IRS Issues Guidance Explaining 2011 Changes to Certain Tax-Favored Arrangements

The IRS has issued new guidance on legislation in the Patient Protection and Affordable Care Act (Affordable Care Act), effective for tax years beginning after Dec. 31, 2010, that changes the rules on use of certain tax-favored arrangements, such as flexible spending arrangements (FSAs), to pay for over-the-counter medicines and drugs. The guidance includes frequently asked questions (FAQs) on the new legislation [Notice 2010-59, 2010-39 IRB; Rev Rul 2010-23, 2010-39 IRB].

Effective Jan. 1, 2011, any amount paid or distributed out of a health flexible spending arrangement (health FSA), health reimbursement arrangement (HRA), health savings account (HSA), or Archer medical savings account (Archer MSA), to pay for the cost of an over-the-counter medicine can't be reimbursed by an employer tax-free without a prescription. This new rule does not apply to reimbursements for the cost of insulin, which will continue to be permitted, even if purchased without a prescription [IRC §106(f)].

The IRS notes in a FAQ that the new rules only affect purchases of over-the-counter medicines and drugs without a prescription after Dec. 31, 2010. The new rules do not apply to purchases of over-the-counter medicines and drugs in 2010, even if they are reimbursed after Dec. 31, 2010.

The new rules also do not apply to items for medical care that are not medicines or drugs. Thus, equipment such as crutches, supplies such as bandages, and diagnostic devices such as blood sugar test kits will still qualify for reimbursement by a health FSA or HRA if purchased after Dec. 31, 2010, and a distribution from an HSA or Archer MSA for the cost of such items will still be tax-free, regardless of whether the items are purchased using a prescription.

The IRS also notes that if a plan allows an employee to use a debit or credit card to pay for over-the-counter medicine or drugs, the card must be reprogrammed no later than Jan. 15, 2011, so that the card can no longer be used to purchase these items.

An employee that uses funds from an HSA or Archer MSA to reimburse the cost of over-the-counter medicines or drugs purchased after Dec. 31, 2010 without a prescription will be required to include the distribution in income and will also be subject to an additional 20% tax.