IRS takes action to encourage flexible spending and health

As the cost of providing health care benefits to employees continues to escalate, more and more employers are experimenting with new types of health care benefits, and the Internal Revenue Service (IRS) appears to be bending over backwards to encourage this experimentation. More specifically, the IRS has taken important action to encourage the use of both health care flexible spending accounts (FSAs) and health reimbursement accounts (HRAs).

FSAs

Under a health care flexible spending account (FSA), an employee elects to have his or her pay reduced in exchange for reimbursement of medical expenses that are not covered by the employee's other health plan coverage. During the last few years, some employers have begun issuing debit cards to their employees, allowing medical expenses to be automatically deducted from an employee's FSA when the debit card is presented to a health care provider.

There has been some concern, however, as to whether debit cards are permitted, because applicable rules require substantiation that health care flexible spending accounts are only used for medical expenses. Helpfully, the IRS recently issued Revenue Ruling 2003-43 which specifically permits the use of debit cards and explains the requirements for their use. The Revenue Ruling retains the substantiation requirement, but provides detailed guidance on acceptable methods of substantiation in regard to debit cards.

In fact, the use of debit cards may increase employee participation in health care flexible spending accounts, because debit cards are easy to use and generally eliminate the need for employees to submit claims. Moreover, increased use of health care flexible spending accounts may benefit employers by decreasing payroll taxes, as neither employers nor employees pay social security taxes on health care flexible spending account contributions or reimbursements.

HRAs

Over the last several years, defined contribution health plans have surfaced as a means of attempting to control the cost of employee health benefits. One form of these plans involves the establishment of an employer funded account for each employee, from which the employee may be reimbursed for medical expenses, with any unused amount being carried over to the next year.

Many benefits professionals hesitated to advocate the use of these plans because of the concern that the IRS would prohibit the carry over feature. (Such a carry over feature is expressly prohibited in health care FSAs.) However, in June 2002, the IRS issued guidance explicitly permitting this feature.

In its guidance, the IRS refers to these plans as Health Reimbursement Arrangements. Reimbursements from HRAs are tax-free to the employee, and the funding is deductible to the employer.

In general:

* An HRA may only be funded by an employer and may not be used by self-employed individuals;

* An HRA may only reimburse substantiated medical expenses, or health insurance premiums, up to the amount that has been contributed to the HRA;

* Only expenses not previously deducted for tax purposes that have been incurred by employees, former employees or their dependents, after the HRA goes into effect, may be reimbursed by an HRA;

* An HRA must specify a maximum dollar amount, and unused amounts may be carried over to another plan year; and

* Unused HRA amounts may not be, directly or indirectly, cashed out to participants.

Nonprescription drugs

The IRS also recently ruled that a health care FSA may reimburse a participant for nonprescription (also known as over-the-counter or OTC) antacids, allergy medicines, pain relievers, and cold medicines - but not vitamins. Revenue Ruling 2003-102 was issued September 3 and also applies to HRAs.

Before this Revenue Ruling, most people believed that health care FSAs could only reimburse medical expenses that would be deductible under the Internal Revenue Code, and the only medicines that are deductible are prescribed drugs and insulin.

However, in the Revenue Ruling the IRS acknowledges that there is no requirement that a health care FSA limit reimbursement to medical expenses which would be deductible, so long as the expense is for the diagnosis, cure, mitigation, treatment or prevention of disease, or for the purpose of affecting any structure or function of the body.

On the other hand, the IRS took the position that expenditures that are merely beneficial to the general health of an individual, such as vitamins and diet supplements, are not considered medical expenses for health care FSA or HRA purposes.

Barry F. Rosen is the chairman and CEO of the Baltimore based law firm of Gordon, Feinblatt, Rothman, Hoffberger & Hollander, LLC. His practice concentrates on health care and business matters, and he can be reached at 410-576-4224 or brosen@gfrlaw.com. Amy S. Moskowitz is an associate in Gordon, Feinblatt's Employee Benefits Practice Group, and she can be reached at 410-576-4002, or amoskowitz@gfrlaw.com.

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