Imagine a small company sets up a generous health reimbursement arrangement. The owner and a few senior managers get every doctor visit, prescription, and dental bill paid back tax-free. Rank-and-file employees get a smaller version, or wait six months before they qualify. Everyone seems happy — until a year later, when those same senior managers discover that thousands of dollars of "tax-free" reimbursements were actually taxable income all along.
That is Section 105(h) at work. It is one of the least understood corners of the tax code, and it routinely surprises small employers who think nondiscrimination testing only applies to giant corporations with armies of HR staff. It does not. If your business self-funds any portion of its medical benefits — including the increasingly popular Individual Coverage Health Reimbursement Arrangement (ICHRA) — Section 105(h) applies to you.
This guide explains what the rule is, who it affects, the two tests every self-insured plan must pass, what happens when a plan fails, and the design mistakes that trip up well-meaning employers.
What Section 105(h) Actually Does
Section 105 of the Internal Revenue Code is the reason most employer health benefits are tax-free in the first place. Subsection (b) lets employees exclude from gross income the money they receive for medical care under an employer plan. That exclusion is the whole point of group health coverage — it is what makes a dollar of benefits worth more than a dollar of salary.
Subsection (h) attaches a condition. For self-insured medical reimbursement plans, the tax-free treatment only holds if the plan does not discriminate in favor of highly compensated individuals. Discriminate, and the exclusion partially disappears for exactly the people the plan favored.
A "self-insured" plan is any arrangement where the employer pays claims out of its own funds rather than buying a fully insured policy from a carrier. That definition is broad. It captures:
- Health Reimbursement Arrangements (HRAs) of every flavor
- Individual Coverage HRAs (ICHRAs) and Qualified Small Employer HRAs in many respects
- Self-funded major medical plans
- Employer-funded medical expense reimbursement plans
- Health flexible spending arrangements, with some special rules
Fully insured plans bought from a commercial carrier are generally outside Section 105(h) — they have their own nondiscrimination regime under the Affordable Care Act, which the IRS has so far declined to enforce. But the moment you reimburse a medical expense from company cash, you are in Section 105(h) territory.
Who Counts as a "Highly Compensated Individual"
The rule protects rank-and-file workers from being shortchanged relative to the people at the top. So the first question is always: who sits at the top?
Under Section 105(h), a highly compensated individual (HCI) is anyone who falls into at least one of three categories:
- One of the five highest-paid officers of the company.
- A shareholder who owns more than 10% of the value of the employer's stock. Family attribution rules apply, so a spouse's or child's shares can be counted toward an owner.
- Among the highest-paid 25% of all employees (other than excludable employees who are not plan participants).
Note that this definition is specific to Section 105(h). It is not the same as the "highly compensated employee" definition used for 401(k) testing, which keys off a flat dollar threshold. Section 105(h) is relative — it ranks your own workforce. In a company where everyone earns roughly the same, the "top 25%" still exists; someone is always in it.
This catches owners off guard. A two-person company still has a top 25%. A founder who owns 100% of the stock is automatically an HCI under the shareholder test, no matter what they pay themselves.
The Two Tests Every Self-Insured Plan Must Pass
A self-insured plan must clear two separate hurdles each plan year: the eligibility test and the benefits test. Passing one does not excuse failing the other.
The Eligibility Test
This test asks whether enough non-highly-compensated employees are allowed into the plan. There are three ways to satisfy it, and a plan only needs one:
- The 70% test: The plan benefits 70% or more of all employees.
- The 70%/80% test: At least 70% of employees are eligible, and at least 80% of those eligible actually participate.
- The nondiscriminatory classification test: The plan benefits a class of employees that the IRS finds does not discriminate in favor of HCIs.
When you run the numbers, you may exclude certain workers from the count: employees with fewer than three years of service, those under age 25, part-timers and seasonal workers, employees covered by a collective bargaining agreement, and nonresident aliens with no U.S.-source income. Excluding them shrinks the denominator and usually makes the test easier to pass — but you must apply the exclusions consistently.
The Benefits Test
This is the test that quietly sinks the most plans. The statute is blunt: all benefits provided to HCIs must be provided to every other participant. Same coverage, same reimbursement limits, same terms.
A plan can fail the benefits test in two ways:
- Discriminatory on its face. The plan document itself spells out better benefits for HCIs — a $5,000 annual reimbursement cap for executives and $2,000 for everyone else, or dental coverage only for officers. Maximum reimbursement amounts must be the same dollar figure for all participants. The IRS does not allow benefits to be tied to a percentage of compensation, because that automatically routes more money to higher earners.
- Discriminatory in operation. The document looks fair, but in practice the plan is administered to favor HCIs. The classic example: an employer expands the HRA to cover a procedure an executive needs, then trims it back once a rank-and-file employee asks for the same thing. Timing plan amendments around the medical needs of the people at the top is operational discrimination, even if the written terms are identical for everyone.
One more wrinkle: a waiting period for new hires must be the same for everyone. If executives are covered on day one but other employees wait 90 days, that is a benefits-test failure.
What Happens When a Plan Fails: Excess Reimbursement
Failing Section 105(h) does not blow up the plan for everyone. It does not generate an employer penalty. Instead, the consequence lands narrowly and specifically on the highly compensated individuals: a portion of their reimbursements becomes taxable income. The tax code calls this taxable portion the excess reimbursement.
How the excess is calculated depends on which test the plan flunked.
If the plan fails the benefits test because a particular benefit is offered to HCIs but not to others, the excess reimbursement is simply the full amount the HCI received for that discriminatory benefit. If executives have dental coverage and nobody else does, every dental dollar reimbursed to an executive is taxable to that executive.
If the plan fails the eligibility test, the math is a ratio. The excess reimbursement for each HCI equals:
Total reimbursed to that HCI for the year × (Total reimbursed to all HCIs ÷ Total reimbursed to all participants)
Suppose a plan reimbursed $100,000 across all participants during the year, and $40,000 of that went to highly compensated individuals. The discriminatory fraction is 40%. An executive who personally received $10,000 in reimbursements would have to report $4,000 of it as taxable wages. The other $6,000 stays tax-free.
The taxable excess is reported in the year the plan year ends, added to the HCI's W-2 income. It is subject to income tax. Notably, because of how the rules interact, the excess reimbursement is generally not subject to FICA payroll taxes — but it absolutely counts for income tax, and an executive who was not expecting it can face an unwelcome bill.
The cruel irony is that the people punished are usually the owners and managers who designed the plan to reward themselves. Section 105(h) does not fine the company. It just hands the architects of a discriminatory plan a personal tax bill.
Section 105(h) and ICHRAs: The Modern Trap
The Individual Coverage HRA, available since 2020, has become a popular way for small employers to fund health coverage without buying a group policy. The employer reimburses employees for individual-market premiums and, optionally, other medical expenses. Because the employer pays those reimbursements from its own funds, an ICHRA is a self-insured plan — and Section 105(h) applies.
ICHRA rules let employers divide their workforce into as many as 11 permitted classes — full-time, part-time, seasonal, salaried, hourly, employees in different rating areas, and so on — and offer different terms to different classes. That flexibility is genuinely useful, but it is not a free pass around Section 105(h). The classes themselves must not be structured to favor highly compensated individuals, and within any class the benefits test still demands uniform treatment.
ICHRA design does allow two specific variations that would otherwise look discriminatory:
- Age-based variation. Allowances may rise with age, because older employees face higher individual-market premiums. The maximum allowance for the oldest employees cannot exceed three times the allowance for the youngest.
- Family-size variation. Allowances may increase based on the number of dependents covered.
Both must be applied consistently to everyone in a class. Beyond those two carve-outs, an ICHRA that gives owners or top earners a richer allowance than rank-and-file workers in the same class is heading straight for an excess-reimbursement problem.
Common Mistakes Small Employers Make
Most Section 105(h) failures are not schemes. They are honest design errors. The recurring ones:
- Never running the test. Self-insured plans should be tested for nondiscrimination at least once a year, before the plan year begins, while the design can still be fixed. Many small employers test never.
- Tying benefits to salary or tenure. A reimbursement cap set as a percentage of pay, or one that grows with years of service, funnels more money to higher earners and fails the benefits test.
- Uneven waiting periods. Covering executives immediately while others wait months is a classic operational failure.
- Reactive plan amendments. Adding a benefit when an owner needs a procedure, then removing it later, is operational discrimination — even with a perfectly worded plan document.
- Assuming owners are exempt. A sole shareholder is always an HCI. A spouse on payroll may be one through attribution. The rules do not spare small or family-run businesses.
- Confusing fully insured with self-insured. Switching from a carrier policy to an HRA or ICHRA quietly moves a plan into Section 105(h)'s reach, and many employers never realize the testing obligation followed them.
The fix is almost always the same: design the plan to give every participant the same benefits on the same terms from the same start date, document it clearly, and test it annually before the year begins. A plan that is uniform by design rarely has anything to fear.
Keep Good Records — They Are Your Proof
Section 105(h) compliance lives or dies on documentation. If the IRS ever asks whether your plan discriminated, you will need the plan document, the annual nondiscrimination test results, employee eligibility records, and substantiated proof of every reimbursed expense. The widely followed practice is to retain these records for at least six years.
That is also where disciplined bookkeeping pays off. Every reimbursement your business pays is a transaction that belongs in your books — categorized, dated, and tied to the right employee and plan. When medical reimbursements are recorded cleanly alongside payroll, running the year-end ratio for the excess-reimbursement calculation becomes a lookup rather than a forensic project. Tracking these payments separately also makes it obvious, in real time, whether reimbursements are skewing toward the people at the top — the warning sign of a benefits-test problem before it becomes a tax bill.
Keep Your Finances Organized from Day One
Whether you self-fund a health plan, run an ICHRA, or simply reimburse the occasional medical expense, the rules reward employers who can show clean, complete records. Beancount.io provides plain-text accounting that gives you full transparency and control over your financial data — every reimbursement, payroll run, and benefit expense in a format you can read, audit, and version-control with no black boxes and no vendor lock-in. Get started for free and see why developers and finance professionals are switching to plain-text accounting.
This article is general information, not tax or legal advice. Section 105(h) testing has technical details that depend on your specific workforce and plan design. Consult a qualified benefits attorney or tax professional before finalizing a self-insured health plan.