This is the 12th in a series of WorkCite articles concerning the recently enacted Patient Protection and Affordable Care Act and its companion bill, the Health Care and Education Reconciliation Act of 2010 (referred to collectively as the Act). This WorkCite deals specifically with a new tax rule that applies to the reimbursement for expenses incurred for over-the-counter (OTC) medicines and drugs that are purchased without a prescription. The rule affects reimbursements under employer-sponsored health plans, health flexible spending arrangements (health FSAs), and health reimbursement arrangements (HRAs), as well as health savings accounts (HSAs) and Archer medical savings accounts (Archer MSAs)
Under the Internal Revenue Code (Code), an employee who participates in an employer-sponsored group health plan may exclude from gross income both the value of coverage under the plan and amounts paid as reimbursements for medical care, including medical expenses, under the plan. Similarly, distributions for qualified medical expenses from HSAs and Archer MSAs are tax-free to the participant.
Presently, the cost of OTC medicines and drugs are medical expenses that are eligible for reimbursement from group health plans (and are qualified medical expenses eligible for distribution from HSAs and Archer MSAs). The Act, however, has amended the definition of “medical expenses” in the Code for these purposes to restrict the reimbursement (and distribution) of funds used to purchase OTC medicine and drugs going forward.
On September 3, 2010, the IRS issued Notice 2010-59, which provides guidance on the implementation of the new rule.
The new rule generally applies to medical expenses incurred after December 31, 2010. This effective date applies without regard to the fiscal year of the employer’s plan, and without regard to any applicable post-year-end grace period for a health FSA.
The same effective date applies to tax-free distributions for qualified medical expenses from an HSA or Archer MSA.
Reimbursement Restricted to Prescribed Drugs, Insulin, and Prescribed OTC Drugs
Under the Act, expenses incurred for medicines and drugs are treated as a reimbursement for medical expenses only if the medicine or drug is (i) a prescribed drug (determined without regard to whether such drug is available without a prescription), or (ii) insulin. Thus, expenses incurred after December 31, 2010, for medicines and drugs may be paid or reimbursed by an employer health plan, including a health FSA or HRA, only if the medicine or drug:
- Requires a prescription,
- Is available without a prescription (i.e., an OTC medicine or drug) and the individual obtains a prescription, or
- Is insulin.
Expenses incurred for OTC medicines and drugs purchased without a prescription before January 1, 2011, may be reimbursed tax-free at any time, pursuant to the terms of the employer’s plan.
Similar restrictions will apply to HSAs and Archer MSAs. For amounts paid for expenses incurred after December 31, 2010, a distribution from an HSA or Archer MSA for a medicine or drug is a tax-free qualified medical expense only if the medicine or drug is (i) a prescribed drug (determined without regard to whether such drug is available without a prescription), or (ii) insulin. This change does not affect distributions made after December 31, 2010, that are for medicines or drugs purchased on or before that date.
If amounts are distributed from an HSA or Archer MSA for any medicine or drug that does not satisfy this requirement, the distribution will be for nonqualified medical expenses. This means that the distributed amounts will be includable in the participant’s gross income and, generally, will be subject to a 20% additional tax.
For purposes of the new rule, a prescription means “a written or electronic order for a medicine or drug that meets the legal requirements of a prescription in the state in which the medical expense is incurred and that is issued by an individual who is legally authorized to issue a prescription in that state.”
Comment: To avoid perverse results, plan sponsors might consider eliminating reimbursement for all, or certain, OTC purchases, even where the participant has a prescription. Clearly, it will not be cost effective for the plan to pay the cost of a doctor’s office visit for a participant who coaxes a prescription for aspirin to ensure reimbursement for its $5.00 purchase price from the participant’s health FSA.
Reimbursement of Items Other Than Drugs
The new rule is inapplicable to items that are not medicines or drugs, including equipment (e.g., crutches), supplies (e.g., bandages), and diagnostic devices (e.g., blood sugar test kits). These items will continue to qualify if they otherwise meet the definition of medical care, which includes expenses for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.
Effect on Health FSA and HRA Debit Cards
Current rules under the Code permit the use of debit cards for expenses under health FSAs and HRAs, subject to certain restrictions. However, the IRS believes that current debit card systems are not capable of substantiating compliance with the new rules for OTC medicines or drugs, because the systems are incapable of recognizing and substantiating that the medicines and drugs are prescribed. Therefore, except as provided below, for expenses incurred on and after January 1, 2011, health FSA and HRA debit cards may not be used to purchase OTC medicines and drugs.
The IRS will not challenge the use of health FSA and HRA debit cards for expenses incurred through January 15, 2011, if the use of the debit cards complies with the current guidance for their use.
Debit cards may continue to be used for medical expenses other than OTC medicines or drugs. By contrast, OTC medicine and drug purchases made on or after June 16, 2011, must be substantiated before reimbursement may be made. Substantiation is accomplished by submitting:
- The prescription (or a copy of the prescription or other documentation that a prescription has been issued), and
- Other information from an independent third party that satisfies the requirements under the proposed cafeteria plan regulations.
Transition Rule for Cafeteria Plan Amendments
Cafeteria plans may need to be amended to conform to the new OTC medicine and drug requirements. Generally, cafeteria plan amendments may be effective only prospectively; however, Notice 2010-59 provides that an amendment to conform a cafeteria plan to the requirements set forth in the Notice may be made effective retroactively for expenses incurred after December 31, 2010, (or after January 15, 2011, for health FSA and HRA debit card purchases), provided the amendment is adopted no later than June 30, 2011.
For more information on the Act and Notice 2010-59, please contact the authors or any member of the McGuireWoods Employee Benefits team.