by George G. Jones and Mark A. Luscombe

There are two widely used tax breaks for medical expenses. There is the itemized deduction on Form 1040 Schedule A, and there is the exclusion for employer-provided health flexible spending accounts.

In recent years, Congress and the Internal Revenue Service have been expanding what is considered a medical expense for Schedule A. Congress added long-term care insurance premiums and expenses, while the IRS added smoking cessation programs, reconstructive cosmetic surgery, laser vision correction and, most recently, obesity programs.

Whatever has been defined as a medical expense for the Schedule A purposes was also good enough to qualify as a medical expense for flexible spending account purposes.

The Treasury wanted to do something about tax benefits for nonprescription drugs. The growing importance of nonprescription drugs in the overall medical costs of individuals has been emphasized recently in the debate over Medicare coverage of drugs and the much-publicized recent conversion of a number of prescription drugs to over-the-counter drugs. Taxpayers with health insurance often end up paying more out of pocket when a drug converts from prescription to over-the-counter status.

The Treasury Department, however, had a problem with expanding itemized medical expenses to include nonprescription drugs. Code Sec. 213(b) expressly limits the itemized deduction for medical expenses to prescription drugs. The statutory language for flexible spending accounts was much more nebulous.

In Revenue Ruling 2003-102, the Treasury Department has therefore taken the unusual step of allowing nonprescription drugs for FSA purposes, as well as for health reimbursement arrangements and other employer arrangements to reimburse employees for over-the-counter medicine and drugs, even though they continue to be disallowed for Schedule A purposes.

The move may eventually pressure Congress to change the statutory language to allow nonprescription drugs for Schedule A purposes as well, but, in the meantime, Rev. Rul. 2003-102 continues to add to the relative attractiveness of the tax benefits of health FSAs.

Nonprescription drugs under Schedule A

The prohibition against itemized deductions for nonprescription drugs dates back to the Tax Equity and Fiscal Responsibility Act of 1982. Prior to that act, nonprescription drugs had been allowed as an itemized deduction, but only to the extent that all medicine and drug expenditures exceeded 1 percent of adjusted gross income.

The prohibition against nonprescription drugs has also been limited to drugs and medicine. It specifically allows a deduction for insulin, and has been interpreted to allow a deduction for nonprescription medical devices, such as wheelchairs or crutches, that are not drugs or medicine.

The main problems with the itemized deduction for medical expenses are that your total itemized deductions need to exceed the standard deduction, and you can only claim an itemized deduction for medical expenses that exceed 7.5 percent of adjusted gross income. Of 129 million individual tax returns filed for the 2000 tax year, only 42.5 million itemized deductions, and only 6.5 million claimed a medical expense deduction.

Flexible spending accounts

Health FSAs are a relatively attractive choice for those taxpayers lucky enough to have them offered by their employers. They provide an exclusion for out-of-pocket medical expenses from the first dollar up to a maximum dollar amount per year that cannot exceed $5,000.

One key drawback of FSAs has been that the employee has to specify the amount to be deducted for the flexible spending account at the beginning of the year, and if the amount allocated to the FSA is not used for medical expenses during the year, it is lost. Efforts have been made in Congress to permit a rollover of these funds from year to year, but nothing has yet been enacted.

The “use it or lose it” nature of FSAs has caused employees to be very conservative in estimating the amounts to be allocated each year, and also to make discretionary medical expenditures, such as for another pair of eyeglasses, near the end of the year to use up any leftover funds before they are lost. The inclusion of nonprescription drugs under FSAs not only adds another advantage over itemized deductions, but also provides another way to use up excess funds in the FSAs at the end of the year.

Although the coverage of nonprescription drugs can relate back to Jan. 1, 2003, employees will want to make sure that their employer’s FSA program accommodates the broader definition of medical expense. There is no requirement that employers offer FSAs, or that they be offered with the maximum possible benefits. Some employers may approach expansion cautiously out of concern for the ability to define what is a qualifying expense and what is adequate substantiation for that expense.

What counts as a nonprescription drug?

Rev. Rul. 2003-102 addresses five purchases: Four qualify and one does not. The qualifying purchases are for antacids, allergy medicine, pain relievers and cold medicine. The purchase that did not qualify was for vitamins.

The ruling held that medicine and drugs are expenditures for medical care, while cosmetics, toiletries and sundry items are not. The ruling specifies that amounts paid by an employee for dietary supplements that are merely beneficial to the general health of the employee, or the employee’s spouse or dependents, are not reimbursable or excludable from gross income.

Even though the ruling appears fairly broad, it will no doubt create some gray areas as to which expenditures qualify and which do not. Many over-the-counter products used for general health can also be of benefit for specific medical conditions.

When a taxpayer is in doubt as to whether a particular expenditure might be covered, one possible solution is to obtain a doctor’s prescription for the nonprescription purchase, to help clarify that the purchase is associated with a particular medical condition. This would give the expenditure protection for both FSA and itemized deduction purposes.

With the recent expansion of the types of conditions that constitute a disease for medical purposes, such as alcohol abuse, smoking-related ailments, and obesity, many over-the-counter products designed to assist with these ailments that might once have been considered treatments for general health would now appear to qualify as nonprescription medicine or drugs for FSA purposes.


Even where the type of medicine or drug clearly comes within the scope of Rev. Rul. 2003-102, the ruling also requires that the employee be able to submit substantiated claims for the expenses to the employer.

One of the advantages of prescriptions was that they provided the necessary substantiation. Over-the-counter drug purchases are often buried in a store receipt along with other purchases without much description.

Taxpayers will have to be proactive to make sure that they obtain receipts that specifically identify the medicine or drug purchased. Taxpayers may even be able to ask stores to go back to purchases earlier in the year and provide more complete documentation for prior purchases.

As discussed above, these new substantiation rules will also place more burden on the administrators of FSAs to review submissions and make sure that the medicine and drugs identified qualify under the terms of the ruling.

Over time, lists will probably be developed to identify the category into which specific products fall. In any event, however, additional administrative costs will be incurred, and eventually will be passed on to those employer/sponsors who amend their FSAs to provide this additional reimbursement.

Also in the category of hidden casualties of the IRS’s generosity, of course, will be the federal deficit, which will increase by the amount of tax revenue lost to the additional salary income that will be flowing into FSAs.


Rev. Rul. 2003-102 adds another important benefit to health FSAs as compared to itemized medical deductions - nonprescription medicine and drugs.

To help employers as much as possible in expanding their health FSA programs to accommodate this change, taxpayers will want to make sure that they obtain substantiation for their nonprescription drug purchases that specifically identifies the type of drug or medicine being purchased. If the drug or medicine is of the type that could be categorized as a dietary supplement or general health item, the taxpayer may want to consider obtaining a doctor’s prescription for the purchase, even though it is a nonprescription item, to demonstrate that this particular purchase was related to treating a specific medical condition.

Before going back to collect documentation for purchases made earlier in the year, or stocking up on nonprescription drugs to use up a FSA balance before the end of the year, employees will also want to verify with their employers that their health FSA program has been updated to accommodate these newly expanded guidelines.

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