allow employers to reimburse employees for individual health insurance premiums and out-of-pocket medical costs.
• Qualified Small Employer HRAs (QSEHRAs): Designed for employers with fewer than 50 full-time employees.
• Excepted Benefit HRAs (EBHRAs): A limited-use option covering specific excepted benefits.
• Self-insured medical reimbursement plans: Plans where the employer funds and administers medical benefits directly, rather than buying fully insured coverage.

The IRS confirms that Section 105 applies to all of these plan types. For a reimbursement to be tax-free, two things have to be true: the expense must qualify under Section 213(d), which covers a broad range of medical costs, and the plan must be formally documented in writing with each expense substantiated by the employee.

That second condition is where organizations get themselves into trouble. The tax treatment is clean. The paperwork requirement is not optional, and it's not a one-time task.

HRA	Yes	Yes	Yes
ICHRA	Yes	Yes	Yes
QSEHRA	Yes	Yes	Yes
EBHRA	Yes	Yes (limited)	Partial
Self-insured plan	Yes	Yes	Yes

For nonprofits and senior care employers, payroll taxes apply to every dollar of cash compensation. Shifting value into a properly designed Section 105 plan means fewer taxable wages, which directly reduces what you and your employees owe in FICA. Every dollar reimbursed tax-free instead of paid as wages saves the employer 7.65 percent in payroll tax. For a nonprofit with 50 employees each receiving $2,000 in annual reimbursements, that's a real budget reduction, and it's entirely legal. Learning about tax-saving employee benefits can help clarify exactly where those savings accumulate.

Key Eligibility and Compliance Rules for Nonprofits

Knowing what the code covers is only half the picture. The other half is knowing who qualifies, what the rules actually require, and what happens when you miss a step. For nonprofits and senior care organizations, the consequences of getting it wrong are more significant than most people realize before they're sitting in one.

Here are the foundational compliance requirements every HR director should know:

1. Written plan document: Your Section 105 plan must exist in writing before the plan year begins. A verbal agreement or informal policy does not meet the IRS standard. Not close, not arguably. It doesn't.
2. Substantiation of expenses: Employees must submit receipts or documentation for every reimbursement. The plan cannot pay out a flat cash amount without proof of an eligible expense.
3. Nondiscrimination testing: Self-insured plans must pass two tests under Section 105(h), an eligibility test and a benefits test. The eligibility test confirms the plan covers a broad enough group of employees. The benefits test confirms that whatever's available to your highest-paid people is also available to everyone else.
4. Reasonable benefit design: Benefits must be structured to serve employees broadly, not to create outsized advantages for executives.
5. Private inurement rules for 501(c)(3) organizations: Section 105 plans are available to tax-exempt nonprofits, but benefits cannot constitute private inurement or substantial private benefit to organizational insiders.

The nondiscrimination rules deserve particular attention. If a self-insured plan under Section 105 fails either test, highly compensated individuals lose tax-free treatment on their reimbursements. Those dollars become taxable income. That's a payroll headache and a morale problem arriving at the same time.

Written plan	Formal document before plan year	Entire plan disqualified
Substantiation	Receipts for each reimbursement	Reimbursements become taxable
Nondiscrimination	Pass eligibility and benefits tests	HCIs lose tax-free status
Private inurement	No excessive benefits to insiders	Loss of 501(c)(3) status

Run your nondiscrimination testing annually, not just at plan inception. Staff turnover and compensation changes can shift your plan's compliance status from one year to the next without anyone noticing until the test fails. For senior care facilities with large hourly workforces and high turnover, a plan designed to cover all full-time employees can drift out of compliance as the workforce changes underneath it. Reviewing tax-advantaged benefit examples and understanding HR's role in nonprofit benefits can help you build a more resilient compliance process.

Optimizing Section 105: Strategies for Tax Savings and Benefit Design

Compliance is the floor. Once you've built a plan that meets the rules, the question is how to design it so it actually does something useful for your organization and your employees.

The most effective strategies for getting real value out of a Section 105 plan:

• Use a written HRA as your primary vehicle. A properly documented health reimbursement arrangement under Section 105 lets you reimburse employees for qualified medical expenses tax-free, reducing taxable wages for both parties.
• Coordinate with your group health plan. An integrated HRA paired with a group health plan can cover out-of-pocket costs like deductibles and copays, reducing financial burden on employees without adding to their taxable income.
• Structure benefits to reduce FICA. Every dollar shifted from taxable wages to a properly designed Section 105 reimbursement saves the employer 7.65 percent in FICA taxes. For a nonprofit with 50 employees each receiving $2,000 in annual reimbursements, that's a real reduction in payroll tax expense.
• Document everything before you pay anything. Substantiation is not optional. Build a process where employees submit receipts before reimbursements are issued, not after. This is a compliance requirement, not a courtesy.
• Avoid discriminatory classifications. A plan that covers only management or salaried employees creates nondiscrimination risk and signals to the rest of your workforce that the good stuff isn't for them. Broad eligibility protects both.

Nonprofit compensation outlooks consistently identify pre-tax benefit strategies, including those generating FICA savings, as among the most cost-effective tools available to mission-driven employers. Before adding any new benefit, confirm it integrates cleanly with your existing Section 105 structure and doesn't create unintended tax consequences. You can also explore available tax credits that may stack with your Section 105 savings for additional relief.

Navigating Nuances, Limitations, and Advanced Considerations

Section 105 has real power, but it also has edges that catch organizations off guard. Understanding them upfront is less expensive than correcting them after an audit.

Start with who is excluded. Self-employed individuals, partners, and shareholders owning more than 2% of an S corporation generally cannot participate in Section 105 plans on a tax-favored basis. For nonprofits with mostly W-2 employees, this rarely comes up. For senior care facilities organized as pass-through entities, it's worth verifying ownership structure before proceeding.

The most important nuances to track:

1. Mixed funding changes the tax math. If both the employer and employee contribute to the plan, only the employer-funded portion qualifies for tax-free treatment. The employee-funded portion may be taxable if not handled through a proper cafeteria plan.
2. HRAs and HSAs don't always mix. A general-purpose HRA makes an employee ineligible to contribute to a Health Savings Account. Offering both requires a limited-purpose HRA covering only dental and vision, or a suspended HRA. IRS Publication 15-B outlines the specific coordination rules.
3. HIPAA applies to self-insured plans. If your Section 105 plan is self-insured, it's treated as a group health plan under HIPAA. Privacy and security rules apply. Many smaller nonprofits are genuinely unprepared for this layer of compliance, and finding out during a review is not the ideal time.
4. COBRA continuation may be required. For employers with 20 or more employees, HIPAA and COBRA rules apply to self-insured Section 105 plans, requiring continuation coverage options upon qualifying events.

The intersection of Section 105 with HIPAA, COBRA, and HSA rules is where most compliance gaps actually live. Each layer adds complexity, and ignoring any one of them creates real audit exposure. For nonprofits tracking cost-reduction strategies, these aren't optional reading. If your organization files Form 990 or manages benefits across multiple entities, benefits reporting compliance becomes part of the picture too.

What Most Nonprofits Miss About Internal Revenue Code 105

The biggest problem isn't intent. It's paperwork. Organizations set up a plan with good intentions, then let the documentation slip. No receipts on file. No written plan document. No annual nondiscrimination testing. An audit arrives, and the plan that was supposed to save money becomes the liability instead. You didn't do anything nefarious. You just didn't keep the records.

The second mistake is treating IRC 105 as a standalone tax mechanism rather than part of a broader compensation and benefits strategy. The real value of health reimbursement arrangements comes when they're coordinated with your group health plan, your retention goals, and your overall compensation philosophy. That coordination is what turns a tax footnote into a structural advantage.

Private inurement is also consistently underestimated. A benefit structure that disproportionately rewards senior leadership, even unintentionally, puts 501(c)(3) status at risk. The IRS has pursued it. The organizations that get the most from Section 105 treat it as a living compliance program, not a one-time setup. If you're ready to think about it that way, start with a review of your current plan documents and consider negotiating nonprofit benefits as part of your next planning cycle.

The tax advantages of IRC 105 are only as good as the documentation supporting them. A well-designed plan with sloppy records is a compliance problem waiting to surface. Build the records first, then optimize the design.

Work With a Benefits Advisor Who Understands Your Sector

Thrive Benefits Group works directly with nonprofits and senior care facilities across the Southeast to build benefit structures that are compliant, cost-effective, and built to hold up year over year. Whether you need to review your health insurance solutions or want a clearer view of your full benefits picture through our custom benefits dashboard, we're ready to help you turn Section 105 into a real structural advantage. Schedule a conversation to talk through your specific situation.

Schedule a Consultation

Frequently Asked Questions

Which employee health expenses qualify under Section 105?

Qualified medical expenses under Section 213(d) include health insurance premiums, deductibles, copays, and over-the-counter medications permitted under current law following the CARES Act.

Are Section 105 plans available to all nonprofits?

Yes, 501(c)(3) organizations can use Section 105 plans, but benefits must not result in prohibited private inurement or excessive benefit to organizational insiders.

What are the nondiscrimination requirements under Section 105?

Self-insured plans under Section 105(h) must pass both an eligibility test and a benefits test confirming the plan does not unfairly favor highly compensated employees over the general workforce.

How do Section 105 plans interact with HSAs or high-deductible plans?

A general-purpose HRA disqualifies an employee from contributing to a Health Savings Account. Careful coordination using a limited-purpose HRA or suspended HRA is required when offering both benefits.

Who is ineligible for Section 105 plan participation?

Self-employed individuals, partners, and shareholders owning more than 2% of an S corporation are generally excluded from participating in Section 105 plans on a tax-favored basis.

Recommended

• Optimize HR's role in nonprofit employee benefits
• 7 Tax-Saving Employee Benefits for Non-Profit HR Managers
• Employee benefits checklist 2026: optimize costs and satisfaction
• Top tax-advantaged benefit examples for nonprofits