HEALTH FSA AND HRA PLANS MAY NOW REIMBURSE FOR OTC DRUGS

November 5, 2003

By Linda Bounds Sherman

Employer-sponsored Health Flexible Spending Account (HFSA) and Health Reimbursement Account (HRA) Plans may now reimburse employees for properly substantiated costs of over-the-counter (OTC) drugs according to a recent ruling by the IRS. This is a change in the IRS's long- standing position that only "prescribed drugs," i.e., a drug that is not available in any form without a prescription, which would qualify as a tax deductible medical expense could be reimbursed under such plans. Only the cost of OTC medicines or drugs obtained for medical care purposes (such as antacids, allergy medicine or cold medicine) may be reimbursed. Amounts paid for dietary supplements (such as vitamins) that are merely beneficial to the general health are not reimbursable expenditures.

Theoretically, employees may take advantage of this change in position immediately for OTC expenses incurred during the current plan year. Technically, however, there may be problems in doing so. The HFSA or HRA plan, in accordance with the prior IRS position, may not provide for or may specifically preclude, reimbursement of OTC drugs. Additionally, since employees were unaware of the availability of reimbursement for OTC drugs, receipts to substantiate the charges may not be available. Additionally, with a HFSA Plan the employee may not have deferred a sufficient amount to his HFSA for the plan year to cover the cost of such reimbursements. A mid-year change in benefits election under the HFSA is not permissible for this purpose under the provisions of the Internal Revenue Code and Treasury Regulations.

What actions should the employer take as a result of this change in IRS position? First, a decision should be made as to whether the reimbursement of OTC drugs will be allowed under your HFSA and/or HRA Plan. Next, the provisions of your HFSA and/or HRA Plan should be reviewed to determine if OTC reimbursement is currently allowed under the plan's provisions. Depending upon the language in your plan, reimbursement for OTC drugs may already be possible under its terms. Other plans, however, will need to be amended to take advantage of this change in the IRS' position. Amendment may also be required if you do not want to allow such reimbursement under your plan. You will also need to review the language of the Summary Plan Description and administrative forms used in connection with the HFSA and/or HRA Plan and amend them, as needed, to clarify whether OTC drugs are reimbursable. Procedures will also need to be determined and put in place for processing reimbursement claims for OTC drug charges. Such cost must be substantiated by the employee; and since no explanation of benefit will be available for such charges, the employer must determine what type of proof will be required to substantiate the cost.

If you have any questions regarding this change in IRS position or if we can be of assistance in amending your plans, SPD, and/or administrative forms in connection with this change, please contact Linda Bounds Sherman or any member of the Labor and Employment Practice Group.

Linda Bounds Sherman is a shareholder in the Firm's Business Solutions and Labor and Employment Practice Groups. She may be contacted at (601) 949-4960 orlsherman@watkinsludlam.com.