by Tony Novak, CPA, MBA, MT revised 3/30/2015
U.S. federal income tax law has always maintained a requirement that a taxpayer must be able to substantiate the deductions taken from otherwise taxable gross income in the calculation of the net taxable income. Usually this means keeping a copy of the invoice and receipt or cancelled check for the expenses. When it comes to a business taxpayer's deductions of health care expenses of employees, the IRS adds an additional requirement: it also requires that the expenses fall into the deductible definitions listed in Publication 502 as "medically necessary".
Separately, outside of the income tax laws, the Department of Labor and a series of medical privacy laws including HIPAA and ACA prevents employers from obtaining or using most types of employee medical information.
Most small firms use a health insurance or managed care company to handle all of these functions. But the growing number of small business employers using Flexible Reimbursement Account (FSA) plans, Cafeteria Plans or Healthcare Reimbursement Arrangement (HRA) plans now face the issue of substantiating employee medical claims.
This claim validation issue is complicated by the recent legislation protecting the privacy of medical information. There are potential legal problems for an employer who comes into possession of an employee' s medical information. Employers may complain that tax law requires them to validate private information about employees they would rather not know.
The IRS remains focused on avoiding tax abuse in employee health plans. It fears that modern health plans allow participants to access tax-free cash for non-medical purposes. Recent IRS publications about health plans have consistently emphasized the need for employers to validate medical plan claims. At a recent benefits industry conference, one IRS official was quoted as saying that the only way to validate medical plan expenses was to utilize a third party administrator. Of course the firms providing this service now cite this reference as a justification of their fees. Some have gone as far as saying that any uninsured health plan without a professional third party administrator does not meet tax law requirements.
The medical plans under scrutiny by the IRS are primarily those that provide a debit card for employees to access cash without the employer' s knowledge. Most small business health plans do not use this feature. A new wave of small business health care plans is gearing up to provide this service to small firms at substantial fees. The lure of these debit cad plans is that the plan administrator essentially loans the cash to employees when they make a debit card withdrawal and then bills the employer at a later date. This is viewed as a lucrative market for many financial institutions. Most small businesses should avoid the sales pitch of these plans in favor of an easier and less expensive health plan.
Substantiation of medical claims is primarily handled with a written employee statement validated by a third party administrator. This continues to be the best method for the majority of small business health plans. Although the IRS has not specifically commented on this issue, the written statement can probably be made after the employee has accessed the cash from the health plan.
For example, a common health plan design makes $2,000 available to each employee from employer general funds for health care expenses on January 1 and then requires a written statement to validate any expenses taken under the plan by December 31 or the same year. This method is similar to the way that many firms handle petty cash accounts. The written statement should provide boilerplate language that the employee has adequate records (receipts) of transactions and has received and reviewed a copy of IRS Publication 502.
An employee statement may be on paper or online, whichever method works best for the specific business.
Additionally, it is smart for employers to provide an additional external resource for employees who may have questions.
Freedom Benefits provides a prototype medical expense claim form with any low cost benefit plan start-up kit. An online claim validation service was launched as an additional service option in 2004 and updated in 2014.
Editorial Note: Since the original date of publication of this article, the IRS position has been clarified and tightened with regard to the validity of self-administered health plans. While a self-directed plan is still possible in very limited circumstances it should only be used if the purpose is to reimburse insurance premium expenses only. Self-administered plans should not be used to reimburse expenses where claim validation would involve disclosure of private medical data to the employer. Health plans should utilize an independent third party claims administrator if the plan includes reimbursement for uninsured health expenses.
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Opinions expressed are the solely those of the author and do not represent the position of any other person, company or entity mentioned in the article. Information is from sources believed to be reliable but cannot be guaranteed. Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues or a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties. Tony Novak operates as an independent adviser under the trademarks "Freedom Benefits", "OnlineAdviser" and "OnlineNavigator" but is not a representative, agent, broker, producer or navigator for any securities broker dealer firm, federal or state health insurance marketplace or qualified health plan carrier. He has no financial position in any stocks mentioned. Novak does work as an accountant, agent, adviser, writer, consultant, marketer, reviewer, endorser, producer, lead generator or referrer to other companies including the companies listed in the articles on this web site.