One of the most contentious issues for plan participants is the requirement that they substantiate their expenses for the purposes of being reimbursed by their employer’s health and dependent care Flexible Spending Accounts (FSAs). They often feel like the plan administrators are just being contrary and confrontational in attempting to administer the plans to the letter. A recent IRS Chief Counsel memorandum restates the IRS position that the plans need to be administered to the letter to properly claim the expense reimbursements pre-tax.  

Background

The general tax rules prohibit taxpayers from being able to choose to take non-taxable benefits in lieu of taxable income to avoid paying income tax. There are exceptions to that general rule in Section 125 of the Internal Revenue Code (“IRC”), among others. That provision permits employees who participate in cafeteria plans, including health and dependent care FSAs, to elect to reduce their taxable incomes and be reimbursed for qualifying expenses on a non-taxable basis. The plans and the expenses must meet a list of rules that the IRS has put into place to make sure the system is not abused. For health FSAs that generally means that they meet the requirements as a medical expense under IRC Section 213(d). Another, for both types of FSAs are that the expenses must be properly substantiated (generally by a third party, but some rules permit the use of debit cards to self-substantiate the expenses if they meet the requirements) to obtain the pre-tax reimbursement from the plan. The substantiation requirement has been problematic for many plan participants, who see it as an unnecessary step in the process to just “get their own money” returned to them.

Over the years, particularly since the IRS rules have not been finalized, many have sought to get the IRS’s view of these rules softened. The latest guidance from the IRS, Chief Counsel Memorandum – 202317020, restates the IRS position that each expense must be substantiated and that there is no de minimus exception. If the substantiation requirements are not met, the IRS notes that the full amount of any reimbursement will be included as the employee’s taxable income and will also be treated as such for purposes of FICA and FUTA employment taxes.  

An employer asked for this guidance from the IRS. But the genesis of the request was not purely altruistic on the employer’s part. The employer that requested this guidance seemed concerned with the FICA and FUTA employment taxes. Reducing employee taxable income under IRC Section 125 saves the employees’ taxes of course, but that reduction also results in tax savings for the employer. It results in lower employee wages for both the employee and employer FICA and FUTA taxes. While the employer would also like to streamline the plan’s administration, it clearly did not want to violate the provisions of the IRC regarding the collection of employment taxes. While there is very little enforcement activity surrounding the income tax implications of proper plan administration, employers fail to properly withhold and pay employment taxes timely.

Examples

1. Independent Certification - An employer provides a health FSA that reimburses section 213(d) medical expenses incurred by employees. The plan only reimburses medical expenses substantiated by information from a third party (independent of the employee and the employee’s spouse and dependents). For example, the substantiation could be an insurance company’s explanation of benefits (EOB). The plan requires that information from the independent third party include (i) the date of the medical care and (ii) the employee’s share of the cost of the medical care (that is, coinsurance payments and amounts below the deductible). The plan also requires the employee to certify that any expense paid by the plan has not been reimbursed by insurance or otherwise and that the employee will not seek reimbursement from any other plan covering health benefits.

The plan also provides debit cards that can be used to reimburse medical expenses that meet the specific requirements for self-substantiation for debit card expenses. There is a set of requirements for the use of debit cards that, if met, will meet the substantiation requirements without additional obligations to submit the expenses to an independent third party.

The IRS noted that this plan properly meets all the substantiation requirements, and that the reimbursement amounts are fully excludable.

2. Self-Certification - The plan reimburses employees for medical expenses for which the employee submits information describing the service or product, the date of service or sale, and the amount of the expenses, but does not provide a statement from an independent third party (either automatically or after the transaction) to verify the expenses. Further, the plan does not substantiate debit card charges (including charges that are not auto substantiated) for recurring medical expenses incurred at certain providers that match the amount, medical care provider, and time period (of previously approved expenses) with a statement from an independent third party.   

The IRS notes that since not all claims will be substantiated, all amounts paid under an FSA with this process will be treated as taxable income. That means the employer is also responsible for the FICA and FUTA employment tax obligations.   

3. Sampling – The plan only substantiates a random sample of the expenses. The IRS notes this type of plan does not meet the substantiation requirement because all expenses need to be substantiated.    

4. De Minimis – The plan does not require amounts below a specified amount to be substantiated.  

The IRS notes that the rules require substantiation of all reimbursements, regardless of the amount, so this would not meet the requirements of the substantiation rules. 

5. Favored providers - If a charge to the debit card (even if it does not meet the auto substantiation rules for debit cards) is from certain dentists, doctors, hospitals, or other health care providers, the plan does not require substantiation of the charge to the debit card through additional third-party information describing the service or product and the date of the service or sale.  

Charges to a debit card must meet the auto substantiation requirements provided in the regulations or otherwise be substantiated by a third party. Therefore, the IRS notes, this plan does not meet the substantiation requirements.  

6. Advance Substantiation for Dependent Care Assistance Program- An employer provides a dependent care assistance program that reimburses dependent care expenses incurred by employees. The plan allows employees to submit a form before receiving dependent care, attesting to the amount of dependent care expenses they will incur in the upcoming year. The plan requires employees to notify the plan sponsor if their dependent care situation changes, and they will not incur the amount of qualified dependent care expenses to which they attested for that year.  The employee is automatically reimbursed every pay period for the pro rata amount of dependent care assistance expenses to which the employee attests.    

The IRS notes that this plan does not meet the substantiation requirements. The plan must require each reimbursement to be substantiated, and this format does not meet that requirement. 

 Conclusion

Perhaps this is a situation where the admonishment against asking questions you don’t want the answers to would apply. The IRS has reiterated the detailed requirements for expense substantiation before an expense under the health FSA and dependent care FSA can be properly reimbursed on a pre-tax basis. The IRS likely had little leeway to do otherwise, given the guidance that has been published. This latest update from the IRS reinforces the plan administrators’ obligations to follow the substantiation requirements to the letter, even in the face of vociferous objections from plan participants.

This Legal Update is not intended to be exhaustive, nor should any discussion or opinions be construed as legal advice. Readers should contact legal counsel for legal advice.