United States: Employee Benefits Legal Alert

Debit Card Guidance: Everyone Likes Plastic (Even the IRS)

The Internal Revenue Service has released its eagerly awaited guidance on the use of debit and credit cards for reimbursement of health expenses by health flexible spending accounts ("Health FSAs") and health reimbursement arrangements ("HRAs"). The guidance was released on May 6 th as Revenue Ruling 2003-43 (the "Ruling"). Three days later, IRS and Treasury officials who were instrumental in formulating the Ruling were present at an American Bar Association meeting in Washington, D.C. ("ABA Meeting"). At the ABA Meeting, the officials clarified aspects of the Ruling and answered questions from a panel that included Mark Wincek and Mark Stember from our Washington office. This Legal Alert summarizes the guidance as well as key comments and clarifications proffered by officials at the ABA Meeting. Overall, the Ruling is a breakthrough for card technologies, with the government approving auto-adjudication of many claims, simplified employee certifications, and a recovery process for improper payments. On sampling, the Ruling applies a sunset date, but leaves the door open to more detailed sampling guidance in the future. In addition, further guidance seems likely on Form 1099 reporting, which the Ruling suggests is required.

Over the past several years, companies have developed technology that allows Health FSA and HRA participants to access funds in their accounts through the use of debit, stored-value or credit cards ("Cards") at the point of service or sale. This frees the participant from cash-flow concerns (i.e., fronting the money and waiting for reimbursement), and routinely leads to higher rates of participation in Health FSAs.

As part of the recent focus on timely guidance regarding emerging practices, the government announced it would address how Card transactions could meet the claims substantiation requirements (the "Substantiation Rules"). Traditionally, the Substantiation Rules have permitted a Health FSA to reimburse a medical expense only if the participant provides a written statement from an independent third-party stating that the medical expense has been incurred and the amount of such expense, and the participant also provides a written statement that the medical expense has not been reimbursed or is not reimbursable under another health plan. (See, Proposed Treasury Regulations 1.125-2, Q&A-7.) Similar requirements also apply to reimbursements of HRA claims. (See, Notice 2002-45).

In a nutshell, the Ruling sets forth three factual situations, only two of which satisfy the Substantiation Rules. Officials clarified at the ABA Meeting that, in essence, the Ruling contains two safe harbors and one unsafe harbor. If employers follow either one of the safe harbors, their Health FSAs or HRAs will satisfy the Substantiation Rules. However, as long as they avoid the unsafe harbor, their Health FSAs or HRAs may still satisfy the Substantiation Rules depending on all of the facts and circumstances.

Card Guidelines. The Ruling provides guidelines that an employer must follow to meet the safe harbor for Card transactions.

• Participant Certification – Participants who use a Card must certify upon enrollment and each plan year thereafter that (i) they will only use the Card for eligible medical expenses for themselves, their spouses and dependents, and (ii) any expenses paid with the card have not been reimbursed and reimbursement will not be sought under any other plan. This is an important change in the certifications that have been required, and it accommodates the ways Cards operate. In addition, officials noted at the ABA Meeting that this change will apply outside the Card context and will be reflected in future section 125 regulations. The Ruling also assumes participants understand that this certification is reaffirmed with each use of the Card, and that it appears on the back of the Card. At the ABA Meeting, it was clarified that it is sufficient to have a short-hand reference to the certification on the back of the Card.

• Use of Card Limitations – The Card must be usable only at specific health and medical care providers by limiting the Card’s operation to specific merchant codes. In addition, the participant’s use of the Card is limited to the maximum dollar amount of coverage available in his or her Health FSA or HRA account.

• Cancellation of the Card – A participant’s use of the Card is automatically cancelled at termination of employment. However, at the ABA Meeting, IRS officials indicated that in appropriate circumstances, participants could continue to use the card post-termination (e.g., if the participant elected COBRA and improper payments could be recovered post-termination).

• Substantiation and Recovery Procedures – As detailed below, claims must be substantiated, automatically or manually, and there must be meaningful procedures to recover improper payments.

Substantiation Procedures. The Ruling provides that every claim paid with the Card must be substantiated. Using one of three automatic substantiation procedures requires no further substantiation. In other cases, additional manual substantiation is required.

1. Automatic Substantiation. The Ruling provides for three categories of transactions where substantiation is automatic.

• Co-payment Transactions – If the dollar amount of a Card transaction equals the dollar amount of a co-payment under the specific major medical plan of the employee/Cardholder, the charge will automatically satisfy the Substantiation Rules. At the ABA Meeting, officials clarified that a percentage co-pay would also satisfy this rule, if feasible under the technology.

• Recurring Transactions – If an expense matches an expense previously approved as to amount, provider and time period, the charge will automatically satisfy the Substantiation Rules.

• Real-Time Transactions – If a merchant, or other independent third party (e.g., a pharmacy benefit manager) at the time and point of sale, provides information to verify that a charge is for a medical expense, the charge will automatically satisfy the Substantiation Rules. For example, if a participant fills a prescription at a pharmacy for $37.00 and the pharmacy benefit manager provides information to the Card administrator that there is a $37.00 charge for a prescription, the matching Card charge will automatically satisfy the Substantiation Rules. The Ruling focuses on real-time transactions, but presumably running the computer match against pharmacy benefit manager records a day or two later should also be acceptable.

2. Manual Substantiation. For those Card transactions that are not automatically substantiated, the Ruling provides that they are treated as conditional pending confirmation of the charge. Therefore, after the sale the participant must submit additional third-party information, such as merchant or service provider receipts, that describe (i) the service or product, (ii) the date of the service or sale, and (iii) the amount. (Participants not using the Card may also submit this third-party information and receive a reimbursement check.) At the ABA Meeting, officials noted there could be a mix of electronic and manual substantiation, i.e., where some information is obtained electronically and the remaining information is obtained manually.

Recovery Procedures. If a claim that has been conditionally paid is found not to qualify for reimbursement, the employer must utilize meaningful recovery procedures. The Ruling describes a succession of steps to correct the improper payment and contemplates that all are available for use as necessary.

• Required Repayment – The employer requires repayment of the amount of the improper claim.

• Wage Withholding – Where allowed by local law, the employer withholds the amount of the improper payment from the employee’s wages.

• Claim Offset – The employer offsets an improper claim with one or more substantiated claims in the same coverage period, thereby denying further reimbursements until the improper claim is recouped.

In addition to the above three recovery methods, the employer takes other actions to ensure that further violations of the terms of the Card do not occur, including denying access to the Card until the improper payment is recovered. Lastly, if all these efforts are unsuccessful, the employee remains indebted and the employer treats the debt as it would any other business debt under its practices.

Officials at the ABA Meeting clarified that an employer can vary the order of the procedures, so long as the final one (treat as business debt) remains last. This is because they understand amounts will be included in income under the final procedure, and they do not want employers to resort to income inclusion too readily. Indeed, immediately including improper payments in income would resemble the "double-dip" scheme that was invalidated in Revenue Ruling 2002-80.

Application of Form 1099 Rules. The Ruling states that "payments made to medical service providers through the use of a Card" are reportable by the employer on Form 1099-MISC under Code Section 6041. (There are a number of exceptions to such reporting, such as for payments to pharmacies and tax-exempt hospitals.) At the ABA Meeting, IRS officials explained that the administrative procedures branch of the IRS provided this interpretation and not the health and welfare branch. In response, the ABA panel explained that current technology cannot capture the data needed to complete Forms 1099, and suggested alternative ways to interpret the Ruling.

One alternate interpretation is based on the fact that the Ruling refers to Card transactions as "reimbursements" (presumably to the participant), rather than "payments" to a provider. Under this interpretation, Card transactions would arguably not be subject to the Form 1099 requirement because they are structured as indirect reimbursements to participants, rather than payments to providers as referenced in the Form 1099 portion of the Ruling. Another interpretation notes that the Ruling expressly states that it "addresses only Code sections 106, 105 and 125," and that "no inference is intended as to any other section of the Internal Revenue Code." Because the Form 1099 requirement derives from Code section 6041, under this interpretation the language in the Ruling regarding Forms 1099 is not positioned as binding guidance.

Given the issues surrounding this question, additional 1099 guidance seems likely. Indeed, the situation calls to mind when IRS issued a ruling on 1099 reporting of medical payments back in 1969, and then in 1970 clarified the earlier guidance and provided for its delayed application. (See Revenue Rulings 69-595 and 70-608.)

Sampling – Down But Not Out. The Ruling provides that reviewing only a sample of Health FSA or HRA claims does not satisfy the Substantiation Rules. The Ruling requires that an employer substantiate every claim (whether through automatic or manual methods as described above). Therefore, only substantiating claims over a specific dollar amount (such as $100) under the theory that claims under that amount are most likely co-payments falls into the unsafe harbor of the Ruling. Further, "deemed co-payments" (e.g., dollar amounts in multiples of five dollars that are not reviewed at all) fall into the unsafe harbor. In order to be automatically adjudicated, a co-payment must be the actual co-payment of the health plan in which the covered person is enrolled. However, the IRS left open the door to sampling by not applying the prohibition on sampling until plan years beginning after December 31, 2003 (which for calendar year plans would be January 1, 2004) and by requesting comments on sampling techniques or other statistical approaches that should be deemed to satisfy the Substantiation Rules. The Ruling notes that any proposed sampling methodology should provide a high degree of certainty that the employee has in fact incurred an eligible medical expense.

Plan Documents. The Ruling also contemplates that the substantiation procedures (both automatic and manual) and the recovery procedures for improper payments appear in the Health FSA or HRA plan document in order to satisfy the safe harbor. The Ruling does not provide any specific date by which the appropriate language must be added to the plan documents, but the implication appears to be that the Ruling safe harbor is not satisfied until the language is added. However, officials at the ABA Meeting suggested that they did not intend a retroactive surprise for plan sponsors.

Employers considering adopting a Card or who have already started using a Card for Health FSA or HRA claims should find this Ruling positive and encouraging. The IRS is clearly interested in adapting the tax laws to fit changing technologies, it has revamped several traditional requirements to accomplish this, and it has left the door open for future changes (e.g., regarding sampling methodologies).

The information contained in this Legal Alert is not intended as legal advice or as an opinion on specific facts. For more information about these issues, please contact us through our Web site at www.kilpatrickstockton.com.

© Kilpatrick Stockton LLP.