On July 11, 2006, the IRS issued Notice 2006–69 (“Notice”) which provides further guidance regarding the use of debit cards, credit cards and stored value cards to reimburse participants in health flexible spending accounts (“health FSAs”), health reimbursement arrangements (“HRAs”) and dependent care assistance programs (“DCAPs”). In addition to expanding on the electronic payment card guidance initially provided in Revenue Ruling 2003–43, the Notice also clarifies certain substantiation methods and requirements that apply to all reimbursements irrespective of whether a card is used.

Prior Electronic Payment Card Guidance

The IRS first provided guidance regarding the use of electronic payment cards for health FSAs and HRAs in Revenue Ruling 2003–43. (Please see our December 2003 issue for a detailed discussion of Revenue Ruling 2003–43.) The guidance describes three situations in which employers implemented electronic reimbursement procedures for their health FSAs and HRAs and whether those procedures met the claims substantiation requirements of Section 105 of the Internal Revenue Code (“Code”). The ruling set forth the minimum requirements that must be met for card transactions to be excludable from an employee-cardholder’s income. These requirements are:

• Use of the card must be limited to the maximum coverage amount available in the employee’s health FSA or HRA
• The card may only be used with merchants and service providers that have merchant category codes related to health care, such as physicians, pharmacies, dentists, hospitals, and vision care offices
• The card must be automatically cancelled at termination of employment
• Participating employees must:
  • certify upon enrollment, and on an annual basis thereafter, that the card will only be used for eligible medical expenses of the employee, the employee’s spouse and dependents (as defined in Code section 152) and that any expense paid by the card has not been and will not be reimbursed under any other health plan;
  • understand that the certification is reaffirmed every time the card is used; and
  • agree to obtain and maintain invoices and receipts for any expense paid with the card.

  The certification must be printed on the back of the card.

• Correction procedures for improper payments must be implemented which allow the employer to recover improper payments:
  • by payment from the employee;
  • if payment cannot be obtained from the employee, by withholding the amount of the improper payment from the employee’s compensation, if such withholding complies with applicable state wage withholding laws; and
  • if any amount is still outstanding, by offsetting the amount from future benefit payments.

  The employer must also take action to prevent further violation of the terms of the card, including denying access to the card until the improper payment is repaid. The employer may treat the improper payment as it would any other business indebtedness if the employee fails to repay the amount owed.

The IRS determined that the following card transactions provide for full substantiation without the need for submission of a receipt or further review under Section 105(b):

• charges for which the amount paid matches the amount of the copayment for that service under the health plan covering the employee-cardholder;
• automatic reimbursements of recurring expenses that match expenses previously approved as to amount, provider and time period; and
• expenses paid by a merchant, service provider or other independent third party, such as a pharmacy benefit manager, who provides information to the employer to verify that the claim is for a medical expense at the point-of-sale (i.e., real-time substantiation).

The IRS stated that all other charges that are paid using a card are considered conditional until the claims administrator receives third-party information, such as a receipt, that confirms that the charge is for an eligible medical expense.

In addition to describing the electronic payment procedures which employers may adopt for their health FSAs and HRAs, the IRS specifically rejected the adoption of sampling techniques that are based on transaction amounts to substantiate card transactions.

Notice 2006–69

The IRS’s new guidance describes additional procedures which employers may adopt to substantiate claims paid via electronic payment cards.

Copayment Match Substantiation

Notice 2006–69 expands this method of substantiation by allowing for automatic substantiation of certain matches of multiple copayments. If an employer’s health plan has copayments in specific dollar amounts, card transactions will be considered fully substantiated without the need for submission of a receipt or further review if the amount of the transaction at a health care provider equals an exact multiple of not more than five times the dollar amount of the copayment. Full substantiation without the need for submission of a receipt or further review is also available if the health plan has multiple copayments for the same benefit (e.g., tiered copayments for prescription drugs) and the employee’s card transaction is an exact multiple of not more five times the maximum copayment or a combination of the copayments. If a card transaction at a health care provider does not meet these parameters, the transaction will not be substantiated until a receipt is provided to the claims administrator to confirm that the charge was for an eligible medical expense.

For example, if an employee’s health plan has a $5 copayment for generic prescription drugs and a $10 copayment for all other prescriptions, an employee’s $45 card transaction at a pharmacy to purchase three generic prescriptions (3 x $5 = $15 generic copayment) and three non-generic prescriptions (3 x $10 = $30 non-generic copayment), will be considered fully substantiated without further review because the amount of the transaction ($45) is an exact match of a combination of the copayments and does not exceed five times the maximum copayment for prescriptions under the health plan (i.e., $50) in this example.

Inventory Information Approval System

The Notice also sets forth the limited instances when cards may be used at merchants that are not health care providers. Health FSA and HRA expenses may be paid via card transactions at non-health care providers only if the merchant has implemented an inventory information approval system for substantiating medical claims. Under this system of substantiation, the merchant compares the inventory control information (e.g., stock keeping units or SKUs) for the purchased items against a list of items that qualify as expenses for medical care under Section 213(d) of the Code. The merchant’s system then approves the use of the card for the total amount of eligible medical expense, but only up to the amount available for reimbursement under the employee’s health FSA or HRA, as applicable. If the transaction is a split-tender transaction that includes medical expenses (e.g., over-the-counter cold medication) and non-medical expenses (e.g., school supplies), the employee-cardholder may use the card to pay for the medical expenses but pay the balance of the amount due for the non-medical expenses with cash, check or other card. Approved transactions are fully-substantiated without the need for submission of a receipt or further review.

If an employer adopts this system of automatic substantiation, the employer must maintain information relating to the claim (i.e., name of the employee, amount reimbursed, type of expense, and date of service), provide for accessibility to the information (e.g. upon an audit of the employer by the IRS), and comply with the recordkeeping requirements set forth in Revenue Procedure 98–25. This Revenue Procedure describes the requirements for maintaining taxpayer records within an automatic data processing system.

Guidance Regarding the Substantiation of Any Type of Claim

Although Notice 2006–69 primarily sets forth the automatic substantiation procedures which employers may adopt in connection with their health FSAs, HRAs, and/or DCAPs, the Notice also provides substantiation guidance for all claims regardless of whether a card is used. The Notice states that if an employer receives information from an independent third party, such as an explanation of benefits (‘EOB”), which states the date of the Section 213(d) service and the employee’s coinsurance or copayment obligation, the claim is fully substantiated without the need for submission of a receipt or further review. This means that if a health FSA receives an EOB from the major medical plan which states the date and the amount owed by the employee, the health FSA may treat the EOB as a fully substantiated claim and, provided the employee has a sufficient health FSA balance, reimburse the employee without requiring the employee to provide a receipt or statement from his or her physician,.

The Notice also clarifies that Sections 105 and 125 of the Code do not permit “self-substantiation” or “self-certification” of any expense. Code sections 105 and 125 require that medical expenses be substantiated prior to payment or reimbursement on a non-taxable basis. To be excludable from income, an expense must be substantiated via a statement from an independent third-party (either automatically or after the transaction) that describes the expense, the amount of the expense and the date of the expense. The information may be provided via the Internet, Intranet, facsimile or other electronic means. If a plan provides for self-substantiation of claims, all of the amounts paid by the plan, including those that have been properly substantiated, will be includable in employees’ respective incomes and subject to applicable Federal and state taxes.

Use of Cards for DCAPS

Notice 2006–69 also describes how an employer may provide DCAP benefits through a payment card program (we note that an employer’s DCAP payment card program will only be useful to the extent that its employees use dependent care providers that have systems in place to accept payment through the DCAP payment card program). The guidance recognizes that while many dependent care providers require payment prior to the provision of the dependent care services, a DCAP may only reimburse those expenses which have already been incurred, i.e., after the services have been provided. The IRS states that a DCAP payment card program provides for full substantiation where the employer receives information substantiating the dates and amounts for an expense paid by the employee to a dependent care provider and makes an amount available through the payment card that equals the amount of the previously substantiated expense or the employee’s total salary reduction amount to date. Such amounts may be made available only after the date the services are provided. The value of the card may be increased in the amount of any additional dependent care expenses only after those additional expenses have been incurred and substantiated. The card may then be used to pay for subsequent dependent care expenses.

Card transactions subsequent to transactions that have been previously approved as to the dependent care provider and time period will be treated as substantiated without further review if they are for an amount equal to or less than the previously substantiated amount. If the employee’s dependent care provider increases its fees or if the employee changes providers, the employee must submit a statement or receipt from the dependent care provider to the employer to substantiate the new expense before amounts relating to the increased amount or new provider may be added to the card.

Effective Date of the Notice

Most of the provisions of Notice 2006–69 are effective as of July 11, 2006, the date of the issuance of the Notice. However, the recordkeeping requirements applicable to the Inventory Information Approval System are effective for plan years beginning after December 31, 2006.