By: HUB’s EB Compliance Team

The IRS recently released a Chief Counsel Memo confirming its long-standing position that all flexible spending account (“FSA”) expenses must be substantiated. This means that, no matter how small, each expense must have some kind of third-party verification. While Chief Counsel Memos are not official, binding IRS guidance, they are informative of the IRS’s views in a particular area.

Insubstantial Substantiation Approaches

The memo goes through a variety of other approaches that are sometimes proposed for FSA substantiation (none of which work), including:

  1. Self-certification – The IRS says this does not work because there is no verification of the expense from a third party.
  2. Sampling – Some vendors only look at a sample of expenses (particularly debit card expenses) rather than requiring proof for each one. This is not permitted.
  3. De minimis/below a certain threshold – All expenses must have some kind of proof, no matter how small. Expenses below a certain threshold (e.g., $100) do not get a pass.
  4. Favored providers – Not requiring substantiation from certain providers is also not permitted. Note that some expenses paid for with a debit card can be auto-substantiated, such as (1) transactions involving dollar amounts that match the copayments under the employer’s health plan covering the employee, spouse, or dependents; (2) certain recurring, previously approved expenses (like maintenance medications); (3) certain charges that are substantiated at the point of sale; and (4) charges incurred at merchants that use an inventory information approval system. The IRS has substantial details on how these auto-substantiation rules work. However, if one of these exceptions does not apply, it is not enough to simply give a provider a “pass.”
  5. Substantiation In Advance – An employee cannot simply submit a statement of dependent care expenses they expect to incur and be told they just need to come back if something changes. This does not work.

What Happens?

According to the IRS memo, it is not only these unsubstantiated expenses that are taxable. If expenses are not properly substantiated, then the employer’s cafeteria plan is invalid. In other words, all deductions for medical insurance premiums, FSAs, and any other items would be treated as taxable compensation to the employees. All FSA reimbursements would be taxable as well. This could result in substantial additional income, Medicare, and Social Security taxes for the employer and the employees.

Takeaway

Most employers do not adjudicate FSA claims themselves. They typically rely on third parties to adjudicate claims and obtain substantiation. Employers should check with their third-party providers to determine if they are complying with the FSA substantiation rules.

As noted above, this is a Chief Counsel Memo, and therefore not binding guidance. However, it is consistent with the existing proposed cafeteria plan regulations (and in fact cites them repeatedly). Therefore, it is likely that this is the position an IRS auditor would take in any review of an employer’s cafeteria plan.

If you have any questions, please contact your HUB Advisor. You can also view more compliance articles in our Compliance Directory.

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.