Excluding reimbursements from health FSAs for OTC drugs.

Reversing its position, the IRS ruled in Rev. Rul. 2003-102 that reimbursements 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 are excludible from gross income under Sec. 105(b); however, amounts paid for dietary supplements are not reimbursable and not excludible. The Service also stated that, despite the availability of the exclusion for an FSA reimbursement, an individual cannot deduct these expenses as Sec. 213 medical expenses.

Facts

In the ruling, employer N sponsors a health FSA that reimburses participating employees for medical care expenses not covered by other insurance. Participating employee A purchases an antacid, an allergy medicine, a pain reliever and a cold medicine from a pharmacy without a prescription. The items are purchased for A's personal use (or for the use of A's spouse or dependents) to alleviate or treat personal injuries or sickness. A also purchases dietary supplements (e.g., vitamins) without a prescription to maintain A's general health and that of his or her spouse and dependents.

A submits substantiated claims for all of these expenses to N's health FSA for reimbursement. A is not compensated for those expenses by insurance or any other plan.

Law and Analysis

Under Sec. 105(b), except for amounts attributable to deductions allowed under Sec. 213 for any prior tax year, amounts reimbursed to an individual for medical care expenses are not included in gross income. Regs. Sec. 1.213-1(e)(1)(ii) provides that an expenditure for an individual's general health is not a medical care expenditure. Kegs. Sec. 1.213-1(e)(1)(ii) provides that expenditures for "medicines and drugs" are medical care expenditures. However, this phrase only includes "items that are legally procured and generally accepted as falling within the category of medicine and drugs"; see Regs. Sec. 1.213-1(e)(2). Toiletries, cosmetics and sundry items are not medicines and drugs and, thus, their costs are not medical care expenditures; see Regs. Sec. 1.213-1(e)(2).

In Rev. Rul. 2003-58, the Service ruled that amounts paid for medicines or drugs purchased without a prescription are not taken into account under Sec. 213(b) and, thus, are not deductible under Sec. 213. However, Sec. 105(b) specifically refers to medical care expenses as defined in Sec. 213(d). Sec. 105(b) does not require that the expense be allowed as a deduction for medical care under Sec. 213(a) or that only prescribed medications be taken into account.

In Rev. Rul. 2003-102, the Service ruled that A's expenditures to purchase the antacid, allergy medicine, pain reliever and cold medicine were medical care expenditures; A's health FSA reimbursement for those costs is excludible from gross income under Sec. 105(b), even though the cost would not have been deductible under Sec. 213(a). Because the dietary supplements are only beneficial to A's general good health,

their cost is not a medical care expense and is not reimbursable or excludible under Sec. 105(b).

Implications

Rev. Rul. 2003-102 clarifies that the exclusion for reimbursements of employees' health expenses is broader than the Sec. 213 itemized deduction for medical expenses. The Service distinguished Sec. 105(b) from Sec. 213 by noting that the former refers to "expenses incurred by the taxpayer for ... medical care" and does not require the expense to be a deductible medical care expense or that only prescribed medications be taken into account. By distinguishing Sec. 105(b) from Sec. 213, the Service made it clear that employer reimbursements of employee health expenses for nonprescription drugs are treated the same as other employer reimbursements of employee health expenses excluded from gross income.

With more and more prescription drugs being made available OTC, their cost has increased for those buying them. The Service's position should result in significant savings for individuals with access to employer plans who have chronic health problems and constantly have to take OTC medicines.

An employee generally forfeits amounts contributed to an FSA that have not been expended by the end of the plan year. In light of this ruling, such forfeitures will become rare; an employee could use those funds to, in effect, replenish his or her medicine cabinet through the purchase of OTC medications. In addition, many employees who might have hesitated to contribute to an FSA due to the forfeiture concern may want to consider contributions during their next enrollment period.

The ruling has no specific effective date and should apply retroactively. However, employers should first review their plan documents to confirm that their plans allow for the reimbursement of OTC drugs. If a plan does not currently permit such reimbursements, it would need to be amended.

For health FSAs, employers would have little reason to disallow the reimbursement of OTC drugs, as participant dollars are used to fund each participant's account. However, many FSAs provide specific deadlines for filing reimbursement claims. Nevertheless, if an employer's FSA does not have such a deadline (or if the deadline has not yet passed), and the plan currently allows for reimbursement of the cost of OTC drugs, claims for medications described in the ruling may still be filed and participants reimbursed for such costs.

On the other hand, with healthcare costs rising by double digits, employers may not be interested in expanding coverage under their basic employer-maintained accident and health plans to include OTC drugs. Employers that want to limit coverage should ensure that their plans do not cover OTC medications and amend their plans as necessary. Likewise, employers interested in expanding coverage to include OTC drugs should confirm that their plans are drafted sufficiently broadly to cover such drugs.

Employers should be advised to closely monitor their claims submission procedure to ensure that claims are properly handled. Insurance carriers and other providers who administer these programs will have to come "up to speed" on how to respond to such claims.

FROM SYLVIA POZARNSKY, CHICAGO, IL