On April 28, 2023, the IRS Office of Chief Counsel issued Chief Counsel Advice Memorandum 202317020 (CCA Memo), with an important reminder to employers who provide health and dependent care flexible spending arrangements (FSAs) under an Internal Revenue Code (Code) Section 125 cafeteria plan: a failure to adequately substantiate FSA expenses before reimbursement may result in the loss of the tax-free status of all benefits provided under the Code Section 125 cafeteria plan.
Background on Code Section 125 Substantiation Requirements
Code Section 125 and its Proposed Regulations require that all claims for reimbursement from a health or dependent care FSA offered as part of a Code Section 125 cafeteria plan be fully substantiated before any claim is reimbursed. For a claim to be fully substantiated, the Proposed Regulations require that the expenses be substantiated by information from a third party that is independent of the employee and the employee’s spouse and dependents. The information from the independent third party must include the following:
- The service or product.
- The date of service or sale.
- The dollar amount.
Self-substantiation or self-certification by the employee is specifically prohibited in the Proposed Regulations. In addition, the Proposed Regulations prohibit substantiating only a percentage of claims or substantiating only claims above a certain dollar amount. Finally, although many dependent care providers charge the cost of care upfront, the Proposed Regulations prohibit reimbursement of dependent care expenses before the care has been provided.
Five Substantiation Practices to Avoid
With this background in mind, the CAA Memo discusses and rejects five specific substantiation practices for FSAs offered under Code Section 125 cafeteria plans:
- Self-Certification: An employer must obtain an independent third party statement – either automatically or after the transaction – in order to reimburse employees for expenses under an FSA. The employer may not reimburse employees for expenses under an FSA for which an employee only submits information describing the service or product, the date of service or sale, and the amount of the expenses but does not also provide a statement from an independent third party to verify the expenses.
- Sampling: An employer may not require substantiation through a random sample of otherwise unsubstantiated charges to the FSA debit card (that is, charges that are not auto-substantiated) through third-party information describing the service or product and the date of the service or sale. Instead, an employer must require all claims for reimbursement to be substantiated.
- De Minimis: An employer may not require substantiation only for FSA reimbursement requests at or over a certain dollar amount. That is, plan sponsors must require that all claims for reimbursement be substantiated without regard to the dollar amount of the claim.
- Favored Providers: An employer may not exempt certain dentists, doctors, hospitals, or other healthcare providers from the substantiation requirement. That is, a plan may not provide that for claims from certain “favored providers,” no third-party independent statement is required, and that the claims may be paid without substantiation.
- Advance Substantiation for Dependent Care Assistance Program: A plan may not allow employees to submit dependent care claims in advance of receiving the dependent care, attesting to the dollar amount of dependent care expenses they will incur in an upcoming year, and then automatically reimburse the employee every pay period with the pro rata amount of dependent care assistance expenses to which the employee attested, without any additional verification.
Adverse Tax Consequences
The consequences for failing to properly substantiate claims for payment or reimbursement of medical and dependent care expenses under an FSA can be severe. If any expense of any employee reimbursed by a health FSA is not fully substantiated, the reimbursement of those medical expenses is included in the employee’s gross income. In addition, any reimbursements made for dependent care assistance expenses that are not substantiated after the expense has been incurred must be included in the employee’s gross income.
Further, if a Code Section 125 cafeteria plan does not comply with the substantiation requirements of the Proposed Regulations, including by engaging in any of the activities above, the plan will not qualify as a Code Section 125 cafeteria plan, and the amount of any benefits that any employee elects under the cafeteria plan must be included in gross income and would be subject to wage withholding. In other words, a failure to properly substantiate FSA claims could lead to the disqualification of the entire Code Section 125 plan for all participants, not just those who participate in the FSAs.
Given the consequences at stake, we urge plan sponsors to review their FSA substantiation procedures and avoid using any of the practices noted above or any practices that would require less than full substantiation of all FSA claims for reimbursement. We also recommend confirming with your FSA vendors and/or plan administrators that their operations comply with the Code Section 125 substantiation requirements.
Please contact a member of our Employee Benefits Practice Group for more information.