Excluding over-the-counter drug reimbursements: make medical reimbursements less of a headache.

Revenue ruling 2003-102 held that an employee's receipt of a reimbursement from an employer-sponsored health flexible spending arrangement (health FSA) under a cafeteria plan, health reimbursement arrangement or other employer health plan for over-the-counter (OTC) drugs is excludible from gross income under IRC section 105(b); however, amounts an employee pays for dietary supplements are not reimbursable or excludible, nor can the individual deduct such costs as section 213 medical expenses. CPAs should familiarize themselves with this ruling to educate eligible clients.

FACTS

N sponsored a health FSA that reimburses participating employees for medical care costs not covered by other insurance. Participating employee A purchased an antacid, an allergy medicine, a pain reliever and a cold medicine from a pharmacy without a prescription to treat personal injuries or sickness and also bought dietary supplements without a prescription to maintain general health and submitted substantiated claims for these expenses to N's plan.

ANALYSIS

Generally under section 105(b), an individual excludes from income amounts reimbursed for medical care costs. Under regulations section 1.213-1(e)(1)(ii), an expenditure for an individual's general health is not a medical care expenditure. Further, the costs of "medicines and drugs" (defined by regulations section 1.213-1(e)(2) as "items ... legally procured and generally accepted as falling within the category of medicine and drugs") are medical care expenditures, but the costs of toiletries, cosmetics and sundry items are not; see regulations section 1.213-1 (e)(2).

The IRS had stated in revenue ruling 2003-58 that an individual cannot deduct under section 213 amounts paid for OTC medicines or drugs. In revenue ruling 2003-102, the service ruled that A's expenditures to purchase the OTC remedies were medical care expenditures; A's health FSA reimbursement for those costs was excludible from gross income under section 105(b), even though the cost would not have been deductible under section 213(a). Because the dietary supplements were beneficial only to A's general health, their cost was neither reimbursable nor excludible under section 105(b).

RAMIFICATIONS 

Revenue ruling 2003-102 clarifies that the exclusion for reimbursements of employees' health expenses is broader than the section 213 itemized deduction for medical expenses. Employer reimbursements of employee health expenses for OTC drugs are treated the same as other excludible employer reimbursements of employee health expenses. The service's position should result in savings for individuals in employer plans who have chronic health problems and constantly take OTC medicines. An employee generally forfeits amounts contributed to an FSA that have not been expended by the plan yearend. Now, an employee could use those funds to replenish his or her medicine cabinet through the purchase of OTC medications. (For background see "FSAs and Over-the-Counter Medications," page 81.)

For more information see the Tax Clinic, edited by David Kautter, in the January 2004 issue of The Tax Adviser.