Optimize employee benefits with Internal Revenue Code 105

Sydney Little
Apr 13
8 min read

Somewhere between setting up the plan and running payroll, the documentation slips. No receipts on file. No written plan document. No annual nondiscrimination testing. And 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 allows employers to reimburse qualified medical expenses tax-free, reduce payroll taxes, and strengthen benefits without increasing cash compensation. The problem isn't the code. It's how rarely organizations treat it as a living compliance program rather than 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 allows employers to reimburse qualified medical expenses tax-free, reducing FICA obligations for both the organization and its employees.
Ongoing compliance required	A written plan document, expense substantiation, and annual nondiscrimination testing are ongoing requirements — not a one-time setup.
HRA and HSA conflict	A general-purpose HRA disqualifies employees from HSA contributions, making coordination between plan types a critical design decision.
Private inurement risk	For 501(c)(3) organizations, benefits that disproportionately favor senior leadership — even unintentionally — create private inurement risk.

What Internal Revenue Code 105 Covers

IRC 105 is the foundational rule that determines whether employer-provided medical reimbursements reach employees tax-free or as taxable income. Get it right, and both sides benefit. Get it wrong, and you've created an unexpected tax liability for the people you were trying to help.

At its core, Internal Revenue Code 105 governs amounts received under accident and health plans. The IRS applies it to a range of 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 for specific excepted benefits.
Self-insured medical reimbursement plans: Plans where the employer directly funds and administers medical benefits rather than purchasing fully insured coverage.

The IRS confirms that Section 105 applies to all of these plan types, making it one of the most versatile tools in an employer's benefits program. For reimbursements to be tax-free, two conditions must be met: the expense must qualify under Section 213(d) of the Internal Revenue Code, which covers a broad range of medical costs, and the plan must be formally documented in writing with each expense substantiated by the employee.

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 FICA obligations. Every dollar reimbursed tax-free rather than 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 IRS code 105 covers is only half the picture. The other half is knowing who qualifies, what the rules require, and what happens when you miss a step. For nonprofits and senior care organizations, the stakes are higher than most people realize.

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

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.
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.
Nondiscrimination testing: Self-insured plans must pass two tests under Section 105(h): an eligibility test and a benefits test. The eligibility test ensures the plan covers a broad enough group of employees. The benefits test ensures that the same benefits available to highly compensated individuals are also available to non-highly compensated employees.
Reasonable benefit design: Benefits must be structured to serve employees broadly, not to create outsized advantages for executives or owners.
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 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. The benefit becomes taxable income for them — a payroll headache and a morale problem at once.

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 year over year. 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 workforce composition changes. 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, not the ceiling. Once you've built a plan that meets the rules, the question becomes how to design it so it delivers real value to your organization and your employees.

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

Use a written HRA as your primary vehicle. A properly documented health reimbursement arrangement under Section 105 allows you to 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.
Avoid discriminatory classifications. A plan that covers only management or salaried employees creates nondiscrimination risk and erodes employee trust. Broad eligibility protects both.

Nonprofit compensation outlooks consistently highlight that pre-tax benefit strategies — including those generating FICA savings — are 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 the nuances upfront is less expensive than correcting them later.

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

The most important nuances to track:

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.
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.
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 unprepared for this layer of compliance.
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 appear. Each layer adds complexity, and ignoring any one of them creates real audit exposure. For nonprofits tracking cost-reduction strategies, these layers 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 a liability instead.

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's when the structure becomes a genuine competitive advantage, not just a tax footnote.

Private inurement is also consistently underestimated. A benefit structure that disproportionately rewards senior leadership — even unintentionally — puts 501(c)(3) status at risk. This isn't a hypothetical. It's a documented IRS concern, and 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 practical implication is straightforward: the tax implications 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 happen. 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 for the long term. 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.

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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 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 an HSA. 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.