Notice 2010-59, 2010-39 IRB; Rev Rul 2010-23, 2010-39 IRB; IR 2010-95; IRS’s OTC FAQs
In Notice 2010-59, IRS has provided guidance on new Code Sec. 106(f) added by Sec. 9003 of the Affordable Care Act (P.L. 111-148, 3/23/2010), which, effective Jan. 1, 2011, provides that unless prescribed or insulin, the cost of over-the-counter medicines cannot be reimbursed from flexible spending arrangements (FSA), health reimbursement arrangements (HRA), Health Savings Accounts (HSA) and Archer Medical Savings Accounts (Archer MSA). IRS has also issued a Revenue Ruling, Information Release, and Frequently Asked Questions (FAQs) on this provision.
Background.
Under Code Sec. 213, expenses for medical care, not compensated for by insurance or otherwise, may be claimed as an itemized deduction to the extent they exceed 7.5% of adjusted gross income (AGI). (For tax years beginning after Dec. 31, 2012, medical expenses will be deductible to the extent they exceed 10% of AGI.) Medical care generally is defined broadly as amounts paid for diagnoses, cure, mitigation, treatment or prevention of disease, or for the purpose of affecting any structure of the body. However, any amount paid during a tax year for medicine or drugs is explicitly deductible as a medical expense only if it is a prescribed drug or is insulin. Thus, any amount paid for non-prescription medicine is not deductible as a medical expense, including any medicine recommended by a physician.
However, the general definition of medical care without the explicit limitation on medicine applies for the exclusion for employer-provided health coverage and medical care. Thus, under an HRA or under a health FSA, amounts paid for prescription and over-the-counter medicine are treated as medical expenses, and reimbursements for these amounts are excludible from gross income. Similar rules apply for a HSA and Archer MSA.
The Affordable Care Act provides that the definition of medical expense for purposes of employer-provided health coverage, including HRAs, health FSAs), HSAs, and Archer MSAs, is conformed to the definition for purposes of the itemized deduction for medical expenses, except that a prescribed drug is determined without regard to whether it is available without a prescription. The changed definition for HSAs and Archer MSAs applies for amounts paid with respect to tax years beginning after Dec. 31, 2010. The changed definition for health FSAs and HRAs applies for expenses incurred with respect to tax years beginning after Dec. 31, 2010. (Code Sec. 106(f), Code Sec. 220(d)(2)(A), and Code Sec. 223(d)(2)(A), as amended by Affordable Care Act Sec. 9003) Thus, under the provision, the cost of over-the-counter medicines can’t be reimbursed with excludible income through a health FSA, HRA, HSA, or Archer MSA, unless the medicine is insulin or prescribed by a doctor.
New guidance.
Notice 2010-59 explains that under Code Sec. 106(f), Code Sec. 220(d)(2)(A), and Code Sec. 223(d)(2)(A), an individual may be reimbursed for over-the counter medicines or drugs, so long as the individual obtains a prescription for the medicines or drugs. 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. The rules in Code Sec. 106(f), Code Sec. 220(d)(2)(A), and Code Sec. 223(d)(2)(A) do not apply to items that aren’t medicines or drugs, including equipment such as crutches, supplies such as bandages, and diagnostic devices such as blood sugar test kits. These items may qualify as medical care if they otherwise meet the definition of medical care in Code Sec. 213(d)(1).
Effective date.
Notice 2010-59 provides that for expenses incurred after Dec. 31, 2010, payments or reimbursements for medicines or drugs from an employer-provided accident and health plan, including a health FSA or an HRA, are restricted to prescribed drugs, insulin, and over-the-counter drugs that are prescribed. This effective date applies regardless of whether the plan year for the employer’s plan is a fiscal or calendar year or whether there is no plan year (or other coverage period in the case of an HRA), and regardless of any applicable grace period for a health FSA (as provided in Prop Reg § 1.125-1(e)). Tax-free distributions for qualified medical expenses from an HSA or Archer MSA for medicines or drugs purchased after Dec. 31, 2010, are restricted to prescribed drugs, insulin, and over-the-counter medicines or drugs that are prescribed.
Thus, expenses incurred for over-the-counter medicines or drugs purchased without a prescription before Jan. 1, 2011 may be reimbursed tax-free at any time by an employer-provided plan, including an FSA or HRA, pursuant to the terms of the employer’s plan. This new law change doesn’t affect HSA or Archer MSA distributions for medicines or drugs made before Jan. 1, 2011, nor does it affect distributions made after Dec. 31, 2010, for medicines or drugs purchased on or before that date.
Debit cards.
Current health FSA or HRA debit card systems are not capable of substantiating Code Sec. 106(f) compliance with respect to over-the-counter medicines or drugs because the systems are incapable of recognizing and substantiating that the medicines or drugs were prescribed. Accordingly, except as provided below, for expenses incurred on and after Jan. 1, 2011, health FSA and HRA debit cards may not be used to purchase over-the-counter medicines or drugs.
Notice 2010-59 provides that to facilitate the significant changes to existing systems to reflect Code Sec. 106(f) ’s change, IRS will not challenge the use of health FSA and HRA debit cards for expenses incurred through Jan. 15, 2011 if the use of the debit cards complies with the existing guidance. But, on and after Jan. 16, 2011, over-the-counter medicine or drug purchases at all providers and merchants (whether or not they have an inventory information approval system (IIAS)) must be substantiated before reimbursement may be made.
Substantiation can be done by submitting the prescription (or a copy of the prescription or other documentation that a prescription has been issued) for the over-the-counter medicine or drug, and other information from an independent third party that satisfies the requirements under Prop Reg § 1.125-6(b)(3)(i). For example, a customer receipt issued by a pharmacy which identifies the name of the purchaser (or the name of the person for whom the prescription applies), the date and amount of the purchase and an Rx number satisfies the substantiation requirements for over-the-counter medicines or drugs, as does a receipt without an Rx number accompanied by a copy of the related prescription.
Under Notice 2007-2, health FSA and HRA debit cards may be used at a pharmacy that does not have an IIAS if 90% of the store’s gross receipts during the prior tax year consists of items which qualify as expenses for medical care under Code Sec. 213(d). Until further guidance is issued, debit cards may be used at a pharmacy that satisfies the 90% test in Notice 2007-2, 2007-1 CB 254 , to purchase over-the-counter medicines or drugs that have been prescribed, if substantiation is properly submitted, in accordance with the terms of the plan, including 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 Prop Reg § 1.125-6(b)(3)(i) . Solely for the purpose of determining whether a pharmacy meets this 90-percent test, sales of over-the-counter medicines and drugs at the pharmacy may continue to be taken into account after Dec. 31, 2010.
Cafeteria plans.
Notice 2010-59 provides that, notwithstanding the rule against retroactive amendments to cafeteria plans, an amendment to conform a cafeteria plan to the requirements set out in Notice 2010-59 that is adopted no later than June 30, 2011, may be made effective retroactively for expenses incurred after Dec. 31, 2010 (or after Jan. 15, 2011 for health FSA and HRA debit card purchases).
Effect on other documents.
Notice 2010-59 provides that IRS intends to amend Reg. § 1.105-1, Reg. § 1.105-2, Reg. § 1.106-1, Reg. § 1.125-1 and Reg. § 1.125-5 to provide for the new definition of medical expenses. Taxpayers may rely on Notice 2010-59 until the amended regs are issued. In addition, Rev Rul 2010-23 obsoletes Rev Rul 2003-102, 2003-2 CB 559 , which provides that reimbursements by an employer of amounts expended for medicines or drugs available without a prescription are excludable from gross income Code Sec. 105(b).
IR 2010-95 can be viewed on the IRS website at http://www.irs.gov/irs/article/0,,id=227301,00.html.
The text of IRS’s OTC (Over-The-Counter) FAQs can be viewed on the IRS website at http://www.irs.gov/newsroom/article/0,,id=227308,00.html.
RIA Research References: For expenditures that qualify as medical care expenses, see FTC 2d/FIN ¶ K-2100; United States Tax Reporter ¶ 2134.04; TaxDesk ¶ 346,003.
Source: Federal Tax Updates on Checkpoint Newsstand tab 9/7/2010 (as provided by kipp.mitchell@thomsonreuter.com)
Contact Schutte & Hilgendorf, PLLC with questions related to over-the-counter medicines and their tax treatment or with any other tax and accounting questions. Schutte & Hilgendorf is a CPA firm in Prescott, Arizona offering tax, accounting, auditing, and consulting services to individuals and business in the greater Yavapai county.
