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On April 28, 2023, the Internal Revenue Service’s (IRS) Office of Chief Counsel released guidance reiterating claims substantiation rules for health flexible spending arrangements (health FSAs) under Internal Revenue Code Section 125 and frowning upon certain substantiation practices that seem to have crept into common usage.

Quick Hits

  • All health FSA reimbursements must be fully substantiated using information from an independent third party.
  • Practices that do not satisfy the substantiation rules include self-certification, sampling, waiving substantiation of claims from favored providers, and not verifying expenses below a certain dollar threshold.
  • Noncompliant plans could be disqualified by the IRS, resulting in adverse tax consequences for the employer and all participating employees.

The rules for the required substantiation of FSA claims under Section 125 were originally set out in proposed regulations issued in 2007. Employers can rely on the proposed regulations pending the release of final regulations. To date, final regulations have not been issued.

The new guidance, IRS Chief Counsel Memorandum Number 202317020, serves as a reminder to employers that all health FSA reimbursements must be fully substantiated using information from an independent third party (generally the provider of the service for which reimbursement is sought).

While the guidance focuses primarily on health FSA substantiation rules, the guidance also briefly addresses substantiation under dependent care assistance programs (DCAP), and the impact of a failure to properly substantiate expenses.

The guidance addresses several practices that do not satisfy the Section 125 substantiation rules, and therefore are not compliant. These include:

  • Self-certification. This is a practice whereby participants certify that reimbursed amounts are valid health FSA expenses. However, this practice does not meet the substantiation rules because third-party information is not used to substantiate the expenses.
  • Sampling. This is a practice in which a small portion of all health FSA reimbursements are audited for substantiation, using third party information, but each and every expense is not individually substantiated.
  • Favored providers. Under this practice, substantiation requirements are waived for expenses originating from certain providers. Essentially, the employer trusts that all expenses originating with these favored providers constitute valid health FSA expenses, without requiring actual substantiation.
  • De minimis amounts. This practice does not require substantiation for reimbursements of small expenses of less than a specified dollar threshold.

Dependent Care Assistance Programs

In addition to its discussion of health FSA reimbursements, the guidance briefly addresses DCAP expense reimbursement, reiterating that DCAP expenses may not be reimbursed before the dependent care services are actually provided. That is, an employee cannot be reimbursed for anticipated future dependent care expenses. DCAP expenses are only eligible for reimbursement after the expenses have been incurred, and they are incurred when the dependent care is provided.

Substantiation Failures and Section 125 Consequences

In the guidance, the IRS reminds employers that plans that fail to comply with the substantiation requirements are noncompliant with Section 125. A noncompliant plan could be disqualified by the IRS, resulting in adverse tax consequences for the employer and all participating employees. Also, any expense reimbursements that are not substantiated in accordance with the Section 125 rules are taxable wages, subject to the same income and employment taxes and withholding requirements as any other wages.

Employers may want to revisit their FSA substantiation practices—or those of their service providers—to ensure compliance with the Section 125 requirements, including this recent IRS guidance.

Ogletree Deakins’ Employee Benefits and Executive Compensation Practice Group will continue to monitor developments and will provide updates on the Employee Benefits and Executive Compensation blog as additional information becomes available.

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