By: HUB’s EB Compliance Team
Health flexible spending accounts (“Health FSAs” or “HCFSA”) offer employees the opportunity to pay for qualified medical expenses with pre-tax contributions. Both employers and employees receive a tax benefit when employees contribute to a Health FSA. Employers lower their payroll tax burden because employees have lower taxable income. Likewise, employees lower their taxable income and receive tax-free reimbursement of medical expenses.
Health FSAs are regulated by the Internal Revenue Service (“IRS”) and must include two important provisions (among other requirements). First, the maximum amount of reimbursement from a Health FSA must be available at all times during the coverage period. (This is known as the “uniform coverage rule.”) This means the employee’s entire annual elected Health FSA contribution must be available as of the first day of the plan year (or, if later, the employee’s participation in the plan).
Second, before qualified medical expenses can be reimbursed from a Health FSA they must be properly substantiated. In this piece we’ll focus on the FSA substantiation process and how employers can address unsubstantiated expenses.
Health FSAs can only provide reimbursements for medical care, which the tax code says must be “for the diagnosis, cure, mitigation, treatment or prevention of disease.” How does a plan participant show the reimbursement was for medical care? By substantiating what the expense was for. (For purposes of this piece we’re going to avoid the ins and outs of what may or may not be medical care, but we discuss those in a couple of other articles.)
Proper substantiation requires three components:
- A written statement from an independent third-party indicating the date of the medical care and the employee's responsibility for payment for that medical care.
- Employee certification that (a) the expense has not been reimbursed; (b) the employee will not seek reimbursement for the expense; and (c) the employee will not claim a tax deduction for the reimbursed expense.
- The substantiation must be provided to, and approved by, a third-party that is independent of the employee and the employee's spouse and dependents.
From a process perspective, typically the employee will submit a receipt, Explanation of Benefits or other written statement to meet the first requirement. The second requirement is met by the employee submitting the written statement either electronically or manually along with the certification language. Finally, the written statement and certification are processed and adjudicated by a third party, typically a vendor providing Health FSA administration services to the employer.
For a variety of reasons, employees don’t always properly substantiate their Health FSA expenses. When expenses are submitted without substantiation, the employee is not reimbursed. The employee is then given the opportunity to provide proper substantiation so they can receive the reimbursement.
However, problems can arise when employees use Health FSA debit cards to pay for expenses. In some cases, the expenses are automatically substantiated, such as by matching the amount paid with the co-payment amount for a provider. Unfortunately, automatic substantiation is not available for all expenses or at all places where the debit card can be used.
Nevertheless, all expenses paid for by a debit card must still be substantiated, but since the employee has already used the Health FSA funds, they may be less likely to complete the substantiation process. Employers are then faced with the difficult task of addressing the unsubstantiated expenses. Thankfully, Proposed Treasury Regulation §1.125-6(d)(7) gives employers a process to follow when this occurs. An employer should keep working through the steps until the amount is substantiated or recovered.
- Deactivate the Card. If the Health FSA provides a debit card, the first step is to turn off access to the card. At the very least, this prevents the employee from incurring additional unsubstantiated expenses. Depending on the terms of the agreement with the Health FSA vendor, an employee with a turned off debit card may still be able to submit manual requests for reimbursement.
- Require Repayment. If there is no debit card, employers will begin the process here. This step accepts that the employee will not substantiate the expense(s) in question and therefore must reimburse the plan for the improperly paid benefits. The employer will need to communicate the amount owed, the reason(s) the amount is owed, when payment must be made by, and how payment must be made. Health FSA vendors should have a payment request process in place.
- Withhold from Pay. If the employee does not repay the plan for the unsubstantiated expenses, the employer may withhold the amount owed from the employee’s pay. Employers must be extremely careful with this step as (a) it must be authorized by the plan language, and (b) it may conflict with state wage laws which require employees to consent to deductions from pay. Employers are urged to consult with their counsel, CPA, or payroll vendor before moving forward with these payroll deductions.
- Offset from valid FSA claims. Under this step, an employer will reduce the payment for valid Health FSA expenses submitted later to recover the unsubstantiated amounts. For example, if an employee has an unsubstantiated $100 expense and later requests reimbursement for a properly substantiated $300 expense, the employer can offset the $100 unsubstantiated amount by only reimbursing the employee $200.
- Treat it like other business debt. If all else fails, the employer can treat the unsubstantiated amounts as they would any other debts owed to them. If the employer takes steps, including legal action to collect other comparable debts owed, they’ll need to take those same steps here. In many cases, amounts owed for unsubstantiated Health FSA expenses will not justify the cost of legal action, but this is not universal. Employers should work with their counsel to determine if legal action is appropriate in these situations.
Note that during each of these steps, the employer can (and probably should) give the employee the opportunity to submit substantiation for the unsubstantiated expense. It is possible the employee is simply being slow to provide the evidence. Employers should understand how much time their vendor allows employees to substantiate expenses before initiating these steps and also what attempts to obtain substantiation the vendor makes. If at any point the employee does provide the proper substantiation, no further steps are necessary.
Payment of W-2 Wages
If the employer follows the steps described above and still cannot collect the unsubstantiated amounts, they may consider forgiving the amounts owed. Forgiveness doesn’t mean the employee gets a free pass; the forgiven amounts are included in the employee’s W-2 wages.
The theory behind this is that the employee received a tax benefit by making the Health FSA contribution and including the unsubstantiated amount in the employee’s taxable income removes the tax benefit they previously received. In addition, outside of certain exceptions, the tax code requires forgiven debt to be included in the employee’s income.
Note, however, that the IRS has not formally approved this approach. Employers should consult with counsel or a CPA on this approach given the potential tax implications to the employee and the Health FSA. To be clear, employers should not simply tax the improper reimbursement; they need to go through the above correction steps.
- Employers should become familiar with the Health FSA substantiation rules and understand how their Health FSA vendor is complying with these rules.
- Employers should request an accounting of unsubstantiated Health FSA expenses periodically from their vendor to understand how often and to what extent this occurs within their plan.
- Employers with high rates of unsubstantiated Health FSA expenses may benefit from issuing a communication on the substantiation requirements to employees.
- Employers will want to consult with their counsel, CPA, or payroll vendor to determine if withholding from employee pay is a viable option given state payroll laws and also review their plan language to ensure this practice is consistent with the plan terms.
- Employers should consult with their counsel to determine practices for addressing debts owed to the business, including forgiving the debt and including the amount in the employee’s income.
NOTICE OF DISCLAIMER
The information herein is intended to be educational only and is based on information that is generally available. HUB International makes no representation or warranty as to its accuracy and is not obligated to update the information should it change in the future. The information is not intended to be legal or tax advice. Consult your attorney and/or professional advisor as to your organization’s specific circumstances and legal, tax or other requirements.