Use of Debit and Credit Cards by Cafeteria Plans Approved

The Internal Revenue Service has ruled for the first time that properly substantiated employer-provided medical expense reimbursements made through debit or credit cards under a health reimbursement arrangement (HRA) or health care flexible spending account (HCFSA) are excludable from gross income under Section 105(b) (Rev. Rul. 2003-43). The use of debit or credit cards by HRAs and HCFSAs will greatly streamline the reimbursement process and will eliminate employees' out of pocket expenses at the point of service — making these programs much more appealing to employees. For example, if an employee has $1,000 in his HCFSA for a year, he can use his debit card to cover a copayment at his doctor's office, purchase prescription drugs at a pharmacy, and pay other medical expenses throughout the year up to $1,000 and he will not be required to substantiate the charges with a receipt. This program is also favorable for employers because increased use of HCFSAs and HRAs will result in employer FICA tax savings. However, it is important for law firms to note in selecting the debit or credit card features for their plans that medical care expense reimbursements under an HRA or HCFSA are not excludable from the gross income of self-employed individuals, including partners.

The revenue ruling examines three scenarios. In the first, the employer sponsors one or more major medical plans for employees that provide coverage under accident and health insurance. The employer also sponsors an HRA and HCFSA that reimburse participants' uninsured medical care expenses up to a maximum reimbursement amount that is fixed at the beginning of each year. In conjunction with the HRA and HCFSA, the employer allows electronic reimbursement of medical expenses through the use of a debit card up to the maximum dollar amount in the cardholder's HCFSA or HRA. Use of the card is limited to health care merchants and service providers authorized by the employer; and the employee must certify that the card will only be used for eligible medical care expenses, that any expense paid with the card has not been reimbursed, and that the employee will not seek reimbursement under any other plan covering health benefits. When the card is used at the point-of-sale, the provider is paid the full amount of the charge provided there is sufficient money available in the HCFSA or HRA, and the cardholder's maximum available coverage remaining is reduced by such amount.

All charges to the card, other than copayments, recurring expenses and real-time substantiation (described below), are treated as conditional pending confirmation of the charge. To substantiate the charges, the employer requires participants to submit additional third-party information, such as merchant or service provider receipts, describing 1) the service or product; 2) the date of the service or sale; and 3) the amount. The employer permits automatic reimbursement, without further review, for amounts that equal dollar amounts of copayments under the major medical plan, and for recurring amounts that have been previously substantiated. Also, if a third-party merchant provides real-time verification for the expense, it is considered substantiated.

In addition, in the first scenario, the employer adopted in its HCFSA and HRA plan documents certain correction procedures with respect to improper payments. First, upon identifying the improper payments, the employer requires the employee to pay back the amount to the plan. If unsuccessful, the employer will withhold the amount from the employee's wages or other compensation to the extent consistent with applicable law. If the amount still remains outstanding, the employer will utilize a claims substitution or offset future charges against the improperly reimbursed amount.

In the second scenario, the facts are the same as the first scenario, except that the employer uses sampling techniques based on transaction amounts to substantiate charges. For example, suppose the employer reviews 20% of dental office transactions above $100, 5% of physician office transactions below $150 and no transactions below a low dollar threshold (eg, $25). Only those payments selected for review are required to be substantiated.

The third scenario is substantially similar to the first, except that instead of using debit cards, the employer has entered into an agreement with a sponsoring bank to issue to each participating employee a credit card with individual limits equaling the coverage available in the HCFSA or HRA. Pursuant to the agreement between the employer and the bank, the employer is liable to the bank for all charges made with the credit card against the line of credit. When the card is used at the point-of-sale, the provider is paid the full amount of the charge by the bank. The certification, substantiation and correction procedures are the same as in the first scenario.

Law and Analysis

Section 105(a) provides that amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts are 1) attributable to contributions by the employer which were not includible in the gross income of the employee, or 2) paid by the employer.

However, Section 105(b) provides that, except for amounts attributable to (and not in excess of) deductions allowed under Section 213 (relating to medical expenses) for any prior taxable year, gross income does not include amounts referred to in Section 105(a) if such amounts are paid, directly or indirectly, to the taxpayer to reimburse him for expenses he incurred for the medical care (as defined in Section 213(d)) for himself, his spouse or dependents. Only amounts that are paid specifically to reimburse eligible medical care expenses as defined in Section 213(d) qualify for this tax-favored treatment. Therefore, the IRS states, to provide certainty that a particular expense is for medical care within the meaning of Section 213(d), all claims for expense reimbursement must be substantiated. Section 105(b), however, does not specify the method of substantiation.

The IRS determined that the procedures adopted by the employers in scenarios one and three meet the requirements of Section 105(b). First, the employers require a certification upon enrollment and a reaffirmation upon each use of the card, as printed on the back, that the card will only be used for eligible medical care expenses. Second, reimbursements for medical expenses are processed only if they originate with certain vendors having health-care-related merchant codes. Third, every claim is reviewed and substantiated, either automatically without additional documentation, or manually through the submission of receipts. Fourth, the employers have adopted meaningful correction procedures for improperly reimbursed claims. Therefore, employer-provided expense reimbursements made through debit or credit cards, as described in these scenarios, are excludable from gross income.

However, the sampling techniques adopted by the employer in scenario two do not provide that every claim is substantiated, and as such, do not specifically limit reimbursements or payments of claims to eligible medical expenses. Thus, the procedures do not meet the requirements of Section 105(b) and all payments made during the year, including reimbursements of medical expenses, are included in the gross income of the employee. This holding in scenario two is effective for plan years beginning after December 31, 2003.

The Internal Revenue Service has ruled for the first time that properly substantiated employer-provided medical expense reimbursements made through debit or credit cards under a health reimbursement arrangement (HRA) or health care flexible spending account (HCFSA) are excludable from gross income under Section 105(b) (Rev. Rul. 2003-43). The use of debit or credit cards by HRAs and HCFSAs will greatly streamline the reimbursement process and will eliminate employees' out of pocket expenses at the point of service — making these programs much more appealing to employees. For example, if an employee has $1,000 in his HCFSA for a year, he can use his debit card to cover a copayment at his doctor's office, purchase prescription drugs at a pharmacy, and pay other medical expenses throughout the year up to $1,000 and he will not be required to substantiate the charges with a receipt. This program is also favorable for employers because increased use of HCFSAs and HRAs will result in employer FICA tax savings. However, it is important for law firms to note in selecting the debit or credit card features for their plans that medical care expense reimbursements under an HRA or HCFSA are not excludable from the gross income of self-employed individuals, including partners.

The revenue ruling examines three scenarios. In the first, the employer sponsors one or more major medical plans for employees that provide coverage under accident and health insurance. The employer also sponsors an HRA and HCFSA that reimburse participants' uninsured medical care expenses up to a maximum reimbursement amount that is fixed at the beginning of each year. In conjunction with the HRA and HCFSA, the employer allows electronic reimbursement of medical expenses through the use of a debit card up to the maximum dollar amount in the cardholder's HCFSA or HRA. Use of the card is limited to health care merchants and service providers authorized by the employer; and the employee must certify that the card will only be used for eligible medical care expenses, that any expense paid with the card has not been reimbursed, and that the employee will not seek reimbursement under any other plan covering health benefits. When the card is used at the point-of-sale, the provider is paid the full amount of the charge provided there is sufficient money available in the HCFSA or HRA, and the cardholder's maximum available coverage remaining is reduced by such amount.

All charges to the card, other than copayments, recurring expenses and real-time substantiation (described below), are treated as conditional pending confirmation of the charge. To substantiate the charges, the employer requires participants to submit additional third-party information, such as merchant or service provider receipts, describing 1) the service or product; 2) the date of the service or sale; and 3) the amount. The employer permits automatic reimbursement, without further review, for amounts that equal dollar amounts of copayments under the major medical plan, and for recurring amounts that have been previously substantiated. Also, if a third-party merchant provides real-time verification for the expense, it is considered substantiated.

In addition, in the first scenario, the employer adopted in its HCFSA and HRA plan documents certain correction procedures with respect to improper payments. First, upon identifying the improper payments, the employer requires the employee to pay back the amount to the plan. If unsuccessful, the employer will withhold the amount from the employee's wages or other compensation to the extent consistent with applicable law. If the amount still remains outstanding, the employer will utilize a claims substitution or offset future charges against the improperly reimbursed amount.

In the second scenario, the facts are the same as the first scenario, except that the employer uses sampling techniques based on transaction amounts to substantiate charges. For example, suppose the employer reviews 20% of dental office transactions above $100, 5% of physician office transactions below $150 and no transactions below a low dollar threshold (eg, $25). Only those payments selected for review are required to be substantiated.

The third scenario is substantially similar to the first, except that instead of using debit cards, the employer has entered into an agreement with a sponsoring bank to issue to each participating employee a credit card with individual limits equaling the coverage available in the HCFSA or HRA. Pursuant to the agreement between the employer and the bank, the employer is liable to the bank for all charges made with the credit card against the line of credit. When the card is used at the point-of-sale, the provider is paid the full amount of the charge by the bank. The certification, substantiation and correction procedures are the same as in the first scenario.

Law and Analysis

Section 105(a) provides that amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts are 1) attributable to contributions by the employer which were not includible in the gross income of the employee, or 2) paid by the employer.

However, Section 105(b) provides that, except for amounts attributable to (and not in excess of) deductions allowed under Section 213 (relating to medical expenses) for any prior taxable year, gross income does not include amounts referred to in Section 105(a) if such amounts are paid, directly or indirectly, to the taxpayer to reimburse him for expenses he incurred for the medical care (as defined in Section 213(d)) for himself, his spouse or dependents. Only amounts that are paid specifically to reimburse eligible medical care expenses as defined in Section 213(d) qualify for this tax-favored treatment. Therefore, the IRS states, to provide certainty that a particular expense is for medical care within the meaning of Section 213(d), all claims for expense reimbursement must be substantiated. Section 105(b), however, does not specify the method of substantiation.

The IRS determined that the procedures adopted by the employers in scenarios one and three meet the requirements of Section 105(b). First, the employers require a certification upon enrollment and a reaffirmation upon each use of the card, as printed on the back, that the card will only be used for eligible medical care expenses. Second, reimbursements for medical expenses are processed only if they originate with certain vendors having health-care-related merchant codes. Third, every claim is reviewed and substantiated, either automatically without additional documentation, or manually through the submission of receipts. Fourth, the employers have adopted meaningful correction procedures for improperly reimbursed claims. Therefore, employer-provided expense reimbursements made through debit or credit cards, as described in these scenarios, are excludable from gross income.

However, the sampling techniques adopted by the employer in scenario two do not provide that every claim is substantiated, and as such, do not specifically limit reimbursements or payments of claims to eligible medical expenses. Thus, the procedures do not meet the requirements of Section 105(b) and all payments made during the year, including reimbursements of medical expenses, are included in the gross income of the employee. This holding in scenario two is effective for plan years beginning after December 31, 2003.