On March 29, 2023, the IRS Chief Counsel’s office issued a memorandum that explains the substantiation requirements for medical and dependent care FSA plan claims. The memo also outlines the consequences of various substantiation shortcuts that have popped up in recent years.
In short, the memo reconfirms that FSA reimbursements must be included in an employee’s income and are not eligible for pre-tax treatment unless the expense is fully substantiated by an independent third party in accordance with IRS rules.
Severe Consequences
If the claims substantiation practices of an FSA plan do not satisfactorily meet the IRS standards, all salary reductions made under the plan would be considered taxable to employees. Effectively, failing to properly substantiate claims according to IRS guidelines invalidates the cafeteria plan. As a result of this disqualification, salary reduction elections would need to be recharacterized as taxable for the employee and considered wages for the purpose of FICA and FUTA taxes. The memo clarifies that the taxation consequences apply to all reimbursements in the year, including any portion of reimbursements that were actually properly substantiated.
Prohibited Substantiation Practices
The memo specifically called out several practices that fail to comply with IRS rules. Any reimbursements made under any of these practices do not qualify as valid cafeteria plan expenses, and any such reimbursements must be taxed to the employee (included in gross income). These practices include:
- Allowing employee self-certification of expenses
- Substantiating only some expenses (random sampling)
- Not requiring substantiation of expenses below a “de minimis” dollar amount
- Not requiring substantiation of expenses from “favored providers”
- Not requiring that dependent care reimbursements be substantiated after the expense has been incurred
Required Substantiation Clarified
The IRS clarifies acceptable substantiation practices by presenting an example that includes necessary requirements. The example outlines the following claim substantiation elements:
- All medical expenses must be substantiated by an independent third party (specifically, a party independent of the employee and the employee’s spouse or dependents).
- Expense documentation must describe the service or product, the date of service or sale, and the amount of the expense.
- Employees must certify that expenses have not been reimbursed by insurance or otherwise and that they will not seek reimbursement from any other plan covering health benefits.
- Reimbursements using “EOB rollover” procedures (based on claims adjudication documentation from an insurance company) that comply with IRS rules are acceptable.
- Reimbursements substantiated via a debit card program that complies with IRS rules are acceptable (substantiation is still required for non-auto-adjudicated claims).
Dependent Care Example Explained
The clarification on dependent care plan substantiation aims to address the situation where certain plans allow participants to submit a form at the beginning of the plan year and attest to the annual dependent care expenses they will incur in the upcoming year.
The form typically requires that employees notify the plan if their dependent care situation changes such that they will not incur the amount of dependent care expenses they projected in the attestation. The plan then automatically reimburses participants each pay period for a pro-rata portion of their personally attested annual dependent care expenses. Reimbursements under these arrangements are not limited to or tied to expenses that have been incurred or substantiated. The IRS deems these arrangements as not meeting the substantiation requirements; therefore, reimbursements must be included in employees’ gross income.
Employer Takeaway
The guidance in the IRS memo is not new news. It generally reiterates information included in the Proposed Regulations issued in 2007. However, the IRS has recognized that some non-compliant claims substantiation practices have been adopted in the marketplace. This memo serves as a reminder to employers and FSA administrators that the IRS is both aware of the non-compliant practices and committed to maintaining the substantiation levels required in the law.
Vita Flex Substantiation Practices
Vita Flex FSA administration has never allowed or adopted any of the “shortcut” substantiation practices addressed in the IRS memo. Vita Flex has and will continue to be committed to ironclad compliance in the administration of FSA plans.
Resources
A copy of the IRS memo can be founded here.
