Back to Legal Updates & Articles
Legal Updates
7/31/2006
IRS Clarifies the Use of Payment Cards in Medical Reimbursement Plans and Approves the Use of Payment Cards in Dependent Care Assistance Programs
In Revenue Ruling 2003-43, the Internal Revenue Service (“IRS”) approved the
use of employer-provided debit cards, credit cards, or stored value cards
(collectively referred to as “payment cards”) to reimburse employees for
eligible medical expenses under medical reimbursement plans, such as flexible
spending arrangements (“FSAs”) or a health reimbursement arrangements (“HRAs”).
To ensure that payment cards would be used to reimburse only eligible medical
expenses, the IRS set forth several requirements and safeguards in this revenue
ruling for the proper substantiation of expenses.
Building on its previous guidance, the IRS recently published Revenue Ruling
2006-69, which offers further guidance on the use of payment cards in medical
reimbursement plans and also approves the use of payment cards in dependent care
assistance programs.
I. Additional Substantiation Methods for Eligible Medical Expenses
One of the primary concerns of the IRS in approving the use of employer-provided payment cards in medical reimbursement plans was the proper substantiation of medical expenses. Since only those amounts paid to specifically reimburse medical care expenses, as defined in Section 213(d) of the Internal Revenue Code of 1986 (“Code”), qualify for tax-free reimbursement, all claims for reimbursement must be documented and substantiated as eligible medical expenses. Thus, the use of payment cards, linked to FSA and HRA balances, to pay for eligible medical expenses presented an interesting question: how would employers substantiate that the expenses paid for by the payment cards were eligible medical expenses?
To answer this question, Revenue Ruling 2003-43 set forth several methods to substantiate medical expenses. While that revenue ruling required that each expense be substantiated, it provided for the “automatic” substantiation of claims that met certain requirements. Revenue Ruling 2006-69 further clarifies the proper substantiation of medical expenses.
A. Automatic Substantiation of Multiple Copayments
Revenue Ruling 2003-43 provided that individual copayments are deemed substantiated if: (i) the employer independently verifies the amount of the copayment under its medical plan; and (ii) the dollar amount of the transaction at an approved health care provider equals the dollar amount of the copayment for the service rendered. In Revenue Ruling 2006-69, the IRS expands this copayment substantiation method to include the automatic substantiation of multiple copayments in a single transaction. The new substantiation method provides for the automatic substantiation of a single transaction at an approved health care provider if: (i) the employer independently verifies the amount of the copayment under its medical plan; and (ii) the dollar amount equals an exact multiple of not more than five times the copayment for the service rendered.
Example: Employee A is a participant in Employer Z’s health FSA and medical plan. Employer Z’s medical plan has a $10 copayment for generic prescriptions. Employee A uses her debit card at a pharmacy to purchase 5 generic prescriptions, for a total debit card transaction of $50. Employer Z’s system matches the amount of the transaction, $50, with the $10 copayments for generic prescriptions and identifies the pharmacy as the vendor. The employer independently verifies the amount of the copayment under its medical plan. The transaction is substantiated without further review or documentation because the amount of the transaction is an exact multiple not in excess of five times the copayment for generic prescriptions and the transaction took place at an approved health care provider.
If the dollar amount of a transaction at a health care provider exceeds five times the dollar amount of the copayment or is not an exact multiple of the copayment, the employer must treat the transaction as conditional pending confirmation of the charge by the submission of additional third party information, such as service provider receipts.
B. Automatic Substantiation through Inventory Information
Revenue Ruling 2006-69 introduces a new method for the automatic substantiation of eligible medical expenses. The new method utilizes inventory information, such as stock keeping units (“SKUs”), encoded on each piece of merchandise to automatically approve and substantiate eligible medical expenses.
The new method for automatic substantiation involves the following steps:
When an employee uses a payment card, the vendor’s system collects inventory information about the items scanned for purchase using the SKUs on the merchandise.
The payment card system will compare the SKUs against a list of pre-approved items which qualify as expenses for medical care under Code Section 213(d).
The payment card system will automatically allow the purchase of any item matching the pre-approved list and no further substantiation of the purchase is required.
Any item that does not match the pre-approved list will not be valid for purchase with the payment card.
The new system is simple in theory, but may be complicated in practice. All parties to each transaction, including the payment card company and health care providers, must utilize the same inventory information system.
Employers may also use the inventory information system to permit employees to purchase items on the pre-approved list of eligible medical expenses from vendors that are not classified as health care providers. For example, an employee may purchase nonprescription cold medication at a gas station. However, these vendors must use the inventory information system as well.
The IRS offers no guidance on how to develop or implement a comprehensive list of pre-approved items which qualify as expenses for medical care under Code Section 213(d).
An employer that adopts the inventory control information system is responsible for complying with the recordkeeping requirements applicable to records maintained within an automatic data processing system for plan years beginning after December 31, 2006.
C. Direct Third Party Substantiation and Prohibition Against Self-Substantiation
Revenue Ruling 2006-69 clarifies two points regarding the substantiation of medical expenses, regardless of whether employers utilize payment cards for the reimbursement of such expenses.
First, as a general matter, a claim for reimbursement under a medical reimbursement program is fully substantiated if the employer is provided with information regarding the date of the service and the employee’s payment responsibility for that service from an independent third party, such as an explanation of benefits from an insurance company. This substantiation method requires independent coordination and cooperation between the employer and the third party, as illustrated by the example below:
Example: Employee A is a participant in Employer Z’s FSA and medical plan. Employee A visits her physician for medical care as defined in Code Section 213(d). Employee A is responsible for 20% of the cost of the physician’s services and pays such amount. Employer Z, through its previous coordination with the medical plan, automatically receives an explanation of benefits from the plan indicating that Employee A incurred a medical expense, the date the service was rendered, and Employee A’s copayment for the service. Thus, Employee A’s claim is fully substantiated by the explanation of benefits.
Second, medical reimbursement plans are prohibited from accepting “self-substantiated” claims for medical expenses. In other words, a mere description of the medical expenses for which an employee is seeking reimbursement is not sufficient to substantiate the claim. Rather, the employee must offer independent substantiation of the claim from a third party, such as a receipt from a health care provider.
Furthermore, employers who utilize the automatic substantiation of copayments (as described in Section A above) must be careful not to run afoul of the prohibition against self-substantiation. An employer will violate the prohibition against self-substantiation if its copayment matching system relies on the employee to verify the amount of the copayment. The employer must independently verify the amount of the copayment in order to fully substantiate the claim.
Medical reimbursement plans that reimburse self-substantiated claims will cause adverse tax consequences for participants: all payments from medical reimbursement plans that permit self-substantiation must be included in the gross income of participants, including reimbursement for medical expenses that were independently substantiated.
II. Use of Payment Cards in Dependent Care Assistance Programs
Revenue Ruling 2006-69 approves the use of payment cards for dependent care assistance programs (“DCAPs”), including dependent care FSAs. As with medical expenses under an FSA, dependent care expenses must be substantiated and may not be reimbursed before the expenses are actually incurred. Dependent care expenses are considered to have been incurred when the dependent care services are provided, not when the expenses are billed to or paid by the employee.
The IRS proposed the following method for implementing payment cards in DCAPs:
For the period at the beginning of the plan year or just after enrollment in the DCAP, the employee pays for the dependent care services provided in the coverage period.
The employee substantiates these initial expenses by submitting a statement from the dependent care provider independently verifying the dates of service and the services rendered.
After the employer receives the substantiation and after the date the services are rendered, the DCAP makes available through the payment card an amount equal to the lesser of: (i) the previously incurred and substantiated expense; or (ii) the employee’s total salary reduction amount to date.
The amounts paid by the payment card will be considered fully substantiated if the amounts are equal to or less than the previously substantiated amounts. If there is an increase to the previously substantiated amount or a change in dependent care providers, the employee must submit a statement or receipt from the new provider substantiating the claim before additional money will be credited to the payment card.
The amount available through the payment card may be increased by the amount of any additional substantiated dependent care expenses after the date that the services have been provided.
Example: Employee A participates in a dependent care FSA offered by Employer Z. Employer Z contributes $100 in salary reduction amounts to Employee A’s dependent care FSA on a weekly basis. At the beginning of the plan year, Employer Z issues a debit card to Employee A with a zero dollar balance. Employee A’s child care provider requires an advance payment of $250 at the beginning of each week that child care services will be provided. Employee A cannot use the debit card to pay for the $250 advance payment since the services attributable to this amount have not yet been rendered. Thus, Employee A submits a claim for reimbursement that includes a statement from the child care provider detailing the services to be provided, the dates of the services, and the amount of the services. At the end of the week after the child care services have been rendered, Employer Z credits $100 to Employee A’s debit card. Employee A then uses the $100 balance on her debit card to pay for a portion of the $250 advance payment required for the next week of child care services.
If you would like to receive our legal news updates by e-mail, please use our online sign-up form.
McGuireWoods news is intended to provide information of general interest to the public and is not intended to offer legal advice about specific situations or problems. McGuireWoods does not intend to create an attorney-client relationship by offering this information, and anyone's review of the information shall not be deemed to create such a relationship. You should consult a lawyer if you have a legal matter requiring attention.