The bar is high; failure to comply has serious, unwanted consequences
In 2023, the Internal Revenue Service (IRS) released a memo reminding sponsors of health flexible spending accounts (HCFSAs) and dependent care flexible spending accounts (DCFSAs) of their obligation to properly substantiate claims as a condition of ensuring favorable tax treatment under Sections 125 & 129 of the Internal Revenue Code (IRC).
If an employee elects to participate in a HCFSA on a pre-tax basis, the amounts reimbursed for qualified medical expenses* are excludable from gross income up to the allowable limit ($3,200 in 2024). Similarly, if an employee elects to participate in a DCFSA, the dependent care assistance program benefits are excludable from gross income up to the allowable limit ($5,000). In each case, however, claims for reimbursement must be properly substantiated.
Permissible Practices
While employers almost universally delegate the claims administration process to a third party administrator – like DBS – clients and participants should be aware of the appropriate protocols/standards.
HCFSAs can only reimburse qualified medical expenses that are incurred during the period of coverage and substantiated by a third party reviewer that is independent of the employee, the employee’s spouse, and the employee’s dependents. The information reviewed by the third party must include a receipt or invoice with: a) the provider’s name; b) the date of service/sale; c) a description of the service received or item purchased; and d) the amount of the expense. The prototypical form of substantiation is an explanation of benefits (EOB) provided by a health plan or insurance company showing the employee’s cost-sharing responsibilities.
Additionally, the IRS imposes a blanket prohibition against using any account-based health plan (i.e. DCFSA, FSA, HRA, HSA) for an expense that has been reimbursed from another health plan. Employees must therefore certify that any expense has not already been reimbursed and that they will not seek reimbursement from any other health benefits plan in the future.
Prohibited Methods
The memo provides several examples of HCFSAs and DCFSAs with impermissible substantiation practices. Those prohibited shortcuts include:
- Requiring only a sample of claims, rather than all claims, to be substantiated.
- Applying a de minimis (minimum) threshold under which claims are not substantiated.
- Allowing employees to self-substantiate an expense or self-certify that an expense is eligible for reimbursement.
- Not requiring supporting docs. for expenses charged through a HCFSA debit card not previously substantiated or incurred at certain locations (i.e. doctor’s office, pharmacy, etc.).
- Providing advance reimbursements for dependent care expenses to be incurred at a later time.
Tax Consequences
Failure of a HCFSA or DCFSA to meet these administrative requirements will result in the loss of tax-favored benefits/status under the employer’s cafeteria plan. In this circumstance, the financial ramifications are not just limited to the improperly adjudicated claims…the IRS could treat all reimbursements from a voided plan – including those that were properly substantiated – as taxable wages. What’s more, any pre-tax payroll deductions must be included in the gross income of the employee(s) and subject to applicable withholding taxes for Federal Insurance Contributions Act (FICA) purposes.
Note: The employer also becomes liable for applicable penalties and interest payable to the IRS for reporting/withholding errors, and might need to amend its prior returns (including employees’ W-2s).
Conclusion
These substantiation rules are long-standing and based on the 2007 proposed regulations, which plan sponsors have relied on for guidance. While the recent memo largely restates prior positions, it suggests that the IRS may adopt a strict stance on the impermissible practices highlighted going forward. Moreover, the IRS has indicated that due to increased budgets and staffing, there may be heightened enforcement efforts, possibly signaling that cafeteria plan reimbursements could be a target for future IRS audits.
To be clear, there are no exceptions to these substantiation requirements…and DBS does not agree with other interpretations that the proposed regulations/subsequent guidance allow for certain practices that have been become more commonplace for reasons such as administrative convenience or cost reduction. We take immense pride in our proven track record of ensuring that all FSA agreements and plan operations comply with the requirements of the tax code. As a result, our clients and agents partners should have confidence in DBS’s long-standing commitment to maintaining the highest standard of compliance.
*Per § 213(d), these expenses include medical services rendered by medical practitioners, drugs/medicines…as well as the cost of equipment, supplies and diagnostic devices for medical purposes.