The IRS’s Office of Chief Counsel recently released Chief Counsel Advice Memorandum Number 202317020, which reiterates the longstanding substantiation requirements that apply to claims for payment or reimbursement of expenses from health and dependent care flexible spending arrangements (FSAs) that are offered under Code Section 125 cafeteria plans. The Memorandum does not break any new legal ground, and may not be used or cited as precedent, but it does offer a helpful summary of the substantiation requirements and the adverse tax consequences of failing to meet them.
Background
All Claims Must Be Substantiated. Longstanding IRS guidance requires that all claims for payment or reimbursement of expenses from a health or dependent care FSA offered under a Section 125 cafeteria plan must be substantiated before any payments or reimbursements may be made. Substantiating only a percentage of claims, or substantiating only claims above a certain dollar amount, fails to satisfy the substantiation requirements.
Substantiation By Independent Third Party. In addition, all claims for expenses must be substantiated by information from a third party that is independent of the employee and the employee’s spouse or dependents. The independent third party must provide information describing the service or product, the date of the service or sale, and the dollar amount. Self-substantiation or self-certification of an expense by an employee does not satisfy the substantiation requirements.
Tax Consequences of Substantiation Failures. Any failure to satisfy applicable substantiation requirements can trigger significant adverse tax consequences for the employer and its employees. If any unsubstantiated medical or dependent care expense claim is paid or reimbursed from a health or dependent care FSA, then all payments or reimbursements made during the year, including amounts paid to reimburse substantiated expenses, would be included in employees’ Federal gross income. In addition, if a health or dependent care FSA that is offered under a Section 125 cafeteria plan pays or reimburses unsubstantiated expenses, then the Section 125 cafeteria plan itself would fail to be a cafeteria plan, causing all salary reduction contributions that employees elect to make under the cafeteria plan to be included in their Federal gross income and FICA and FUTA wages.
Chief Counsel Advice Memorandum Describes Six Situations
The Chief Counsel Advice Memorandum describes six factual situations. Situation 1 describes a health FSA which meets all applicable substantiation requirements. Situations 2 through 5 describe health FSAs that fail to meet applicable substantiation requirements, and Situation 6 describes a Code Section 129 dependent care assistance program that fails to meet applicable substantiation requirements.
Situation 1: Health FSA Satisfies Substantiation Requirements. In Situation 1, an employer provides a Section 125 cafeteria plan with a health FSA that reimburses Code Section 213(d) medical expenses incurred by employees.
The plan only reimburses expenses that are substantiated by an independent third party who provides information that describes the service or product, the date of the service or sale, and the amount of the expense. In addition, the plan reimburses expenses based on information from an independent third party such as an “explanation of benefits” (EOB) from an insurance company.
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 health plan.
Finally, the plan also provides debit cards, meeting applicable substantiation requirements, that can be used to reimburse qualifying medical expenses.
IRS’s Conclusion in Situation 1. The IRS concluded that in Situation 1, the substantiation of all claims complied with applicable health FSA and Section 125 cafeteria plan substantiation requirements, and that nothing in the way the plan substantiates claims would prevent the employer from excluding the amounts reimbursed from employees’ Federal gross income and FICA and FUTA wages.
Situation 2: Health FSA Does Not Satisfy Substantiation Requirements (Self-Certification). Instead of only reimbursing substantiated medical expenses as in Situation 1, in Situation 2, the plan also reimburses medical expenses for which an employee only submits information describing the service or product, the date of the service or sale, and the amount of the expenses, but does not provide a statement from an independent third party to verify the expenses. The plan also does not substantiate debit card charges with a statement from an independent third party.
Situation 3: Health FSA Does Not Satisfy Substantiation Requirements (Sampling). In addition to reimbursing medical expenses that are substantiated as described in Situation 1, in Situation 3, the plan reimburses all charges to the debit card and only requires substantiation of a random sample of otherwise unsubstantiated charges to the debit card through third-party information describing the service or product and the date of the service or sale.
Situation 4: Health FSA Does Not Satisfy Substantiation Requirements (De Minimis). In addition to reimbursing medical expenses that are substantiated as described in Situation 1, in Situation 4, the plan provides that, if a charge to the debit card is less than a specified dollar amount, the plan does not require substantiation of the charge through additional third-party information describing the service or product and the date of the service or sale.
Situation 5: Health FSA Does Not Satisfy Substantiation Requirements (Favored Providers). In addition to reimbursing medical expenses that are substantiated as described in Situation 1, in Situation 5, the plan provides that, if a charge to the debit card 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.
IRS’s Conclusions in Situations 2, 3, 4 and 5. In Situations 2 through 5, the IRS concluded that self-certification of claims (Situation 2), requiring only randomly-sampled claims to be substantiated (Situation 3), not requiring substantiation of claims that are less than a specified de minimis dollar amount (Situation 4), or not requiring substantiation of charges from favored providers (Situation 5), does not ensure that every claim will be substantiated. Because the plan in each of Situations 2 through 5 does not limit reimbursements or payments of claims to medical expenses that are substantiated, the plan does not satisfy applicable substantiation requirements. As a result, all amounts paid or reimbursed from the health FSA during the year, including amounts paid to reimburse substantiated medical expenses, are included in employees’ Federal gross income. In addition, the failure to comply with the substantiation requirements causes the cafeteria plan itself to fail to be a cafeteria plan, such that all salary reduction contributions that employees elect to make under the cafeteria plan are included in their Federal gross income and FICA and FUTA wages. (Note that all of this would result in significant additional income and employment taxes for the employer and its employees.)
Situation 6: Dependent Care FSA Does Not Satisfy Substantiation Requirements (Advance Substantiation). In Situation 6, an employer provides a Section 125 cafeteria plan that offers a Section 129 dependent care assistance program that reimburses dependent care expenses incurred by employees. The plan allows employees to submit a form in advance of receiving the dependent care, attesting to the amount of dependent care expenses they will incur in the coming 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 a pro rata amount of the amount of dependent care assistance expenses to which the employee attested.
IRS’s Conclusion in Situation 6. In Situation 6, the IRS concluded that all claims for payment or reimbursement of the employee’s dependent care assistance expenses are not substantiated because they are claimed in advance without additional verification. Because the plan does not limit reimbursement or payment of claims to dependent care assistance expenses that have been incurred or substantiated, the plan does not satisfy the dependent care assistance program requirements of Section 129 and does not satisfy the cafeteria plan requirements of Section 125. As a result, the reimbursements for dependent care assistance expenses are not excludable from Federal gross income under Section 129, and all payments made during the year under the dependent care assistance program are included in employees’ Federal gross income and FICA and FUTA wages. In addition, the failure to comply with the substantiation requirements causes the cafeteria plan itself to fail to be a cafeteria plan, such that all salary reduction contributions that employees elect to make under the cafeteria plan are included in their Federal gross income and FICA and FUTA wages. (Note that all of this would result in significant additional income and employment taxes for the employer and its employees.)
The Upshot. Although the Chief Counsel Advice Memorandum does not cover any new legal ground, it is a helpful and comprehensive reminder of the substantiation requirements that apply to health and dependent care FSAs that are offered under Section 125 cafeteria plans. The Memorandum also offers up a cautionary tale about the significant adverse income and employment tax consequences for employers and employees when substantiation requirements are not satisfied. Most employers do not process health or dependent care FSA claims themselves, but rather engage third-party service providers to perform those tasks. Prudent employers should be reaching out to their third-party service providers to determine whether all applicable substantiation requirements are being met in connection with their plans.
Finally, even though the Chief Counsel Advice Memorandum is not binding, and cannot be used or cited as precedent, it is a clear statement of the IRS’s longstanding substantiation requirements and could be applied in an IRS audit of an employer’s Section 125 cafeteria plan, health FSA or dependent care FSA.
