On March 29, 2023, the IRS released Memorandum #202317020, which highlights the need to comply with Health FSA reimbursement requirements when substantiating medical and dependent care expenses. In this discussion, we’ll explore the consequences of not following the IRS substantiation requirements correctly under a Health FSA provided in a Section 125 Cafeteria Plan.
Improperly set up claims substantiation can result in reimbursements being treated as part of the employee’s gross income. This can have implications for Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) purposes, which may require withholding by the employer.
Having a knowledgeable and seasoned benefits administrator such as Flyte HCM on your side ensures plan setup and ongoing plan substantiation is compliant under these regulations.
Below we’ll take a closer look at the different scenarios that the IRS examined in relation to complying with the IRS substantiation requirements outlined in regulations.
Health FSA Scenarios and Compliance Analysis
Scenario 1: Independent Third-Party Substantiation (the compliant scenario)
An employer offers a Health FSA that covers Section 213 (d) medical expenses, independent third-party documentation such as an Explanation of Benefits (EOB) is needed to substantiate these expenses. This documentation will need to include a description of the service or product, the date of service or sale, and the expense amount. The employee also certifies that incurred medical expenses have not been reimbursed prior by their insurance or other health benefit plans.
In the following scenarios, the plans all have scenario one in their plan with the following additions:
Scenario 2: Self-Certification (not compliant)
In this scenario, employees can get reimbursed for their expenses simply by submitting details regarding the amounts, dates, and types of expenses incurred. Third-party substantiation, such as an Explanation of Benefits (EOB), is not required to validate the expenses. The IRS found that Self-certification does not satisfy the substantiation requirements specified in Prop. Reg. § 1.125-6(b)(3).
Scenario 3: Sampling (not compliant)
In this situation, the cafeteria plan will reimburse all charges made with a debit card. However, substantiation is only required for a selected portion of expenses while the rest are automatically substantiated. This approach does not comply with the substantiation requirements of Prop. Reg. § 1.125-6(b)(2), which mandates substantiation of all claims.
Scenario 4: De Minimis (not compliant)
In this scenario, expenses below a certain dollar amount on a debit card are automatically substantiated. However, if a cafeteria plan exempts charges below this limit from substantiation, it would fail to meet the substantiation requirements, rendering the plan invalid. All expenses, regardless of the amount, should be substantiated.
Scenario 5: Favored Providers (not compliant)
This situation enables automatic verification of debit card transactions made with certain vendors, without the need for independent third-party verification as mandated by regulations. Regardless of the healthcare provider or vendor, the plan must require substantiation for all expenses.
Scenario 6: Dependent Care FSA’s
This scenario allows employees to submit Dependent Care expenses before incurring their expenses, simply attesting to the dependent care expenses they expect to incur in the coming year, and notifying the employer when changes occur. Dependent care expenses that were prorated are automatically reimbursed through payroll each pay period.
If a cafeteria plan does not substantiate the Dependent Care incurred, it fails to meet the requirements of Section 129 and does not satisfy the cafeteria plan requirements of Section 125.
It is essential for both employers and employees to properly substantiate medical and dependent care expenses when participating in a Health FSA as well as other cafeteria plans. Failing to meet the IRS substantiation requirements outlined in the current regulations, and reiterated in Memorandum #202317020, can result in reimbursed amounts being included in employees’ gross income, potentially leading to tax consequences. It is crucial to comply with these regulations to avoid any negative outcomes.
Compliance with the IRS substantiation requirements in Scenario one enables the exclusion of benefits from gross income. However, Scenarios 2 through 5 fail to comply and may result in non-compliance of the entire plan as they do not operate according to their written plan under section 125 and proposed regulation 1.125-1 (c) (7)(ii)(G).
To avoid negative consequences and stay compliant, it’s important for employers to follow the guidelines outlined in proposed regulation § 1.125-6(b) when setting up their cafeteria plans. Properly adhering to IRS substantiation requirements and being aware of potential scenarios can help both employers and employees manage Section 125 plans effectively and prevent any tax-related problems.
It’s important for Section 125 cafeteria plans to comply with the substantiation rules outlined in proposed regulation § 1.125-6(b). Plans that don’t require independent third-party verification or limit expense substantiation may not meet these requirements, resulting in non-compliance and the inclusion of employees’ benefits in gross income. It’s crucial to ensure cafeteria plans follow these regulations to maintain their status as compliant plans.