Section 105 Plan Guide: How to ‘Legally’ Set Up [+ IRS Pitfalls]

By now you are probably aware of how great Section 105 plans can be. In the right situation, they can be a home run.

But how much do you know about the plans? In this guide, we will discuss some of the plan details and show you how to structure a plan for maximum tax benefit. We will also point out a few pitfalls along the way.

What is a QSEHRA Plan, and How Does it Work?

A Qualified Small Employer Health Reimbursement Arrangement (QSEHRA) is a company-funded health reimbursement plan small businesses offer to their employees. It is advantageous to small businesses that want to provide a formal benefit to their employees and realize the advantages of a tax-free Section 105 plan but want to reduce the cost of a traditional group insurance plan. 

QSEHRA enables small businesses to contribute up to $5,150 for single employees per year or $10,450 per family towards qualified health care expenses. There are no minimum contribution requirements.

The employee can, in turn, choose to purchase a health insurance plan that fits their needs through the health insurance marketplace. The contribution can also be used for other qualified medical expenses, such as physician co-payments or prescription medications. QSEHRA contributions are not taxable to the employee.

QSEHRA’s are flexible, and they can be used by any company with less than fifty full-time employees that do not offer any other option for a group insurance, dental or vision plan. The plan can also be provided to part-time employees at the company’s discretion, stipulating that the same benefit offered to full-time employees must be available to part-timers.

To set up a QSEHRA, a company should meet with a qualified plan administrator and a certified public accountant (CPA). The CPA can assist with any tax-related questions that the small business owner may have and ensure that the QSEHRA is the best option for the type of business that the owner has.

The plan administrator can advise the business owner of plan options, rules, and filing requirements. The administrator can also set up the formal plan documents to ensure that the company complies with Department of Labor and IRS regulations. 

Once the plan has been set up, the company can notify its employees of the new benefit. The owner can invite the plan administrator to explain the unique benefits and answer any questions the employees may have about choosing a health plan, qualified medical expenses, and how reimbursement of medical costs occurs.

Employees must understand that proper receipts must be submitted to the plan administrator to receive reimbursement. Otherwise, fees may be denied, and employees may not realize the full benefit. 

To the business owner, QSEHRA expenses for W-2 employees are fully deductible as a business expense up to the annual contribution limit. However, only owners of C-Corporation entities can fully deduct the plan’s cost as a tax-free benefit to themselves.

Sole proprietorships and partnerships can realize the tax-free advantages of the plan, but only if they employ a spouse as a regular employee and offer the benefit to them. S-Corporations cannot realize a tax-free benefit of a QSEHRA plans themselves at all. 

QSEHRA’s are an excellent way to improve employee retention and morale. They allow employees to choose their insurance plan that fits their needs without paying for the plan with after-tax dollars. 

What Types of Expenses Can Be Covered By A Section 105 Plan?

Qualified medical expenses under a Section 105 plan include amounts paid for the diagnosis, cure, treatment, or prevention of disease or affecting any structure or function of the body. Qualified expenses also include any relevant transportation to receive medical care.

Lodging expenses up to fifty dollars per day to receive specialized care in a specific location are reimbursable, so long as there is no vacation element to receiving the medical care in that location. 

A Section 105 plan can also include qualified long-term care services. Specific yearly premium amounts that are fully deductible using Section 105 plans include the below:

40 years old or less: $200 per year

Between 40 and 50 years old: $375 per year

Between 50 and 60 years old: $750 per year

Between 60 and 70 years old: $2,000 per year

More than 70 years old: $2,500 per year

Let’s look at an example of Jane, who spent $10,000 on medical-related fees, indicated below:

AmountExpense Type
$5,000Medical Premiums
$500Prescriptions
$250Co-pays for physician visits
$250Nutritional supplements
$1,000X-ray to diagnose a back injury
$1,500Dental crown
$500Teeth whitening
$750Hair removal
$250Gym fees

Jane may be reimbursed for $8,500 of these expenses. Teeth whitening, hair removal, and gym fees are non-qualified medical expenses under Section 105 plans and cannot be reimbursed tax-free. 

Annual Compliance Requirements for Section 105 Plans

Department of Labor Filing Requirements:

Companies that offer Section 105 plans must submit Form M-1 by March 1 of the calendar year following the calendar year for which the report is required. Form M-1 provides specific information on the plan, including the following:

– What type of coverage is provided

– Insurance coverage information

– Number of participants covered in the plan

– Information about any enforcement actions

– Information regarding compliance with Part 7 of ERISA, including any litigation alleging non-compliance

The form must be filed electronically to the U.S. Department of Labor, Employee Benefits Security Administration. 

At least thirty days before offering a Section 105 plan, the business must file Schedule M-1 to comply with regulations. Only companies that plan to provide medical coverage benefits (not just disability or life insurance benefits) must file Form M-1. If significant changes occur during a calendar year that affects the plan’s status, a Form M-1 must be filed.

Significant changes can include coverage for employees located in another state or an increase in the number of employees covered by the plan by more than 50% from the preceding calendar year. If the plan experiences a material change as defined in the plan documents, Form M-1 must also be filed.

Companies must ensure that they file Form M-1 completely and accurately. EINs and contacts for any other individuals or companies who have control or authority over the Section 105 plan or its assets should be given.

Information regarding every state in which the Section 105 plan operates must be listed. A confirmation number will be presented at the end of the filing process, which should be retained until the following year since it will be required for the new filing. 

IRS Annual Filing Requirements

Companies must file either Form 5500, Form 5500-SF, or Form 5500-EZ with the IRS depending upon the number of participants in the plan. This form provides general information on the plan, including the plan’s name, plan administrator information, number of people covered under the plan, total assets available in the plan, contributions made towards the plan during the year, and specific compliance and funding questions.

Companies that offer the plan to more than 100 participants must file Form 5500, which is quite complicated and requires outside actuarial valuation done by an outside qualified party. 

Smaller businesses can complete form 5500-SF with less than 100 participants. It must be filed electronically. Form 5500-EZ is available for one-person (or one-person plus spouse) plans. It must be filed on paper and submitted to the IRS. However, if the company would instead file electronically, the owner may submit Form 5500-SF instead.

Typical schedules in the Form 5500 filing include Schedule A, which details premium and agent commissions. This schedule does not apply to self-funded plans. Schedule C is sometimes required and lists the fees associated with the plan. Form 5500, Form 5500-SF, and Form 5500-EZ must be filed by the last day of the seventh month following the plan year’s end.

Where Are Section 105 Expenses Included on My Tax Return?

Section 105 expenses are classified on the tax return according to the type of legal structure the company falls under. Business owners should work with their CPAs to ensure correct classification.

Sole Proprietorships

Sole proprietorships who qualify for Section 105 plans by employing a spouse or family member may include the expense in line 14 of Schedule C (Profit or Loss from Business). Under labor and tax regulations, the reimbursement expense must be paid directly to the employee.

The employee must, in turn, cover the sole proprietor on the insurance policy for this to be deductible from the business’s taxable income. The reimbursement expense will appear on the employee’s W-2 as non-taxable fringe benefits, generally in box 12 FF. These amounts are excluded from the employees’ taxable income.

chart with finance, tax and debt

 Owners of sole proprietorships with no employees do not qualify for the Section 105 tax-free treatment of medical expense deduction. Instead, they can include the cost of their medical plans in line 29 of Form 1040. However, they are still subject to the 15.3% self-employment tax on these expenses.

Partnership

Partnerships who qualify for Section 105 plans by employing a spouse or family member may include the expense in line 19 of form 1065. This expense is directly deducted from the business’s taxable income divided into each partner’s K-1 tax form.

However, partners who do not qualify for Section 105 treatment must include any payments for health insurance premiums made by the business in the “Guaranteed Payments” section of form 1065. This amount is then included in taxable income to the partner but can be deducted in line 29 of Form 1040. It is still subject to the 15.3% self-employment tax like a sole proprietorship. 

S-Corporation

S-Corporations are eligible to set up Section 105 plans. Still, they cannot claim tax-free exemptions that sole proprietorships or partnerships can if they have family members who work for the company.

Instead, the payments for shareholder health insurance premiums and reimbursements made through the company appear on 1120-S under item 1b) Returns and allowances. These payments are taxable income to the business owner. However, payments made for group health employee benefits to employees who are not classified as shareholders can be deducted directly from taxable income in line 18. 

Like sole proprietorships and partnerships, the premiums and medical reimbursements can be deducted on Form 1040, line 29. It is still subject to the 15.3% self-employment tax.

C-Corporation

C-Corporations file Form 1120 and may deduct the total cost of health insurance premiums for both owners and employees on line 24, Employment benefit programs. C-corporations enjoy the tax-free benefits of Section 105 plans and are not subject to some of the limitations on individual reimbursements that sole proprietorships, partnerships, and S-Corps are.

Premiums and reimbursement payments flow through to the owner’s and employee’s W-2 forms as fringe benefits and are not subject to further taxation. 

Paul Sundin

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