IRS Guidelines: Addressing Claims Substantiation for FSAs

The IRS has recently released an advice memorandum from the Chief Counsel that serves as a valuable reminder regarding the substantiation requirements for flexible spending accounts (FSAs). These requirements specifically pertain to two types of FSAs: health FSAs, which reimburse medical expenses, and dependent care FSAs, which reimburse expenses related to dependent care.

Substantiation Requirements

Most FSAs are offered under a Section 125 cafeteria plan to allow employees to make pre-tax contributions. Under federal tax rules, all claims for reimbursement from an FSA must be substantiated by information from a third party that is independent of the employee and the employee’s spouse and dependents, such as an explanation of benefits (EOB) from an insurance company or a detailed receipt from a medical or dependent care provider.

Debit cards are commonly used with FSAs for convenient fund access. Some electronic transactions automatically qualify for substantiation, eliminating the need for additional employee information submission.

Compliance Reminders

According to the IRS memorandum, the following methods are not permissible for substantiating reimbursements of medical expenses from an FSA:

• Allowing employees to self-substantiate expenses;
• Requiring substantiation of only a random sample of unsubstantiated charges to the debit card (that is, charges that are not automatically substantiated);
• Not requiring substantiation for debit card charges that are less than a specified dollar amount; and
• Not requiring substantiation for debit card charges from certain dentists, doctors, hospitals or other favored health care providers.

In addition, dependent care expenses may not be reimbursed before the expenses are 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.

Tax Consequences

Reimbursements from FSAs that are not fully substantiated must be included in the employee’s gross income. Also, if a Section 125 cafeteria plan does not comply with the substantiation requirements for FSAs, the plan will no longer qualify for favorable tax benefits. To avoid these negative tax consequences, employers with FSAs should review their substantiation procedures to make sure they comply with IRS rules.

Recap

• Dependent care expenses must be incurred before they are eligible for reimbursement.
• The IRS issued a memorandum on FSAs that provides helpful reminders about the strict substantiation requirements for these accounts.
• FSA expenses are not considered properly substantiated if employees self-certify expenses, if the plan uses sampling, if only amounts over a certain level are substantiated or if charges from favored providers are not substantiated.