How Do You Set Up a Section 105 Plan?

Setting up a Section 105 plan takes five things: a written plan document adopted before it takes effect, a benefit design limited to §213(d) medical care, a substantiation process run by an independent third party, §105(h) nondiscrimination testing, and payroll integration. Done in-house it is a real project. Done through an administrator it takes about 30 to 60 days.

This is the whole checklist, in order, with the authority behind each step. It is written so you could hand it to your own advisor and execute it without us — and by the end you will know exactly what you are outsourcing if you choose not to.

Step 1: Decide What Kind of §105 Plan You Are Building

“Section 105 plan” is a family, not a product, and the first decision is which member you need. Employer-funded only, integrated with your group plan — an HRA. No group plan and fewer than 50 full-time employees, counting full-time equivalents — a QSEHRA. Funding individual market coverage instead of running a group plan — an ICHRA. Funded by employee pre-tax election alongside a group plan you are keeping — a health FSA, or a self-insured medical expense reimbursement plan (SIMERP). The comparison, including which combinations coexist with HSAs, is at MERP vs HRA vs FSA vs Section 125.

Everything below applies to all of them. The design choice changes the funding mechanics, not the compliance skeleton.

Step 2: Adopt a Written Plan Document — Before, Not After

Treasury Regulation §1.105-11 requires a self-insured medical reimbursement plan to be a separate written plan for the benefit of employees. The order of operations is the trap: the plan must exist before the expenses it reimburses. Reimbursing a medical bill in March and adopting a plan document in June does not make the March payment tax-free. Nothing here is retroactive.

The document needs, at minimum: who is eligible and when, what is reimbursable, annual limits, how claims are substantiated and paid, the plan year, and how the plan is amended or terminated. If the plan is funded through a §125 election, you also need a cafeteria plan document with an election procedure and a defined enrollment window.

A §105 plan is also, in almost every case, an ERISA welfare benefit plan: expect a summary plan description for participants, and plan records kept six years from filing under ERISA §107.

Step 3: Define What It Reimburses — and Stay Inside §213(d)

A §105 plan may only reimburse medical care as IRC §213(d) defines it: diagnosis, cure, mitigation, treatment or prevention of disease, or care affecting a structure or function of the body. The working reference is IRS Publication 502, with one caution covered on that page: the deduction list and the reimbursement list diverge in places, and your plan document can always be narrower than the law but never broader.

General wellness spending, gym memberships without a diagnosed condition, and anything cosmetic are outside the line. A plan that drifts across it is manufacturing taxable wages and calling them benefits.

Step 4: Build Substantiation That Would Survive an Audit

This is the step that separates plans that work from plans that fail, because it is the step the IRS actually tests. Two rules govern:

Every claim, independently verified. Under the cafeteria plan rules (Proposed Treasury Regulation §1.125-6(b), on which the IRS permits reliance), a claim is reimbursable only after substantiation by information from an independent third party. The employee’s own say-so is not substantiation. Neither is reviewing a sample — the IRS said so explicitly in CCA 202317020.

No payment irrespective of expense. Treasury Regulation §1.105-2 denies the exclusion for amounts an employee would receive “irrespective of whether or not he incurs expenses for medical care.” Design nothing that pays on a trigger — completing an activity, watching content, filling out a form. Payment follows documented care, or it is wages. The enforcement record behind that sentence is quoted at What Does the IRS Actually Say About SIMERP?

Practically, this means electronic records tying each reimbursement to a dated service by an identifiable licensed provider, retained alongside payroll records (four years under Publication 15; six under ERISA).

Step 5: Run the §105(h) Tests — Especially If You Own the Company

A self-insured plan must pass the eligibility and benefits tests of IRC §105(h). Failing does not kill the plan; it pushes “excess reimbursement” into the income of highly compensated individuals — the five highest-paid officers, shareholders owning more than 10%, and the highest-paid 25% of all employees. Owner-heavy and family businesses should test before launch, not at year end. Note also that partners and more-than-2% S corporation shareholders generally cannot participate at all; the details, including why the spousal-employment route fails for S corporations, are at What Is a Section 105 Plan?

Step 6: Wire It Into Payroll Correctly

If the plan is funded by pre-tax election, payroll must reduce §125 wages for income tax and FICA, apply the reimbursement as non-wage payment per Publication 15 Section 5, and keep any post-tax program cost separate and visible on the stub. Two checks before the first cycle: elections for hourly employees near the wage floor need an FLSA analysis under the Department of Labor’s deduction rules (29 CFR part 531), and elections must respect Treasury Regulation §1.125-4 — they lock for the plan year absent a change in status, so your enrollment communications must say so before anyone signs.

Step 7: Enroll Employees Honestly

Participation is voluntary. The enrollment meeting should state the post-tax cost, the Social Security wage effect, and the plan-year lock-in as plainly as the benefits — the full list is at SIMERP Pros and Cons. A plan sold accurately stays enrolled; one oversold generates the year-two exodus and the complaints that draw scrutiny.

Doing It Yourself vs. Having It Done

Nothing above requires us. A benefits attorney can draft the documents, your CPA can run §105(h), a TPA can substantiate claims, and your payroll provider can build the codes. Budget legal drafting, testing, administrator selection, payroll configuration and enrollment — and assign someone to own the annual cycle, because every step above recurs.

What an administrator-run SIMERP implementation changes is who carries that: documents, substantiation, testing support, payroll coordination and enrollment run as a package, in 30 to 60 days with under 5 hours of your team’s time. Same skeleton, different labor.

Your Next Step

Either way, the first real input is the same number: what the payroll arithmetic yields at your headcount. The Savings Assessment takes three minutes and books your next step on the screen straight after — a 20 minute Discovery Call at 50 or more W-2 employees, or the live group briefing below that.

Get your Savings Assessment