FSAs and Over-the-Counter Medications

BY EDWARD L. HOBBS AND THERESA J. HRNCIR

TAX BRIEF

A recent ruling by the IRS has given individuals who have “cafeteria plans” at work and who elect to fund medical reimbursement accounts an opportunity to be reimbursed for a much wider range of health-related expenses (also see From the Tax Adviser ).

Cafeteria plans. The majority of cafeteria-plan funding comes from voluntary salary reductions by employees who wish to participate in one or more of a plan’s qualified benefits. This means employees essentially have a choice between cash or qualified benefits.

As a rule, if an individual can choose between receiving money or some other benefit, the tax law considers the individual to have constructively received the cash, with the result that the value of the benefit is taxable as wages. However, the voluntary salary reductions covered under the cafeteria-plan provisions of IRC section 125 are not considered constructively received and thus are not salary or wages for income tax purposes. Additionally, in most circumstances, under IRC sections 3121(a)(5)(G) and 3306(b)(5)(G) these amounts are not considered salary or wages for federal employment tax purposes (FUTA or FICA).

To qualify for this preferential treatment, section 125 says a cafeteria plan may not discriminate in favor of highly compensated or key employees. Some other general requirements are that the plan must be in writing and all participants must be employees and able to choose among two or more alternatives consisting of cash and qualified benefits.

One cafeteria-plan benefit can be a health flexible spending account (FSA). These accounts reimburse employees for medical expenses they incur during the coverage period. If structured correctly, the salary reductions that fund the account come from pretax dollars and the reimbursement employees receive is not taxable. If unreimbursed medical expenses during the plan year are less than the money that funds the account, the employee forfeits the excess. Obviously losing unused funds significantly reduces the account’s tax benefits. A recent IRS ruling could minimize that risk by offering more purchase options for employees. (CPAs can find more information about health FSAs created under cafeteria plans in proposed Treasury regulations section 1.125-2, question 7.)

Reimbursement for over-the-counter medications. The IRS released revenue ruling 2003-102 in September of last year. It says reimbursements an employee receives from an employer-sponsored health FSA for over-the-counter medications are excluded from his or her gross income.

Up until the time of this ruling most, if not all, FSA plans would reimburse only the amount of prescription medications—including copayments—not covered by other insurance. The general understanding was that if IRC section 213 allowed an expense as a medical deduction for tax purposes, then it would be acceptable for reimbursement under a health FSA. Section 213 is clear that only prescription medications are deductible for income tax purposes. However revenue ruling 2003-102 also allows for the reimbursement and exclusion from income of amounts employees spend on over-the-counter medications such as cold medicines, pregnancy test kits or antacids not reimbursed by insurance or otherwise.

It is important to note that over-the-counter items purchased for general health purposes such as vitamins or suntan lotion still are not reimbursable. Companies, such as American Fidelity Assurance Co., are distributing lists with examples of the types of items that now will be reimbursable, items that are still not reimbursable and items that may be reimbursable with a physician’s statement (see exhibit below).

OTC Medical Items: What Qualifies?
Eligible expenses
The following is a list of over-the-counter items the IRS has determined to be primarily for medical care and that can be reimbursed when purchased in reasonable quantities without a medical practitioner’s note.
Allergy medicine.
Antacids.
Bactine.
Band-Aids/bandages.
Anti-diarrhea medicine.
Bug-bite medication.
Calamine lotion.
Carpal-tunnel wrist supports.
Cold medicines.
Cold/hot packs for injuries.
Condoms.
Contact-lens cleaning solution. Cough drops.
Diaper rash ointments.
First aid cream.
First aid kits.
Hemorrhoid medication.
Incontinence supplies.
Laxatives.
Liquid adhesive for small cuts.
Menstrual cycle products for pain and cramp relief.
Motion sickness pills.
Nasal sinus sprays.
Nasal strips.
Nicotine gum or patches for
stop-smoking purposes.
Pain reliever.
Pedialyte for ill child’s dehydration.
Pregnancy test kits.
Products for muscle or joint pain—BenGay and Tiger Balm, for example.
Reading glasses.
Rubbing alcohol.
Sinus medications.
Sleeping aids used to treat occasional insomnia.
Special ointment or cream for
sunburn.
Spermicidal foam.
Thermometers (ear or mouth).
Throat lozenges.
Visine and other eye products.
Wart remover treatments.
Ineligible expenses
Some OTC items will not be reimbursed under any circumstances since they are toiletries or cosmetics or likely to be primarily for general health and well-being.
Chapstick.
Face cream, moisteners.
Medicated shampoos and soaps.
One-a-day vitamins.
Suntan lotion.
Dual purpose
Some dual purpose OTC items can be reimbursed if they are used for a medical purpose. They must be accompanied by a medical practitioner’s note stating that the person has a specific medical condition and the doctor recommends the OTC drug to treat it and the treatment is not a cosmetic procedure.
Acne treatment (Retin A)—only to treat a specific medical condition such as acne vulgaris.
Dietary supplements or herbal medicines to treat a specific medical condition in narrow circumstances.
Fiber supplements under narrow circumstances.
Glucosamine/chondroitin for arthritis or other medical condition.
Orthopedic shoes and inserts (for orthopedic shoes, you can be reimbursed only for the extra cost over buying non-orthopedic shoes).
OTC hormone therapy and treatment for menopause for symptoms such as hot flashes and night sweats.
Pills for persons who are lactose intolerant.
Prenatal vitamins.
St. John’s Wort for depression.
Sunscreen.
Weight-loss drugs to treat a specific disease (including obesity).
Note: This list does not include all reimbursable items.

Source: American Fidelity Assurance Company, Oklahoma City, Oklahoma, www.afadvantage.com/flex-list-otc.shtml .

Observation. This policy change will greatly expand the medical items employees can purchase with pretax dollars through FSAs. Employees who have access to such accounts should reconsider their decision not to participate or consider adjusting the amount they have deducted from their wages on a pretax basis in light of this new ruling. Companies need to decide whether to expand their FSAs to cover these new over-the-counter medicines in the face of potentially higher administration costs and fewer employee forfeitures.

Prepared by Edward L. Hobbs, CPA, assistant professor of accounting at Southeastern Oklahoma State University in Durant, and Theresa J. Hrncir, CPA, PhD, associate professor of accounting at Southeastern Oklahoma State University.

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