The Section 105 Medical Reimbursement Plan

How it works

A Section 105(b) plan is a self-insured employer arrangement that reimburses an employee, tax-free, for the medical care of that employee, the employee's spouse, dependents, and children under 27. The reimbursement is excluded from the employee's gross income under Section 105(b), and if the business also pays toward accident or health coverage for that employee, those contributions are excluded too, under Section 106(a). On the business side, the reimbursements are an ordinary and necessary business expense under Section 162(a): deductible against the business's income, the same as any other payroll-adjacent cost.

None of that is useful to a business owner on its own, because of one gate. A self-employed person, defined by reference to Section 401(c)(1), is not treated as an "employee" for Section 105 purposes. Section 105(g) says so directly. The owner of a sole proprietorship cannot be his or her own Section 105 employee, no matter how the paperwork is written.

What turns this into a planning position rather than a dead end is that the owner's spouse can be a real employee. Section 105(b) coverage for a W-2 employee reaches that employee's own spouse and children under 27, and the employee's spouse, in this arrangement, is the business owner. Revenue Ruling 71-588 is the IRS recognition of that structure: a self-employed individual may employ a spouse who is active in the business and provide a Section 105 medical benefit package covering the employee, that employee's spouse, and dependents. Hire the spouse as a genuine employee, adopt a written plan on the business, and the family's out-of-pocket medical costs, and often its health insurance premiums, can be reimbursed by the business and excluded from the spouse's income.

The reason this is worth doing rather than simply paying medical bills personally is what it replaces. An itemized medical deduction is reduced by 7.5% of adjusted gross income under Section 213(a), and a household that takes the standard deduction gets no medical deduction at all. Route the same dollars through a Section 105 plan instead, and they become a full business deduction with no floor and no dependence on itemizing. Because the reimbursement also lowers the business's net profit, it can reduce self-employment tax on that profit as well as income tax, though how much depends on where the owner's earnings already sit relative to the Social Security wage base for the year, since only the Medicare portion of the self-employment tax rate keeps applying above that ceiling.

What this is worth in Florida

The income-tax benefit here is entirely federal. Florida does not tax individual income, so a Florida resident's medical costs were never doing anything on a state return to begin with, and there is no state layer for this strategy to improve on. A Florida owner gets the same federal income-tax and self-employment-tax result anyone gets from this plan, no more and no less for living in a state with no income tax.

Who this applies to

Whether this is available at all turns on the business's entity type before anything else does.

• A Schedule C sole proprietorship, or a single-member LLC taxed as one. This is the setting the strategy is built for. The owner is self-employed and barred from covering himself under Section 105(g), but a spouse hired as a genuine W-2 employee is a real employee, and that employee's family coverage reaches the owner.
• A partnership or multi-member LLC. A partner is self-employed rather than an employee and cannot self-insure any more than a sole proprietor can. The same spouse-employee structure is available in principle, though it gets more complicated once more than one owner's household is affected by how the plan is designed.
• An S corporation: this does not work for the owner's own family. Section 1372 treats a more-than-2% S-corp shareholder as a partner for fringe-benefit purposes, not an employee, and the family-attribution rule in Section 318 makes the owner's spouse a more-than-2% shareholder too, purely by virtue of the marriage. A spouse pulled into shareholder status that way cannot be a tax-free Section 105 employee for the owner's family. Whether an S-corp election makes sense for other reasons is a separate question, one I cover in my Florida S-corp guide.
• A C corporation. A Section 105 plan works here for any bona fide employee, including an owner who is genuinely an employee of the corporation, but it is subject to the same self-insured nondiscrimination rules described below.

Entity type only clears the first gate. The employment itself has to be real, and this is the most litigated part of the whole arrangement: the spouse has to perform actual, non-trivial services for the business and be compensated for those services, so the reimbursement functions as compensation for real work rather than a disguised payment of the owner's own medical bills. What that has to look like in practice, real duties, a real paycheck, a real place in the business, is the subject of my piece on hiring your spouse.

What it requires

Three conditions have to be in place from the start, and a fourth becomes binding the moment the business has employees beyond the owner's spouse.

• A separate written plan, adopted before any reimbursement. Treasury Regulation 1.105-11(b) requires a written plan for a self-insured medical reimbursement arrangement. The document has to exist and be adopted before the first reimbursement goes out; a plan written after the fact does not reach back to cover what already happened.
• Real payroll, not a distribution. The spouse's wages have to run through actual payroll, with income-tax withholding and Social Security and Medicare tax on both sides, reported on a Form W-2, following the same employment-tax rules the IRS lays out for every employer in Publication 15. Wages paid to a spouse by a sole proprietorship are exempt from federal unemployment tax, and Florida mirrors that exemption in its own reemployment tax, so those wages carry neither one. What neither exemption says anything about is whether the underlying job is real. The spouse is an employee, not the proprietor, and should never appear on the Schedule C as such.
• A defined, reimbursable benefit. The plan should specify what it reimburses: medical care as Section 213(d) defines it, which reaches insurance premiums as well as out-of-pocket costs for the employee, the employee's spouse, dependents, and children under 27, and it should set a reimbursement ceiling rather than leaving the benefit open-ended.
• Nondiscrimination, once there is a second employee. A self-insured plan cannot favor a "highly compensated individual" as to eligibility or benefits, under Section 105(h) and Treasury Regulation 1.105-11(c). A highly compensated individual, defined under Section 105(h)(5), is one of the five highest-paid officers, a more-than-10% shareholder, or someone in the highest-paid quarter of all employees. Section 105(h)(3) sets the eligibility test: the plan generally has to benefit 70% of all employees, or 80% of eligible employees where at least 70% are eligible. With only a spouse on payroll there is no one else to measure against, so the test is satisfied automatically. It becomes the real constraint the day the business hires rank-and-file staff, since covering every employee's family medical at that point can make a bare Section 105 plan uneconomic, which is usually where a QSEHRA or ICHRA design takes over instead. Failing the test does not disqualify the whole plan; it makes the highly compensated individual's "excess reimbursement" taxable under Section 105(h)(7).
• Fewer than two participating employees, if the plan reimburses premiums. This is the constraint that actually bites on a second hire, and it is a different order of problem from nondiscrimination. A plan that reimburses individual-market premiums is a group health plan, and once it covers two or more current employees it has to meet the ACA market reforms, which an arrangement of this shape cannot: Notice 2015-17 treats it as failing the annual-dollar-limit and preventive-services requirements, exposing the employer to the Section 4980D excise tax of $100 per day per affected individual. What keeps the spouse-only plan viable is Section 9831(a)(2), the exception for a plan with fewer than two participants who are current employees. So the second employee is not merely an economics question. It is the point at which a premium-reimbursing Section 105 plan has to become a QSEHRA, an ICHRA, or a real group plan.

What you need to document

This strategy is decided on its facts, not on how the return is prepared, so the file matters as much as the plan document itself.

A contemporaneous job description and time record

What the spouse actually does, recorded as the weeks go by rather than written after the fact. This is the core evidence that the employment is real.

A wage tied to the work

Payroll records and Form W-2s showing a wage that lines up with the hours and duties, not a number chosen to make the plan look right.

The written plan itself, dated

A copy showing when it was adopted, which has to be before the first reimbursement, along with what it defines as a reimbursable expense and what ceiling it sets.

Substantiation for every reimbursement

Receipts and explanation-of-benefits statements matching each dollar paid out. A flat monthly allowance with nothing behind it is not a Section 105(b) reimbursement; it is taxable wages.

A clean money trail

Reimbursements paid from the business to the spouse, ideally into an account kept separate from the owner's personal funds, so the flow of money does not read as one household paying its own bills through a business account.

Where it goes wrong

This is a legitimate, well-supported position, not a listed or reportable transaction, but it is an audit favorite in closely held and family businesses precisely because so much of it rests on facts rather than on a number on a form. Almost every failure mode below is a facts-and-circumstances problem, not a technical one.

• The employment was not real. No documented duties, no time records, or a wage untethered to the work performed, and the spouse was never a bona fide employee. If that gate fails, the whole deduction fails with it, because there is no employee whose family coverage the reimbursement could ride on.
• Reimbursing before the written plan existed. A plan adopted after the fact does not satisfy Treasury Regulation 1.105-11(b) for reimbursements paid before it existed.
• No substantiation. An allowance paid without receipts behind it is wages to the spouse, not a tax-free reimbursement, whatever the money was actually spent on.
• Running it inside an S corporation. This is a planning trap, not a variation on the strategy. Section 318 attribution reaches the spouse regardless of intent, and the tax-free benefit simply is not available there for the owner's own family.
• Double-dipping the same premiums. Premiums reimbursed through the plan cannot also be claimed as the self-employed health insurance deduction under Section 162(l), and out-of-pocket amounts reimbursed this way cannot also be itemized under Section 213(a). The same dollar does not get deducted twice.
• Discrimination once there are other employees. Failing the Section 105(h) tests does not fail the whole plan; it makes the highly compensated individual's excess reimbursement taxable income.

What the courts have said about the employment question

Shellito v. Commissioner is the case to know, because it addresses the standard rather than just one set of facts. The Tenth Circuit vacated and remanded a Tax Court decision that had denied a sole proprietor's Section 105 deductions for his wife's medical reimbursements, holding that the Tax Court had used the wrong test and should instead have applied the common-law agency doctrine to decide whether the wife was a bona fide employee. Speltz v. Commissioner reached the taxpayer-favorable result on materially similar facts, upholding a spouse-employee Section 105 arrangement in a non-precedential summary opinion. Read together, the two cases say the same thing from opposite directions: the outcome turns on whether the employment relationship holds up under ordinary agency principles, not on how the plan document happens to be worded.

A situation where this comes up

The pattern I run into most is a small Schedule C practice where the owner's spouse has already been doing real work, bookkeeping, scheduling, client follow-up, for years, informally and either unpaid or paid in a way that never went through payroll. The business is real and the work is real; none of the formality around either one is there yet.

Getting this in shape means putting the spouse on actual payroll first, with a real paycheck and a real job description, before anything about medical reimbursement gets adopted. The plan document comes next, dated before the first reimbursement rather than backdated to match it. Then the substantiation habit starts: every reimbursement tied to a receipt, filed as it happens rather than assembled the following spring.

The pattern that concerns me is the mirror image: an S-corp owner who adopted a Section 105 plan for the family without anyone checking the entity type first. The strategy simply is not available there for the owner's own household, no matter how carefully the plan document is drafted, and finding that out after reimbursements have already gone out is a much worse conversation than finding it out before.