Yes, that seems reasonable to me, however, the IRS hasn't really provided any guidance with regard to this sort of situation where a refund was obtained that cannot be returned to the HSA. It seems seems reasonable that the refund would be taxable if not applied to medical expenses. IRS Notice 2004-50 Q&A-37 discusses the tax treatment if the HSA accepts the return of the mistaken distribution but does not explicitly address what happens if the mistaken distribution is not returned. One can infer that the mistaken distribution is subject to tax and potential early distribution penalty if not used for qualified medical expenses, but it does not address how to apply it to qualified medical expenses or to even identify what medical expenses would be considered to be qualified medical expenses under these circumstances. There is certainly no problem treating as qualified medical expenses those incurred before the original distribution from the HSA. The only question is what medical expenses incurred after the original distribution might be considered to be qualified medical expenses to which the refund can be applied. It seems reasonable that one would be able to apply the refund to qualified medical expenses incurred between the time of the original distribution and the time of the refund since the recipient did not have control of the funds during that time.
Applying the refund to medical expenses incurred after receipt of the refund is more questionable, but would still seem to satisfy § 223(f)(1) which simply says that to be nontaxable that the distribution from the HSA must be used for qualified medical expenses. However, that interpretation would suggest that anyone could take a distribution from and HSA at any time to apply in the future to medical expenses not yet incurred and not have it be taxable, which seems unreasonable. I am not aware of any case where the IRS has audited the medical expenses to which an HSA distribution has allegedly been applied, but that doesn't necessarily mean that it hasn't happened.
With regard to my own HSA I keep some qualified medical expenses in reserve by paying them without using a distribution from the HSA. This provides me with a buffer against which I can apply an otherwise mistaken distribution at some time in the future while keeping a larger balance in my HSA to grow tax free. I have a set of folders where I keep records of all qualified medical expenses with respect to the HSA, both those already paid from the HSA and those incurred after the establishment of the HSA but yet to be paid from the HSA to be able to document the application of HSA distributions to qualified medical expenses.
