IRS Requirements for HSA/FSA Purchases: How to Remain Compliant as a Merchant

Health Savings Accounts (HSAs) and Flexible Spending Accounts (FSAs) are tax-advantaged accounts used to pay for qualified medical expenses.

There are a few key differences between these two accounts. HSAs are employee owned, portable, and paired with a High Deductible Health Plan where funds roll over year to year. Whereas FSAs are employer owned and therefore can’t be transferred when a person resigns. These funds are typically a “use it or lose it” model.

For merchants, these accounts expand a customer’s effective purchasing power without requiring discounts and provide a great opportunity to increase your AOV and conversions.

Purchases are eligible if they meet the IRS’s definition of a qualified medical expense. Along with product specific criteria, both the consumer and the merchant must comply with substantiation rules which becomes particularly important if your customer or their employer is audited.

But what is a qualified medical expense?

A qualified medical expense is a purchase that is primarily intended for medical care. According to the IRS Publication 502, qualified medical expenses are products or services that are used to diagnose, cure, mitigate, treat or prevent diseases or ailments that affect the structure or function of your body. This includes:

These categories tend to have high approval rates because their medical purpose is clear.

Expenses that are primarily for general health or personal use are not eligible. These include cosmetic procedures, general wellness products, and gym memberships.

Keep in mind that some of these products can become eligible under specific conditions, the IRS labels these products or services as dual-use products. These products can open more avenues for sales but they do come with added compliance requirements.

Dual-use products are items that serve both a general wellness purpose and a medical purpose. These can include:

• Gym memberships
• Personal trainers
• Fitness trackers
• Vitamins
• Nutritional supplements
• Protein powders
• Orthopedic shoes
• Mattresses
• Air purifiers
• Humidifiers
• Special pillows (for asthma and allergies)

These products are not automatically eligible and their eligibility depends on whether they are used to treat a specific medical condition. In cases like these, your customer would need a Letter of Medical Necessity to prove that there is a genuine medical need for the product or service.

Some examples would include if a supplement is recommended for a diagnosed deficiency or a fitness program is prescribed for obesity or rehabilitation.

Without an LMN, these purchases are usually not approved.

Getting a LMN for a dual-use product is often a sticking point for customers as it interrupts the purchase flow and adds a layer of complexity (and inconvenience) to what should be a simple process.

The process typically involves consulting with a licensed healthcare provider to establish a diagnosis and treatment plan, and then requesting a LMN from the provider. The process usually occurs off your platform. This increases the risk of churn since your customers may not want to go through the arduous process of getting the LMN, or because they find a competing product that offers a better checkout flow.

Approval rates and customer experience depend heavily on how easy it is for customers to complete this process. Fortunately, it is possible to simplify the process by offering an LMN as part of your checkout flow.

At Truemed*, we remove the biggest barrier to HSA/FSA adoption by embedding a compliant medical review directly into the checkout experience, allowing eligible customers to obtain a Letter of Medical Necessity through an independent, licensed clinician during the checkout flow instead of scheduling a separate doctor’s visit.

*Truemed is for qualified customers. See terms at truemed.com/disclosures.

But what about the IRS’s substantiation requirements?

Substantiation is the process of verifying that a purchase qualifies for FSA or HSA use.

The FSA substantiation process for merchants differs from the HSA process since there are more FSA payment rules for merchants and a larger compliance burden. According to the IRS Proposed Treasury Regulation §1.125-6(3)(b), all products and services purchased using an FSA must be substantiated by a third party. This would include Letters of Medical Necessity and the Inventory Information Approval System(IIAS) if you don’t qualify for the 90% Rule exception.

As a merchant, you’ll be required to provide documentation that includes the purchase date, product description, SKU eligibility confirmation, an itemized receipt, and where necessary, an LMN.

For HSA purchases, most of the compliance burden lies with your customer but you will need to provide your customer with itemized receipts and keep basic transaction records. Your customer will need to keep their itemized receipts and Letters of Medical Necessity where required.

These documents are not only necessary to confirm IRS HSA/FSA eligibility but will also be required by the IRS during an audit. Should you or your customer not be able to provide these documents, the IRS may impose a 20% penalty on the cost of the item purchased which could sour the shopping experience and affect your brand reputation in the long run

IRS compliance is critical for merchants as poor substantiation leads to rejected claims, frustrated customers, and lost revenue.

A well-structured substantiation flow can increase approval rates and improve conversion at checkout while also protecting your brand reputation.

Since substantiation is so crucial, how do you ensure that you remain compliant?

Most ecommerce brands are relying on the traditional substantiation method which is to say that the burden of identifying eligible products, and splitting the cart according to eligibility, falls on the customer. Understandably this can cause frustration and confusion and may ultimately lead to your customer shopping elsewhere.

There are currently three auto substantiation methods available.

The Inventory Information Approval System (IIAS) is an IRS-mandated system that confirms eligibility of products at checkout. This system ensures that only eligible products are purchased with HSA/FSA cards.

Copayment match substantiation allows for automatic substantiation of payments that match standard copayment amounts, eliminating the need for receipts or manual review.

As the name suggests, this method allows for repeat claims to be auto approved after the first claim is approved.

These auto substantiation methods are for eligible products only so dual-use products would still need LMNs and you would need to partner with a payment processor that accepts HSA/FSA cards.

Substantiation doesn’t have to be a bottleneck and when done well, it can become a growth lever.

Here are a handful of improvements that you can make to your checkout flow to improve the substantiation process:

• Add clear eligibility guidance before checkout (i.e clear product tagging)
• Implement integrated workflows for LMN qualification and collection
• Automate itemized receipts with customer details and payment tagging

These changes reduce friction and increase trust, which can directly impact conversion rates.

Merchants who optimize this process often see higher average order values because customers are more willing to purchase higher-priced items when they understand they can use pre-tax funds.

Partnering with a dedicated HSA/FSA payment processor like Truemed, can streamline your checkout flow by handling eligibility checks, providing LMN’s, and providing itemized receipts.. Ensuring that you and your customer remain compliant. This not only boosts your sales, but also increases trust in your brand and gives your customers peace of mind, especially when the IRS comes knocking.

At Truemed, we also offer a marketplace component, connecting your business with high-intent HSA and FSA shoppers who are actively looking to spend their funds. Our marketplace adds a layer of customer acquisition that many traditional payment solutions don’t provide.

Complying with the IRS’s requirements for HSA and FSA purchases is a critical component of accepting HSA/FSA cards as a merchant. It not only ensures that your customers can shop with peace of mind but also gives you access to over $65 billion in annual pre-tax spending to grow your revenue. Speak to one of our sales representatives today to get started.