The Internal Revenue Service (IRS) recently issued a Chief Counsel Memorandum (“Memo”) providing helpful insight into the claims substantiation process for Health Care and Dependent Care Flexible Spending Accounts (“HC FSA” and “DC FSA”, respectively). Read on for more information.
Memo Details and Conclusions
HC FSA Claims
The Memo confirms that HC FSA claims cannot be self-certified and must be fully substantiated by an independent third party, pursuant to IRS proposed cafeteria plan regulations and previous guidance.
Full substantiation generally means that the third party submitting information to substantiate a HC FSA claim is independent of the employee and the employee’s spouse and dependents, and the information from the third party describes the IRC § 213 medical service or product, the date of service or sale, and the amount of the expense. An example of full substantiation would be an employee submitting an explanation of benefits (EOB) from an insurance company.
Moreover, an employee is required to certify that any expense reimbursed by the HC FSA has not been reimbursed by insurance and the employee will not seek any other reimbursement from any other health benefit plan.
The Memo specifically states that the following claims substantiation practices are not permitted under the full substantiation requirements outlined above.
- Self-certification: HC FSA plans cannot substantiate claims that do not include an independent third-party statement verifying the claims expense or that do not substantiate debit card charges, including recurring charges, without an independent third-party statement.
- Sampling: HC FSA plans cannot substantiate only a random sample of otherwise unsubstantiated debit card charges without an independent third-party statement describing the qualified service/product and date of service/sale.
- De minimis: HC FSA plans cannot substantiate only debit card charges above a specified dollar amount. This means that all debit card charges, regardless of the amount, must be substantiated with additional third-party information describing the qualified service/product and the date of service/sale.
- Favored providers: HC FSA plans cannot only require substantiation of debit card charges from certain doctors, dentists, hospitals, or other health providers. All debit card charges, regardless of the provider rendering the qualified service, must be substantiated.
If any of the practices detailed above are permitted under an HC FSA’s claim substantiation processes, then the reimbursed amounts will be considered unsubstantiated medical expenses under the cafeteria plan. As a result, the amounts will be included in the gross income of employees (i.e., taxable benefit) and subject to applicable withholding taxes.
Permissible auto-substantiated HC FSA debit card charges: Auto-substantiated HC FSA debit card charges are permissible and not included in the prohibited HC FSA claims substantiation practices outlined above. Auto-substantiated HC FSA debit card charges allow a payment of recurring medical expenses for medical expenses incurred at certain providers that match expenses previously approved as to amount, medical care provider, and time period, pursuant to Prop. Reg. § 1.125-6(e)(4).
DC FSA Claims
The Memo also clarifies that DC FSA reimbursements will be included in employees’ gross income (i.e., taxable benefit) if DC FSA claims are substantiated before the expenses have been incurred. Dependent care expenses are incurred when the care is provided and not when the employee is formally billed or charged for (or pays for) the dependent care.
DC FSA Claims Reimbursement Example: The Memo confirms that advance reimbursement of DC FSA claims is impermissible pursuant to Prop. Reg. § 1.125–6(a)(4) and Prop. Reg. § 1.125–6(b)(4).
The example provided in the Memo illustrating this prohibited practice involves employees submitting a form in advance of receiving the dependent care services and attesting to the amount of DC FSA expenses they will incur in the upcoming year. Employees are then automatically reimbursed every pay period a pro rata amount of the attested DC FSA expenses.
Impact to Employers
IRS Chief Counsel Memoranda are internal advice generally issued to attorneys and revenue agents within the IRS. Although these memos explicitly state they may not be used or cited as precedent, they provide useful insight into the IRS’s stance on certain taxation issues. This Memo serves as instructive guidance on the IRS’s position regarding HC FSA and DC FSA claims substantiation process concerns presented in the memo.
Employers sponsoring HC FSA and/or DC FSAs are encouraged to confirm that their FSA administration vendors are in full compliance with the Memo’s guidance in connection with claims substantiation processes and practices to avoid cafeteria plan operational failure determinations. Plan operational failure determinations can result in penalties, and interest, and potentially jeopardize the tax advantages for employees who elect to contribute to HC FSAs and DC FSAs as well as employers who sponsor the plans.
The IRS also recently released helpful FAQs guidance addressing HC FSA reimbursements for nutrition and wellness expenses. Click here for a previous Risk Strategies article with more information. These two recent occasions of IRS guidance being released, both in connection with HC FSAs, serve as a strong signal to HC FSA plan sponsors to ensure that their plans are operated in compliance with IRS regulations and guidance.
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 Also known as Dependent Care Assistance Programs (DCAPs) under IRC § 129.
 More specifically, Prop. Treas. Reg. §1.125-6(b)(2) & (3) and IRS Notice 2006-69.
 IRS Rev. Rul. 2003-43.