In its never-ending battle in the pursuit for perfection, the IRS has modified its guidance, originally issue in July 2006, on debit card expense substantiation by issuing further guidance in Notice 2007-2.

July 2006

Last July, the IRS issued guidance on debit card and stored value (pre-paid) cards for use with Flexible Spending Accounts (FSAs) and Health Reimbursement Accounts (HRAs). The July guidance centered on claims substantiation expanding the types of transactions that would allow automatic claims substantiation. One of the methods discussed was the use of stock keeping units (SKUs) when obtaining medical related goods from merchants, whether health related or not.

Notice 2007-2

Last December, the IRS issued a Notice for limiting the use of debit cards to only merchants with a health related merchant code. This new Notice takes away some of the flexibility offered in the July guidance. Following is a somewhat technical description of substantiation methodologies where non-health merchants such as grocery stores, Walgreens, Wal-mart, Costco, and other big box stores sell prescription drugs and other medical related products. It is clear that the IRS intends to require irrefutable substantiation of the medical expense for compliance with the debit card rules.

Background

Rev. Rul. 2003-43 issued in May 2003 sets forth rules for determining whether employer-provided medical expense reimbursement made through debit cards and other electronic media are excludable from gross income under §105(b) of the Internal Revenue Code. The ruling validated the use of employer provided debit or credit cards in connection with flexible spending and health reimbursement accounts, but made it clear that, to be eligible, each claim must be substantiated through a “pay and chase” requirement. Mere sampling would not be acceptable. The 2003 ruling limited merchants for such debit card charges to “physicians, pharmacies, dentists, vision care offices, hospitals, and other medical care providers.” It expanded the list to include other non-health care related merchants in its July 2006 ruling. And now comes stricter guidelines.

Stricter Guidelines

Providing transitional relief, the IRS will deem any expenses incurred on or before December 31, 2007 from all supermarkets, grocery stores, discount stores, wholesale clubs, mail order vendors, and web-based prescription drug vendors as "other medical care providers."  Employers will still be required to substantiate all debit card charges incurred during the transition relief period as qualifying for medical expense reimbursement and must follow the required correction procedures for any unsubstantiated payments. After December 31, 2007, health FSA or HRA debit cards may not be used at any store, vendor or merchant that does not have a health-care-related merchant category code unless the store, vendor or merchant has implemented an Inventory Information Approval System (IIAS) as described in Notice 2006-69, I.R.B. 2006-31, 107.

Effective December 31, 2008 the use of health FSA and HRA debit cards at stores with drug stores and pharmacies merchant category codes will also be limited. Such debit cards will not be allowed unless (1) the store participates in the IIAS described in Notice 2006-69, or (2) on a store location by store location basis, 90 percent of the store’s gross receipts during the prior taxable year consisted of items which qualify as expenses for medical care under Code Sec. 213(d) (including nonprescription medications as described in Rev. Rul. 2003-102).

Inventory Information Approval System Requirement for
Drug Stores and Pharmacies

Under Rev. Rul. 2003-43, health FSA and HRA debit cards may be used at stores with the merchant category code for drug stores and pharmacies. However, many of these stores also sell a significant number of nonqualifying products. The IRS has determined that it is appropriate to require such stores to follow similar substantiation rules as all other stores that sell a significant number of items that don’t qualify as medical expenses under Sec. 213(d). Effective December 31, 2008 these drug stores and pharmacies will be required to implement the IIAS as well in order to accept charges from participants’ debit cards.

Under the IIAS, the payment card processor provides a system for approving and rejecting card transactions using inventory control information (e.g. stock keeping units or SKUs) with merchants. Card transactions using this method are fully substantiated without the need for submission of a receipt by the employee or further review. Under this method, when an employee uses the card, the merchant's system collects information about the items purchased using SKUs. The system compares the inventory control information for the items purchased against a list of items, the purchase of which qualifies as expenses for medical care under §213(d) of the Internal Revenue Code. The §213(d) medical expenses are totaled and the merchant's or payment card processor's system approves the use of the card only for the amount of the §213(d) medical expenses subject to coverage under the health FSA or HRA. If the transaction is only partially approved, the employee is required to pay for the remaining items wit h another form of payment.

Implementation

Plan Sponsors who may be considering the implementation of debit cards for their next FSA Plan Year will need to proceed carefully to assure that the cards are accepted by a reasonable number of merchants, including drug stores, and that the merchants are prepared to comply with the IRS IIAS requirements which are one year away

Copyright © 2007 Alfred B. Fowler, Attorney at Law.
All Rights Reserved. Reprint with permission only.
This legislative update is published as an information source for our clients and colleagues. It is general in its nature and is no substitute for legal advice or opinion in any particular case.

 

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