A Flexible Benefit

An IRS revenue ruling (IR2003-102), issued in September 2003, expands the benefits of having an employer-sponsored health flexible spending arrangement. These are also referred to as ‘health FSAs’ or ‘medical reimbursement accounts’ (MRAs). Many medical practices already have these in place.

Health FSAs allow employees to pay for medical expenses that are not covered by employer-sponsored health insurance, with pre-tax dollars. The new ruling makes these plans more attractive to doctors and their employees. The added benefit of these plans is that the tax benefits are not subject to phase-out limits based on income. Paying for medical expenses through a medical reimbursement plan is also far more advantageous than itemizing on Schedule A of the federal income tax return, which limits deductions.

How It Works

An employee elects to have an amount withheld from payroll on a pre-tax basis. Out-of-pocket medical expenses are then reimbursed to the employee upon rendering an itemized accounting with receipts for qualified medical expenses.

Historically, ‘qualified medical expenses’ included the following: co-pays and deductibles; dental and/or orthodontic expenses; vision care, including exams, eyeglasses, and contact lenses; hearing care, including exams and hearing aids; prescription drugs; medical supplies and equipment; elective surgery (such as laser and cosmetic); birth control; professional services often not covered by insurance; and other deductible expenses under Section 213(a) of the IRS code.

That portion of the IRS code is clear that only prescription medications are deductible for income tax purposes. However, Revenue Ruling 2003-102 now allows for reimbursement for amounts employees spend on over-the-counter items such as cold medicines, pregnancy test kits, first aid kits, allergy medicines, antacids, and a host of other items not previously allowed.

The IRS has determined that the following items are primarily for medical care and can be reimbursed when purchased in reasonable quantities without a medical practitioner’s note.

A partial list includes: allergy medicine, antacids, anti-diarrhea medicine, bactine, Band-Aids or bandages, bug-bite medication, calamine lotion, carpal-tunnel wrist supports, cold medicines, cold and 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 adhesives for small cuts, menstrual cycle products for pain and cramp relief, motion-sickness pills, nasal sinus sprays, nasal strips, nicotine gum or patches, pain reliever, Pedialyte for an ill child’s dehydration, pregnancy test kits, products for muscle or joint pain such as BenGay and Tiger Balm, reading glasses, rubbing alcohol, sinus medications, sleeping aids for occasional insomnia, spermicidal foam, sunburn ointment or cream, thermometers, throat lozenges, Visine and other eye products, and wart remover treatments.

Ineligible expenses include general health items such as Chapstick, face cream and moisteners, medicated shampoos and soaps, one-a-day vitamins, and suntan lotion.

Some dual-purpose over-the-counter 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.
These include acne treatment, such as Retin-A, only to treat a specific medical condition such as acne vulgaris; dietary supplements of herbal medications to treat a specific medical condition in narrow circumstances; glucosamine/chondroitin for arthritis or another medical condition; orthopedic shoes and inserts (for shoes, reimbursement is only for the extra cost over buying non-orthopedic shoes); OTC hormone therapy and treatment for menopause symptoms such as hot flashes and night sweats; pills for lactose-intolerant people; prenatal vitamins; St. John’s Wort for depression; sunscreen; and weight-loss drugs to treat specific diseases, including obesity.

Plan Costs and Administration

Health FSA plans are relatively simple to implement and administer. A plan document is required, but there is no requirement for an annual filing with the IRS. The costs to have a plan set up are about $500. Many payroll service companies will assist in setting up these plans.

Voluntary payroll reductions are not considered salary or wages subject to income tax. Accordingly, these amounts are not subject to Social Security (FICA) or federal unemployment taxes. In most situations, the payroll tax savings to the employer can more than make up for the costs of administration.

For instance, if payroll deductions for four employees total $10,000, the savings include $3,000 (30{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of $10,000) in federal and state income taxes, and $670 (6.7{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}) in FICA and Medicare tax, for a total of $3,670, or $918 in savings per employee. The savings to the employer, in FICA, Medicare, and FUT, would total $926.

The IRS has not set an upper limit on the amount an employee may have withheld, but some employers set limits in their plans, usually $5,000. Employees must choose the amount to be withheld at the start of each plan year and cannot change it until the following year. Am-ounts withheld but not reimbursed due to overestimating are not returnable to the employee, so employees must carefully estimate their expenditures each year.

In summary, health FSAs are one of the most tax-advantaged employee benefits available. If you do not have one in place, you should. The costs are minimal, and the benefits to you and your employees are valuable. If you already have one in place, be sure to inform your employees of the expanded health expenditures that qualify for reimbursement under the plan. It is a win/win benefit for everyone.

James B. Calnan, CPA, is partner-in-charge of the Health Care Services Division of Meyers Brothers Kalicka, P.C., in Longmeadow; (413) 567-6101.