On April 28, 2023, the IRS Office of Chief Counsel issued Memorandum Number 202317020, which serves as “Chief Counsel Advice” concerning the requirement for health and dependent care flexible spending accounts (FSAs) to substantiate expenses. The memorandum is a reminder of the IRS’s long-established rule which says that in order to exclude the value of FSA reimbursements from an employee’s taxable income and wages, the FSA must first rely on information supplied by an independent third party to adequately substantiate the individual’s expenses.
Nothing in the Chief Counsel Advice memorandum is new, but it does illustrate existing regulations through a series of examples of more common administrative practices, most of which the memorandum affirms as noncompliant with IRS rules. Those examples include:
- Situation 1: Full Substantiation of Health FSA Claims
In this example, a cafeteria plan reimburses employees’ medical expenses only after they are substantiated by information from a third party that is independent of the employee, their spouse, and dependents (e.g., an “explanation of benefits” from an insurance company). The information describes the medical service or product, the date of service or sale, and the amount of the expenses incurred by the employee. 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. This the only situation that the memorandum categorizes as compliant, and accordingly, reimbursements under this FSA plan are excludable from employees’ income and wages for FICA and FUTA tax purposes.
- Situation 2: Self-Certification
In this situation, the cafeteria plan also reimburses medical expenses for which employees submit only their own information describing the service or product, the date of service or sale, and the amount of the expenses, absent a verifying statement from an independent third party (either automatically or after the transaction). The memorandum concludes that this practice results in unsubstantiated claims according to IRS regulations that govern IRC section 125. Therefore, all amounts reimbursed under the cafeteria plan should be included in employees’ taxable gross income.
- Situation 3: Sampling
In this example, the cafeteria plan also reimburses all charges to employees’ debit cards and only requires third-party substantiation of a random sample of otherwise unsubstantiated charges. Similar to the conclusion in Situation 2, the memorandum concludes that the cafeteria plan fails to meet the section 125 substantiation requirements because the sampling practice “does not ensure that every claim is substantiated.”
- Situation 4: De Minimis
In this scenario, the plan exempts from the third-party substantiation requirement any charge to an employee’s FSA debit card that is below a specified dollar amount, even in cases where the expenses were not auto-substantiated by a third party at the point of the debit card transaction. The memorandum again concludes that this practice does not satisfy the cafeteria plan requirements for substantiation under section 125 because it does not require “substantiation for all claims, regardless of the amount.”
- Situation 5: Favored Providers
In this situation, the plan fails to require third-party substantiation that includes the requisite details whenever a charge to an employee’s debit card is from certain favored dentists, doctors, hospitals, or other health care providers and is otherwise not auto-substantiated at the point of the transaction. Again, the memorandum concludes that the plan does not satisfy the cafeteria plan requirements for substantiation under section 125 because it fails to require substantiation for all claims.
- Situation 6: Advanced Substantiation of Dependent Care Claims
In the final example, the employer maintains a cafeteria plan with a dependent care FSA component. The plan reimburses expenses for which employees submit a form (in advance of receiving the care) that attests to the amount of dependent care expenses they expect to incur in the upcoming year. No further substantiation is required after care is received unless the employee’s expenses differed from the amount to which they originally attested. Also, the employee is automatically reimbursed every pay period a pro rata portion of the amount to which they originally attested. The memorandum concludes that the plan fails to satisfy the requirements of both sections 125 and 129 because it does not limit reimbursements and payment of claims to those that have already been incurred and substantiated. Therefore, all reimbursements made by the plan should be included in the gross income and wages of the employees for FICA and FUTA tax purposes.
While the Chief Counsel Advice supplied here does not offer any novel or groundbreaking insight, employers that offer health and dependent care FSA benefits to their employees might find some aspects of this memorandum notable:
First, it serves a conspicuous reminder that the failure of an FSA to meet IRS administrative requirements will result in the loss of tax-favored status for all expenses reimbursed under the employer’s cafeteria plan. In other words, it’s not just the unsubstantiated FSA expenses that will be taxed as income; instead, all substantiated FSA expenses—as well as payroll deductions taken to fund insurance premiums and self-funded plan costs—will also be taxable. This could have significant adverse consequences on individual employees (and the employer alike) by way of increased income, Social Security, and Medicare tax liability.
Second, the issuance of this Chief Counsel Advice memorandum may seem somewhat peculiar, given that it merely restates some fairly basic and long-standing tenets of FSA plan administration—and that might be a hint of enforcement activity to come. IRS Chief Counsel Advice is not formal, binding guidance of the Department of Treasury; rather, it is instruction that the National Office of the Chief Counsel circulates to the various regional Field Offices to inform both new and existing field staff of IRS leadership’s interpretation of the Code and its regulations. Of additional note is that this particular memorandum is directed to the Small Business/Self-Employed Employment Tax Policy Division, perhaps signaling that the FSA administrative practices that it addresses are soon to become a focus of IRS investigations and audit activity.
In summary, there’s never a bad time for FSA plan sponsors to review the procedures of their third-party administrators to confirm that they are closely adhering to the Code’s requirements, and the recent Chief Counsel Advice should serve as a compelling reminder. Employers themselves should also be certain to avoid the practices highlighted in the memorandum, such as making discretionary exceptions for employees who faiil to issue valid documentation of their FSA claims, even for negligible amounts.