Guest Article

(From the September 8, 2003 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks within the article have been added by BenefitsLink.)

Health FSAs Can Reimburse Participants' Nonprescription Drug Costs, IRS Rules

Americans spend millions of dollars each year for nonprescription pain relievers, antacids, and cough medicines, etc., to treat the common cold and other maladies that affect them and their families. Health insurance generally doesn't cover the cost of these over-the-counter medications, and they don't count as "medical care expenses" for purposes of the IRC section 213(a) deduction. But health flexible spending arrangements (FSAs) and other self-insured health plans (including HRAs) now may be able to reimburse participants for these nonprescription drug expenses, according to just-released Revenue Ruling 2003-102.

Summary of Revenue Ruling 2003-102

The revenue ruling involves a health FSA participant that buys a nonprescription antacid, allergy medicine, pain reliever, and cold medicine for her own use, and for use by her spouse and dependent children, to alleviate or treat personal injuries or sickness. She also buys nonprescription vitamins that she and her family use to maintain their general health. The issue is whether the health FSA can reimburse her for some or all of these expenses.

For years the answer was thought to be "no" because the gross income exclusion provided by IRC section 105(b) applies only to reimbursements for medical care expenses, as defined in IRC section 213(d). (According to section 213(d), "medical care" means "amounts paid ... for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body," among other things.) Most interpreted this to mean that health FSAs and other self-insured health reimbursement plans (including HRAs) must limit reimbursements to medical expenses that otherwise would be eligible for the section 213(a) medical expense deduction. And section 213(b) makes it clear that nonprescription drugs do not count under section 213(a).

But the IRS now takes the position that health FSAs can reimburse participants for the cost of buying nonprescription drugs so long as the expense is for medical care as defined by section 213(d). The reason is that section 105(b) does not specifically limit its scope to otherwise deductible medical care expenses, and section 213(d) does not distinguish between prescription and nonprescription drugs or reference section 213(b).

Thus, the revenue ruling concludes the health FSA can reimburse the participant for the cost of the antacid, allergy medicine, pain reliever, and cold medicine. The health FSA cannot reimburse the participant for the cost of the vitamins, however, because they are "merely beneficial to [the participant's] general good health." (According to Treas. Reg. Sec. 1.213-1(e)(1)(ii), "... an expenditure which is merely beneficial to the general health of an individual ... is not an expenditure for medical care.")

The revenue ruling does not specifically talk about HRAs and other self-insured health reimbursement arrangements covered by section 105(b), but its reasoning should apply to them as well. (According to Notice 2002-45, 2002-2 I.R.B. 93, HRAs must limit reimbursements to "medical care expenses (as defined by section 213(d) of the Internal Revenue Code) incurred by the employee and the employee's spouse and dependents.")

Effect on Plan Sponsors

As noted, Americans spend a lot of money on nonprescription drugs each year. Because these expenses generally are not covered by insurance and are not tax deductible, this revenue ruling is significant for health FSA and HRA participants.

For sponsors and administrators of health FSAs and HRAs, the revenue ruling may be more of a mixed blessing. It might encourage more employees to participate in health FSAs if available, and to contribute greater amounts to them. This participation lowers the plan sponsor's payroll tax liabilities because salary reduction contributions to health FSAs are not subject to Social Security, Medicare, and federal unemployment taxes. But it also may cause plan administrators to be inundated with new reimbursement requests they may not yet be prepared-- either legally or logistically-- to handle.

Issues for Plan Sponsors to Consider

Before plan sponsors and administrators begin handing out reimbursement checks for nonprescription drugs, there are several issues they need to consider. The first is whether their plans will need to be amended to permit reimbursements for nonprescription drugs. If the plan document permits reimbursements for "expenses incurred for medical care, as defined by IRC section 213(d)," an amendment may not be necessary. If the plan document limits reimbursements to "expenses that otherwise would be eligible for the deduction under IRC section 213(a)," a plan amendment will be needed before reimbursements can begin.

If the plan does not need to be amended, the administrator may have to deal with a number of requests to reimburse participants for eligible nonprescription drugs they purchased before the IRS issued Rev. Rul. 2003-102. The revenue ruling does not specify an effective date, so it presumably applies to expenses incurred at any time. Of course, neither health FSAs nor HRAs can reimburse participants for expenses they incurred before the plan was established or before they became participants. But unless the plan specifies otherwise (e.g., "claims must be filed within 90 days after the expense is incurred"), health FSA and HRA participants may be able to seek reimbursements for nonprescription drugs purchased since the beginning of the current plan year (i.e., January, in the case of calendar year plans).

Another issue plan sponsors and administrators may need to address is the suitability of their plans' current substantiation procedures for claims involving nonprescription drugs. Health FSAs and HRAs can reimburse participants only for medical care expenses incurred for themselves, their spouses, and their dependents. This is relatively easy to verify in the case of prescription drugs because the prescription is issued in the name of an individual. But how is the plan administrator to know if the participant is buying aspirin for himself or the family dog? A participant certification procedure (and perhaps participant education) will be needed to help the plan avoid improper reimbursements.

Finally, as Rev. Rul. 2003-102 points out, health FSAs and HRAs cannot reimburse participants for all their nonprescription drug expenses. The expense must be for medical care as defined by section 213(d), which generally rules out vitamins and other products that do not "alleviate or treat personal injuries or sickness." Administrators of plans that allow reimbursements for nonprescription drugs will need to pay careful attention to this distinction when reviewing reimbursement claims.

If you have any questions or need additional information, please contact your Deloitte advisor.

The information in this Washington Bulletin is general information only and not intended to provide advice or guidance for specific situations. Contact your Deloitte advisor for information regarding your specific circumstances. If you have questions or need additional information about this article and you do not have a Deloitte advisor, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Human Capital Advisory Services, Deloitte LLP, 555 12th Street NW, Suite 500, Washington, DC 20004-1207. Copyright 2003, Deloitte.