In a recently issued Chief Counsel Advice memorandum, the Internal Revenue Service (IRS) reminded sponsors of health and dependent care flexible spending arrangements (FSAs) of their obligation to properly substantiate claims as a condition of ensuring favorable tax treatment under Section 125 of the Internal Revenue Code (the Code). The IRS’s advice is clear: the substantiation bar is high, and the failure to comply has serious, unwanted consequences for employers. The memorandum includes a useful summary of the applicable law as it applies in six example situations of claims practices.
Code Section 125 allows an employer to establish a cafeteria plan that permits an employee to choose among two or more benefits, consisting of cash (generally, in the form of salary reductions) and qualified benefits, including health coverage or accident insurance. If an employee elects to participate in a health FSA on a pre-tax basis through salary reductions, the value of the coverage by the health FSA and the amounts reimbursed for medical expenses are excludable from gross income up to the allowable limit. Similarly, if an employee elects to participate in a dependent care FSA, the dependent care assistance program benefits are excludable from gross income up to the allowable limit. In each case, however, claims for reimbursement must be properly substantiated.
Through these examples, the IRS clarifies that a health or dependent care FSA that fails to satisfy the applicable substantiation requirement is not considered a cafeteria plan and, consequently, will not receive favorable tax treatment under Code Section 125. As a result, the full amount of all employee elections between taxable and nontaxable benefits are included in gross income and treated as wages for payroll tax purposes. Substantiation generally requires that all expenses must be supported by information from a third party that is independent of the employee, the employee’s spouse and dependents.
The IRS provided six examples of how sponsors have substantiated claims in the memorandum:
Situation 1: The plan only reimburses medical expenses that are substantiated by information from a third party that is independent of the employee and the employee’s spouse and dependents or from an explanation of benefits issued by an insurance company.
Situation 2: The plan allows for self-certification.
Situation 3: The plan uses sampling techniques.
Situation 4: The plan generally requires third-party certification, but it treats certain expenses paid with a debit card as auto-substantiated if the charge is less than a specified dollar amount.
Situation 5: The plan maintains a list of dentists, doctors, hospitals or other healthcare providers, the charges from which are treated as auto-substantiated.
Situation 6:A dependent care assistance plan allows employees to submit a form in advance of receiving the dependent care, attesting to the amount of dependent care expenses they will incur in the upcoming year and to thereafter notify the plan sponsor only if the anticipated amount of expenses change.
According to the memorandum, only Situation 1 complies with the applicable substantiation requirements of Code Section 125. The plans in Situations 2 through 6 fail to do so. Thus, all employee election amounts in Situations 2 through 6 are treated as taxable for both income and payroll tax purposes.
The IRS’s holdings are all based on the 2007 proposed regulations, which do not have the force of law. Nevertheless, plan sponsors and their advisors have long looked to these proposed rules for guidance. The memorandum itself also provides that it may not be used or cited as precedent. Therefore, employers that sponsor health and dependent care FSAs should review their vendor service agreements and plan administration to ensure the agreements and plan operations comply with the requirements of Code Section 125.
For any questions, please contact your regular McDermott lawyer or one of the authors.