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Employers, Retailers Struggle to Define Eligible Expenses Under Flexible Spending Accounts

Amy S. Elliott for Tax Analysts

The expanded use of tax-advantaged accounts to pay for medical expenses under employer-sponsored cafeteria plans drew the attention of the Senate Finance Committee in mid-May when it announced proposals for financing comprehensive healthcare reform. But rather than hold out flexible spending accounts (FSAs) as a model for controlling rising healthcare costs, the committee proposed eliminating the accounts to help pay for a healthcare overhaul.

In case that proposal turns out to be hard to swallow, the committee suggested an alternative -- cap contributions to health FSAs and/or standardize the definition of what qualifies as a medical expense eligible for reimbursement through an FSA. That revised definition would mean that the cost of nonprescription, over-the-counter medical items would no longer be reimbursable.

The congressional proposals come at a time when health FSA plan administrators and retailers have been under the gun to implement Service guidelines requiring point-of-sale determinations as to which products qualify for reimbursement under a health FSA. The effort involves a complex cast of players that includes everyone from product manufacturers to third-party credit card processors, and large sums of money are at stake for consumers and firms.

The tax advantages (in the form of reduced income tax liabilities for taxpayers) provided by health savings accounts (including FSAs), came to $500 million in 2008, according to the Finance Committee. That amount, however, is tiny compared with the other revenue raisers among the committee's proposals.

About 27 percent of all U.S. employers with 10 or more employees offer plans, including FSAs, that allow employees to pay for some medical expenses not covered by their insurance using pretax dollars, according to the National Survey of Employer-Sponsored Health Plans 2008 by Mercer LLC. Within those plans, an average of 37 percent of eligible employees voluntarily contribute to such an account, the survey found. The average voluntary contribution per participant is $1,385.

Participants of health FSA plans can use the accounts to pay for some medical expenses as defined by section 213(d). For many participants, the guidance in the statute is not seen as particularly helpful. Eligible expenses include those incurred "for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body."

The IRS has put out a limited amount of additional guidance on what qualifies as an expense eligible for reimbursement. Also, Publication 502 lists various categories of products that are eligible. "Goods or services that are merely beneficial to general health" are not generally eligible.

In 2003 the IRS in Revenue Ruling 2003-102 expanded the definition of what does count to include some over-the-counter or nonprescription items. In a release announcing the expanded interpretation, Treasury said "the statutory exclusion for reimbursements of employee health expenses is broader than the itemized deduction for medical expenses."

For the Service to effectuate the committee's proposal to standardize the definitions so that "the cost of nonprescription medicines would not be reimbursed through a flexible spending arrangement," Rev. Rul. 2003-102 would need to be, in effect, undone.

A Treasury official told Tax Analysts that a legislative change would be required to make that happen.

"If there's a statutory change then that's an obvious reason for the IRS as a whole to change its opinion about what constitutes a permissible reimbursable expense," said Roberta Casper Watson, an employee benefits attorney with the Tampa, Fla., firm Trenam Kemker. "If there was no statutory change, then for them to say, 'Oops. We were wrong.' That's a hard thing for them to do. The IRS isn't supposed to set policy. The IRS is supposed to apply the law."

The Price of Charging a Candy Bar

The goal of the Finance Committee's proposals is to raise money to pay for the healthcare reform that the Obama administration says is necessary to control rising healthcare costs. But some in the employee benefits field fear these proposals will have the opposite effect.

"I think [the Senate Finance] proposal will do the very thing they don't want it to do, which is exacerbate health spending," said Jody Dietel, the compliance officer for WageWorks, a third-party administrator of tax-advantaged benefits programs including FSAs. "It removes the incentives for Americans to engage in their own healthcare."

A few years ago, the IRS realized that as health FSAs became more prevalent and as more and more plans were issuing payment cards to account holders, the issue of what was and was not a qualified medical expense that is eligible for reimbursement became more pressing.

The scenario is a simple one. A plan participant goes to a pharmacy to purchase a prescription drug with a health FSA payment card. The participant has to wait while the prescription is getting filled and decides to pick up a candy bar. He uses his health FSA payment card to pay for both the prescription and the candy. A few years ago, nothing was in place at the pharmacy to prevent that.

When the plan's managers realize that the participant uses the health FSA payment card for an ineligible expense, they are forced to chase after the participant for the cost of the candy or face possible disqualification by the Service. The way the guidance reads, one candy bar can disqualify a whole plan.

To address this problem, the Service has issued several items of guidance on the use of payment cards in connection with health FSAs (including Notice 2006-69 and Notice 2007-2). The Service is requiring that before an item can be charged to a health FSA payment card, the item must be prequalified as an eligible expense. To that end, some retailers must implement an inventory information approval system (IIAS) that would enable this prequalification.

Does this mean the IRS will decide on a product-by-product basis what is considered a section 213(d) medical expense eligible for reimbursement under a health FSA? No, according to specialists. Does this mean that most retailers who want to accept health FSA payment cards have to make such a determination? Yes, they say.

Retailers Organize

A large group of industry stakeholders saw this requirement as an opportunity to bring some standardization to an area full of divergent practices. Those stakeholders formed the Special Interest Group for IIAS Standards (SIGIS). Dietel, in addition to her role at WageWorks, is vice president of SIGIS and chair of the SIGIS List Review Working Group. The group is responsible for deciding which products are FSA eligible and which are not.

"We just felt that there would be a better end-participant experience if they could count on having the same experience at every retailer," Dietel said. "If Band-Aids are eligible, they're eligible everywhere I shop for them."

That vision may have limits because not all retailers have chosen to become SIGIS members, and multiple lists are still floating around the industry. On some level, that doesn't really matter because plan sponsors are not required to allow reimbursement for some otherwise eligible medical expenses. For instance, Dietel said, some religious organization may choose not to allow reimbursement for condoms.

But for those plans that allow their participants to use health FSA payment cards, a master FSA-eligible list is still a concern. Dietel said that 100 percent of the plans that use a debit card are represented at SIGIS in some fashion. That representation may be in the form of the major payment card brands (Visa and MasterCard), which are both founding members of the group and, as such, have invested more than $150,000 each in the nonprofit SIGIS.

One product that was recently added to the SIGIS eligible product list is GoodNites brand bed-wetting diapers, manufactured by Kimberly-Clark. Individuals who shop at retailers that use the SIGIS list can purchase this product with their health FSA payment card without needing a letter of medical necessity stating a medical condition.

According to SIGIS, eligible products "are primarily for a medical purpose" and are not "merely beneficial to general health or used for personal hygiene." But according to the GoodNites Web site, bed-wetting is "a stage of development that kids simply outgrow with patience and time." Bed-wetting diapers seem to fall in the gray area between mitigating or treating a disease and merely benefiting general health.

Up until SIGIS stepped in to push for industry standardization, every third-party administrator kept a list of those products it thought were FSA eligible. Many pharmacies and retailers also tracked the items. While this may sound like duplication of effort that could be done away with if the IRS just maintained its own product list, such a solution is unlikely, observers say.

OPM's Model List

To make a determination whether a nonprescription product may in fact be considered a qualified medical expense eligible for reimbursement under a health FSA the taxpayer's specific situation must be considered, an IRS spokesperson told Tax Analysts.

Although the IRS won't weigh in on the gray areas (other than on a taxpayer-specific basis), the federal government is forced to address the issue in its role as a plan sponsor. Because it's the responsibility of the employer to abide by the Service rules or face plan disqualification, the federal government in its role as employer has weighed in.

The Federal Flexible Spending Account (FSAFEDS) program is the health FSA plan sponsored by the U.S. Office of Personnel Management. It publishes a chart of eligible FSAFEDS expenses on its Web site.

According to that chart, diapers are a potentially eligible expense that would require a letter of medical necessity and might be eligible if they are used "to relieve or ameliorate the effect of a particular illness or disease." Incontinence products in general also require a letter of medical necessity stating that they are used for a diagnosed medical condition.

Neither bed-wetting nor adult diapers receive blanket FSA-eligible status by FSAFEDS such as that given by SIGIS to GoodNites bed-wetting diapers and incontinence supplies like Kimberly-Clark's Depend products.

The conservative line taken by FSAFEDS seems to correspond with the limited guidance available from the Service. Publication 502 states: "You cannot include in medical expenses the amount you pay for diapers . . . unless they are needed to relieve the effects of a particular disease," which would require additional documentation.

Watson agrees with the line drawn by FSAFEDS to disallow those products unless provided with a letter of medical necessity. She advises cafeteria and health plans on what is considered an eligible medical expense "all the time."

"I would advise my clients to follow that same guidance. Not necessarily because I'm 100 percent sure that's the only way to do it, but if you do things with a cafeteria plan that aren't permissible, you can make everything under the cafeteria plan taxable. It's a big-stakes game to take an aggressive position with a cafeteria plan," Watson said.

Risking plan disqualification may be "big stakes," but Watson and Dietel both acknowledged they didn't think the Service had disqualified any plans because the plans had allowed reimbursement for ineligible expenses. The Service declined to confirm or deny any disqualifications.

"I'm not aware that the IRS yet is aggressive about cafeteria plan enforcement on anything," Watson said, adding that she expects it to get a lot more aggressive about enforcement once the final cafeteria plan regs (yet to be issued) become effective.

What might be big stakes is the amount of money consumers spend on FSA-eligible products. As the scope of products widened with Rev. Rul 2003-102 and as more plans made purchase cards available to plan participants, the potential has increased.

Evaluating Personal Care Products

Purchase card brands such as Visa and MasterCard, which get a cut of the amount charged to their health FSA purchase cards, might have thought their $150,000-plus investment in SIGIS made business sense. When the SIGIS product list increased from 3,500 to more than 39,500 individual products in a matter of 18 months, their profit potential presumably also increased. (For perspective, Drugstore.com carries more than 45,000 over-the-counter products -- about 3,000 of them FSA-eligible -- through its online store, according to Anne Marshall, the company's director of public relations.)

Below is a list compiled by Tax Analysts that highlights some of the difficulty in making product-by-product FSA eligibility determinations.

May Be Eligible

Sunscreen SPF 30+
Elastic support sheer hosiery
Bed-wetting diapers
Hand sanitizer
Prenatal vitamins
Incontinence pantiliners
Earwax removal drops

Generally Not Eligible

Sunscreen SPF 15
Regular sheer hosiery
Breast pump
Sanitizing soap
Kid or adult multivitamins
Feminine hygiene pantiliners
Q-tips cotton swabs

So how exactly is this FSA-eligible determination made by SIGIS? A group of 18 third-party administrators, headed by Dietel, comprises the SIGIS list review working group, which updates the list monthly. Any SIGIS member can submit products for review and inclusion.

"Every month, we have between probably 600 and 6,000 items to review," Dietel said. "We discuss it from the foundational IRS guidance and principles about [section] 213 eligibility." She added that they use many sources of governmental guidance -- including from agencies other than the IRS, like the Food and Drug Administration -- in making their determinations.

"That group of third-party administrators has worked tirelessly to make the list as broad as it can be, as consistent as it can be, and I think we've really thoroughly vetted the eligibility of the items," Dietel said.

While Kimberly-Clark took GoodNites to the SIGIS list review working group through SIGIS member Visa, according to a company spokesperson, it isn't clear that all manufacturers have caught on. A comparable product by another manufacturer -- UnderJams by Procter & Gamble, the makers of Pampers -- was not added to the SIGIS eligible product list. If a consumer goes to a SIGIS retailer like Drugstore.com, he or she can't use a health FSA payment card to buy UnderJams but could use it to buy GoodNites.

Once GoodNites gained SIGIS approval, Kimberly-Clark began marketing the product as "FSA-approved." A Kimberly-Clark spokesperson said the company plans to add this distinction to its packaging. The GoodNites Web site heralds the news: "Save up to 30 percent now that GoodNites brand is eligible for Flexible Spending Accounts."

A major non-SIGIS retailer -- Walgreens -- does not recognize GoodNites as FSA eligible for purchase on its Web site. And some plans -- including FSAFEDS -- will allow consumers to get reimbursed for a purchase of GoodNites only with a letter of medical necessity from a doctor.

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