Employers offer a variety of account-based arrangements to help employees offset medical costs. From health flexible spending arrangements (health FSAs) to health reimbursement arrangements (HRAs) to health savings accounts (HSAs), many questions can arise about reimbursable expenses and substantiation. As such, it’s important for employees, administrators, and advisors to understand the federal tax laws that govern these arrangements and how they apply in practice.
What are the differences between account-based health arrangements?
Health FSAs and HRAs are plans under which employees can be reimbursed on a pre-tax basis for medical expenses that are not reimbursed by insurance or any other arrangement. Health plan copays, deductibles, eyeglasses, and orthodontia are common examples of expenses that can be reimbursed under a health FSA or HRA. Health FSAs are usually offered as part of a cafeteria plan and are funded with employees’ pre-tax salary reductions (or with employer credits or contributions, if offered by the employer). In contrast, HRAs are paid for by the employer and may not be funded with employee salary reductions or provided under a cafeteria plan.
HSAs are tax-favored IRA-type trust or custodial accounts from which contributions can be withdrawn for any reason, but the withdrawal will only qualify for tax-free treatment to the extent it is used to pay for qualified medical expenses.
Which expenses qualify for tax-free treatment?
Only expenses for “medical care” will qualify for tax-free treatment under a health FSA, HRA or HSA. (Other requirements must also be met.) For an expense to be considered “medical care,” under federal tax law, it must¾
- Diagnose, cure, mitigate, treat or prevent disease or affect a structure or function of the body;
- Prevent or alleviate a physical or mental defect or illness (not just maintain general health);
- Comply with any additional rules that apply to expenses of that type; and
- Not fall within a category for which reimbursement or tax-free distribution is prohibited.
What expenses are not considered medical care?
Cosmetic procedures do not qualify as medical care and will not qualify for tax-free treatment under a health FSA, HRA or HSA. These procedures are directed at improving a person’s appearance and do not meaningfully promote the proper function of the body or prevent or treat illness or disease.
However, some procedures with cosmetic purposes can still be considered medical care if they are necessary to ameliorate a deformity arising from, or directly related to, a congenital abnormality, a personal injury arising from an accident or trauma, or disfiguring disease.
What are dual-purpose expenses and how are they substantiated?
Some expenses have personal as well as medical purposes. These expenses are sometimes referred to as “dual-purpose” or “potentially qualifying” expenses.
For example, an individual might receive massages to promote general good health (not reimbursable), while another may have them because a medical practitioner has recommended them to treat a specific medical condition. The latter may qualify as medical care and qualify for tax-free treatment.
Health FSA and HRA administrators generally require claims for dual-purpose expenses to be accompanied by additional substantiation demonstrating that the expense is primarily for medical care. Typically, participants are asked to provide a written note from a medical practitioner as evidence of the diagnosis of a specific medical condition and recommending the product or service to treat the condition.
The IRS has also indicated that an item with a personal element is only reimbursable if it would not have been obtained “but for” the medical condition. Some expenses will not meet this standard.
When are medicine and drugs reimbursable?
Medicines and drugs must meet all the requirements described above. In addition, they must be “generally accepted as falling within the category of medicine and drugs,” cannot be toiletries or cosmetics, and must be legally procured. Medicines and drugs (other than insulin) must be prescribed to be qualified for tax-free treatment. This includes OTC (over-the-counter) medicines or drugs, which are considered to be prescribed if a prescription is obtained for them (even though a prescription is not legally required to obtain them).
For this purpose, a prescription is a written or electronic order that satisfies the legal requirements for a prescription in the state in which the expense is incurred, including being supplied by someone who is legally authorized to issue a prescription in that state.
When are transportation expenses reimbursable?
Transportation expenses are reimbursable if they are primarily for and essential to medical care.
They may include bus, taxi, train, plane and ferry fares and ambulance services. Out-of-pocket car expenses allocated to medical care trips, such as gas and oil costs, are also reimbursable. Fixed costs such as depreciation and insurance are not reimbursable. In lieu of tracking actual car expenses, a standard mileage rate can be used. This rate is announced each year by the IRS. For 2017, the rate is 17 cents per mile. Parking and tolls are eligible, too.
Are capital expenditures reimbursable?
If an item obtained for medical care lasts beyond the end of the taxable year (e.g., eyeglasses), it is considered a “capital expenditure”. The amount of reimbursement for a capital expenditure (if any) depends on additional factors such as whether it also serves personal purposes (e.g., a recliner chair) and whether it is permanently fixed to an individual’s property (e.g., an elevator).
The costs of operating or maintaining a capital expenditure (e.g., repairing a wheelchair) is also reimbursable, so long as the medical reason for the original purchase still applies (e.g., the individual for whom the wheelchair was purchased still cannot walk because of a medical condition).
Not all expenses will qualify for tax-free treatment, even if they are for medical care. For example, an expense will not qualify if it is prohibited by law, it is unreasonably expensive, or, in the case of a health FSA or HRA, the employer’s plan documents provide that the expense is not eligible for reimbursement. There are also differences in the rules that apply to each arrangement.
Factors That Must Also Be Considered
Other factors must also be considered when determining whether an expense will qualify for tax-free treatment. These include the person who received the product or service, when the product or service was provided, whether any limits apply to the reimbursement amount, and whether appropriate documentation has been provided (in the case of a health FSA or HRA) or retained (in the case of an HSA).
For more information on FSAs, HRAs and HSAs, download our special report, Which Expenses Quality for Tax-Free Treatment Under a Health FSA, HRA, or HSA?
Susan Monkmeyer, J.D., is a Senior Editor of EBIA products for Checkpoint Learning within the Tax & Accounting Business of Thomson Reuters. She has more than 25 years experience in the field of employee benefits law. She has been the editor and a contributing author of EBIA’s Cafeteria Plans manual since 2005 and of EBIA’s Self-Insured Health Plans manual since 2016. Ms. Monkmeyer also serves on the ECFC Technical Advisory Group.