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When Claritin, once a highly popular prescription drug for allergies, was approved for sale as an over-the-counter product, employees lost the benefit of their prescription plans to purchase that drug. To compound matters, they could not get reimbursement for that expense under their employers’ health care flexible spending account (FSA) or health care reimbursement arrangement (HRA). Starting now, however, according to a recent IRS announcement, employees can be reimbursed tax-free from their employer’s health care FSA or HRA for the cost of purchasing over-the-counter drugs. This means that nonprescription drugs can be purchased with pretax dollars, so long as the employee follows proper procedures for obtaining reimbursements from his or her employer (such as submitting a receipt). When does the change take effect? Because this ground-breaking ruling interprets existing law, it can be relied upon now. In fact, Internal Revenue Service officials confirmed to us that an employer’s FSA or HRA may reimburse nonprescription drug purchases made anytime during calendar year 2003 (provided that the plan allows it and that the employee provides proper documentation for the purchase — usually a dated receipt identifying the product and the amount paid). The timing of this announcement may be particularly significant for employees since the end of the year is approaching and health care FSAs (but not HRAs) impose a “use-it-or-lose-it” rule for amounts the employee sets aside in the FSA for calendar year 2003. Many employees often struggle to use up their health care FSA funds towards the end of the year. They try to cram in year-end expenses for items such as preventative doctors’ visits, dental cleanings or purchasing extra pairs of eyeglasses or contact lenses. Now, however, employees can add over-the-counter medicines to their year-end shopping list in an effort to use up money that otherwise would be forfeited. WHY THE CHANGE? In announcing this change in long-standing policy, the IRS noted that in recent years, many drugs that were formerly available by prescription are now only available over-the-counter. The Internal Revenue Code also noted that this trend is likely to continue. Historically, employer’s health plans have not covered the cost of nonprescription drugs, but health plans regularly reimbursed employees for prescription drugs. While an over-the-counter drug is often less expensive than a prescription drug equivalent, the out-of-pocket cost to many employees for the over-the-counter drug may actually be higher than the employee’s out-of-pocket cost for the prescription drug. For example, many employers’ prescription drug plans require employees to pay a $5 or $10 co-payment per prescription. However, when a prescription drug has become available over-the-counter (like Claritin for allergies), the cost of the now nonprescription drug could actually be greater to the employee than the cost of a prescription co-payment. This can be an unexpected financial burden for employees who remedy chronic health problems by regularly taking an over-the-counter medicine that was once available by prescription only. The Treasury Department and IRS released a press statement acknowledging the significance of this problem and the welcome relief that this solution provides to employees. “Flexible Spending Accounts are an important tool in helping people meet their health care costs,” stated Treasury Secretary John Snow. “Since many prescription drugs have moved to the over-the-counter market, this action today makes paying for them a little bit easier to swallow.” “Flexible Spending Accounts were established under the tax code to provide incentives for better health care,” said IRS Commissioner Mark W. Everson. “This action is a sensible expansion and simplification of the program consistent with existing law.” LIMITATIONS Revenue Ruling 2003-102 sets out two important limitations with respect to over-the-the-counter drugs. First, the cost of over-the-counter drugs continues to be nondeductible for purposes of itemizing medical deductions on an individual’s personal federal income tax return (i.e., on Schedule A of Form 1040). Second, the cost of dietary supplements that are merely beneficial to the employee’s health (such as vitamins) are not reimbursable under an employer’s FSA or HRA. The IRS noted that toiletries (such as toothpaste), cosmetics (such as face creams) and sundry items do not qualify as expenditures for medical care that are eligible for pretax reimbursement. Thus, while Revenue Ruling 2003-102 is welcome news for employees, it nevertheless leaves some questions open as to its scope. Revenue Procedure 2003-102 states that amounts that are spent for “medicines and drugs” are costs incurred for providing “medical care” and are, therefore, reimbursable. In contrast, expenses that are not for medical care do not qualify for pretax reimbursement. Specifically, the ruling states that the costs of over-the-counter antacids, allergy medicine, pain relievers and cold medicines are now reimbursable on a pretax basis, but that the cost of over-the-counter vitamins, which are for general maintenance of good health, are not reimbursable. The ruling also notes that expenditures for vacations are not expenditures for medical care, even though vacations are beneficial to one’s general health. It is somewhat unclear where health plan administrators should draw the line in determining whether a particular cost qualifies for reimbursement. For example, would an over-the-counter product used to treat or prevent “athlete’s foot” be reimbursable? On one hand, the product could be used to treat a medical condition, but on the other hand, it could be used merely to promote general good health. First-aid products are also problematic — it is unclear whether Ace bandages and joint braces would be reimbursable (arguably, these could be “sundry” items that are not reimbursable, but they could be used to treat a medical condition). Likewise, weight-loss products present a quandary for health plan administrators. On one hand, morbid obesity is a disease that the IRS has recognized as qualifying for the medical expense deduction rules, but it is unlikely that over-the-counter weight loss products would qualify as a medical expense — although reasonable arguments could be made that, in certain situations, they ought to qualify as medical expenses. A trip through any drug store would reveal a myriad of products that do not clearly fit within one category or the other. Until the IRS releases a more comprehensive list, health plan administrators will need to develop their own approach to determining whether to honor reimbursement requests for such hybrid products. The downside for health plan administrators that get it wrong is likely to be minimal, since the language of the Revenue Ruling and other existing guidance is somewhat unclear. It appears that the improperly reimbursed amounts would be includible in the employee’s gross income (presumably on Form W-2) and would also be subject to employment taxes. However, because most employers limit the maximum amount that can be deferred into a health FSA, it is unlikely that such improper reimbursements would be a significant tax burden for the employer and the employee. ACT NOW As soon as possible, employers should examine their FSA or HRA plan documents to ensure that the plan’s definition of eligible expenses does not inadvertently exclude nonprescription medicines. If the plan defines eligible expense using a very broadly-worded definition (such as, “an eligible expense is an expense that is otherwise deductible under Code section 213,” which is very typical for this type of plan), then an amendment to the plan document would be needed to clarify that nonprescription drugs are eligible expenses. The critical legal issue here is that the IRS now interprets � 105(h) — which governs tax-free reimbursements under FSAs and HRAs — as not specifically requiring that the medical expense must be “ deductible under Code section 213.” This interpretation opens the door for employers’ plans to reimburse over-the-counter drugs under FSAs and HRAs, while simultaneously preventing individuals from deducting the cost of over-the-counter drugs on their federal income tax returns. Employers should carefully review all open enrollment documents and employee communications before they are distributed and modify them as needed to reflect the new IRS view, so that employees can budget a year’s worth of nonprescription drug costs into their 2004 FSA elections. It is possible that employees will ask employers to allow them to put more money into their health FSA for the remainder of 2003 in order to take advantage of this IRS change in position. However, such midyear changes are not allowed for health FSAs. Therefore, employees remain limited to their unused 2003 health FSA contributions for pretax reimbursements for over-the-counter medicines. Berlin is a partner at Buchanan Ingersoll and heads the firm’s New Jersey labor and employment law practice in Princeton. Weis is counsel to the firm and is a member of the tax section in the firm’s Pittsburgh office. Sharara is an associate and is a member of the tax section in the firm’s Washington, D.C., office. 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