In 2003, the U.S. Internal Revenue Service (IRS) first addressed the use of credit, debit and stored value cards as a means of reimbursing participants for their out-of-pocket eligible medical expenses under self-insured medical reimbursement plans in IRS Revenue Ruling 2003-43 (ruling). The ruling applied to plans such as flexible spending accounts (FSAs) and health care reimbursement arrangements (HRAs). Many plan sponsors and participants had questions regarding substantiation of expenses paid through such cards.
The IRS recently provided further guidance, Notice 2006-69 (notice), which supplements the ruling on the use of cards to reimburse participants for eligible medical expenses. For the first time, the IRS addresses dependent care assistance programs (DCAPs) and dependent flexible spending arrangements (dependent care FSAs). The notice also provides additional methods for substantiating claimed medical expenses and clarifies other substantiation issues when no card is used.
In the ruling, the IRS provided three methods (co-payment match, recurring expenses and real-time substantiation) a plan sponsor could adopt to substantiate claimed medical expenses under Internal Revenue Code Section 213(d) after a participant uses a debit or credit card. (Please see May 13, 2003 On the Subject, “IRS Approves Use of Credit Cards for FSAs and HRAs.”) The ruling concluded that each of the three methods satisfied the requirements of Code Section 105(b), thus excluding the card payment from a participant’s income.
Additional Substantiation Methods for HRAs and FSAs
Expansion of Co-payment Match Amounts
Automatic Substantiation: The notice permits automatic substantiation for transactions with health care providers or merchants that employ a merchant category code (these are codes that are tied to health care expenses). As long as the participant uses a credit or debit card to pay for eligible medical expenses, and the charge is for an exact multiple of not more than five times the dollar amount of the co-payment for the specific service or product, then the transaction is fully substantiated without the need to submit a receipt or further review. Additionally, if a plan requires multiple co-payments for the same benefit, exact matches of multiples or combinations of co-payments not in excess of five times the maximum co-payment are treated as fully substantiated. To meet the substantiation requirement before the notice was issued, the dollar amount of the charge from the health care provider or merchant had to be the same as the dollar amount of the co-payment for that service under the participant’s health plan.
Example 1: A $50 charge to purchase five non-generic prescriptions at a pharmacy when the plan has a $10 co-payment for non-generic prescriptions results in automatic substantiation.
Example 2: A $45 charge at a pharmacy to purchase three generic prescriptions and three non-generic prescriptions when the plan has a $10 co-payment for non-generic prescriptions and a $5 co-payment for generic prescriptions results in automatic substantiation.
Third-Party Substantiation: If a participant uses his or her card in a transaction with a health care provider or merchant, and the transaction exceeds a multiple of five times the dollar amount of a co-payment for a specific service under the health plan, the transaction must be treated as conditional pending a third-party submitted confirmation of the charge. If a transaction is treated as conditional pending confirmation of the charge, the plan sponsor must require that additional third-party merchant or provider receipts be submitted for review and substantiation. The information must describe the service or product, the date of the service or sale, and the amount. It is not sufficient if the participant submits the additional confirmation.
If the dollar amount is not an exact multiple of the co-payment or an exact match of a multiple or combination of different co-payments, the transaction will also be treated as conditional pending confirmation (even if the amount is less than five times the co-payment).
Example 3: A $60 charge at a pharmacy to purchase six non-generic prescriptions for a total charge of $60 when the plan has a $10 co-payment for non-generic prescriptions results in conditional pending confirmation of the charge.
Example 4: A $27 charge at a pharmacy to purchase two non-generic prescriptions and a non-prescription medication when the plan has a $10 co-payment for non-generic prescriptions results in conditional pending confirmation of the charge.
Inventory Information Approval System
A second method of substantiation is the inventory control method. This method may be employed by a plan sponsor for its health FSA or HRA. A credit or debit transaction will be treated as fully substantiated if the card processor (plan sponsor or third-party administrator) employs an inventory control system that approves and rejects card transactions with merchants based on a stock keeping unit (SKU). This system compares the inventory control information for the items purchased against a list of items and determines whether the purchased item qualifies as an expense for medical care under Code Section 213(d). Under this system, the merchants or service providers need not be health care providers, nor do they need to have merchant category codes. The system only approves use of the card for the amount of Code Section 213(d) expenses subject to coverage under the health FSA or HRA. If the transaction is only partially approved, a split-tender transaction results, and the participant must pay the remaining balance.
Example 5: A participant purchases two non-prescription drugs for a total of $7.50 from a convenience store with the card. Both are Code Section 213(d) medical expenses. The total transaction can be paid for with the card.
Example 6: A participant purchases a non-prescription drug for $5 and a magazine for $3 from a convenience store with the card. The $5 drug is an approved payment with the card, while the vendor must ask the participant for $3 for the magazine.
Plan sponsors adopting this new system for plan years beginning after December 31, 2006 must comply with the recordkeeping requirements of Revenue Procedure 98-25, 1998-1 C.B. 689, in addition to all requirements of the notice.
Other Substantiation Methods
Direct Third-Party Substantiation
If an independent third-party provides a plan sponsor with information indicating the date of the Code Section 213(d) service and the participant’s responsibility for payment of that service, (i.e., an explanation of benefits (EOB) from an insurance company), the claim is fully substantiated without the need for submission of a receipt by the participant or further review.
- Example 7: D visits a doctor and has a co-payment of $150. The doctor submits an EOB to D’s plan sponsor. D’s plan sponsor sends the doctor payment of the $150 from D’s FSA account. No further substantiation is necessary.
Prohibition Against Self-Certification
The notice clarifies that a participant’s self-substantiation or self-certification of an expense does not satisfy the substantiation requirements. Participants may not submit information via internet, intranet, facsimile or other electronic means that merely describes the nature, amount and date of medical expenses. A statement from an independent third-party, either automatically or subsequent to the transaction, is necessary to verify the expense.
Additional Substantiation Methods
The notice permits plan sponsors to adopt additional methods for substantiating claimed medical expenses. Any plan sponsor doing so must comply with requirements set forth in previously published regulations and guidance. This includes, but is not limited to, participant certifications and adoption of meaningful correction procedures for amounts that are not automatically substantiated at the point-of-sale or within a reasonable time after the transaction.
Dependent Care Assistance Programs
The notice permits a plan sponsor to use a card program to provide benefits under its DCAP, including a dependent care FSA. If a plan sponsor chooses this arrangement, it must inform participants that dependent care expenses may not be reimbursed before the expenses are incurred (in this case, when they are provided and not when they are billed). Thus, if a dependent care provider requires payment before services are provided, the participant must pay the money up front and wait for reimbursement after the services are provided.
The notice suggests the following reimbursement method: the participant pays initial expenses to the dependent care provided at the beginning of the plan year or upon enrollment in the DCAP. The participant then substantiates the initial expenses with a statement from the dependent care provider verifying the dates and amounts for the services. After the plan sponsor or plan administrator receives the substantiation, and on or after the date the services are provided, the plan makes available through the payment card an amount equal to the lesser of the previously incurred and substantiated expense, or the participant’s total salary reduction amount to date. A later card transaction that has been previously approved may be treated as substantiated without further review if the later transaction is for an amount equal to or less than the previously substantiated amount.
Implications for Plan Sponsors
In light of this newly released notice liberalizing the use of debit and credit cards and clarifying substantiation issues, it is anticipated that more plan sponsors will implement card-based reimbursement systems. Participation in these programs likely will increase due to improved convenience.
Plan sponsors who have already implemented card programs should review their programs and any vendor contracts carefully to ensure they comply with the new IRS guidance. This may require additional or revised participant communication. In addition, plan sponsors who either have these programs or would like to implement them should consider the revised guidance for tax reporting purposes. Failure to meet the IRS-approved standards could result in adverse tax consequences to both plan sponsors and participants.