IRS Chief Counsel Memorandum 202317020 (Mar. 29, 2023)
Available at https://www.irs.gov/pub/irs-wd/202317020.pdf
The IRS Chief Counsel’s office has released a memorandum that addresses the substantiation requirements for medical and dependent care expenses and the consequences of various substantiation shortcuts. The memo reconfirms that medical expense reimbursements from a health FSA are included in an employee’s gross income if the health FSA fails to fully substantiate any expense of any employee in accordance with IRS rules (see our Checkpoint article). Furthermore, cafeteria plans that do not require an independent third party to fully substantiate all medical expense reimbursements (e.g., by permitting employee self-certification or by substantiating only some expenses (sampling) or not substantiating expenses below a “de minimis” dollar amount or from “favored providers”) or do not require substantiation of all DCAP reimbursement claims fail to operate in accordance with those rules and will not qualify as cafeteria plans under the Code, resulting in gross income to employees. The memo also reconfirms that dependent care expense reimbursements cannot be excluded from an employee’s gross income if any such expenses of any employee are not substantiated after the expense is incurred.
The memo addresses six situations. In the first, a cafeteria plan employs traditional substantiation methods under its health FSA, only reimbursing eligible medical expenses that are substantiated by information from an independent third party (i.e., a party independent of the employee and the employee’s spouse and dependents) that describes the service or product, the date of service or sale, and the amount of the expense. The plan also makes reimbursements using “EOB rollover” procedures that comply with IRS rules, requires employees to certify that expenses have not been reimbursed by insurance or otherwise and that they will not seek reimbursement from any other plan covering health benefits, and provides a debit card program that complies with IRS rules. [EBIA Comment: It is interesting to note that the IRS has reiterated that the individual will not “seek reimbursement” from another plan rather than requiring that there be no other source of reimbursement.] In this situation, the memo explains, all claims are substantiated in accordance with applicable Code and IRS requirements.
Four situations involve plans with different practices: allowing employee self-certifications (instead of independent third-party statements); not requiring an independent third-party statement for debit card charges that are not auto-substantiated; or using sampling, de minimis, or favored provider approaches for debit card charges. According to the memo, because reimbursements are not limited to expenses that are substantiated, the plans do not satisfy applicable substantiation requirements and all reimbursements made during the year—including reimbursements of substantiated expenses—are included in employees’ gross income. In the remaining situation, the plan automatically reimburses DCAP participants each pay period for a pro rata portion of their attested annual dependent care expenses. Reimbursements are not limited to expenses that have been incurred or substantiated, so the plan does not satisfy applicable substantiation requirements and all payments made during the year are included in employees’ gross income. The memo also notes that cafeteria plans in these five situations fail to operate in accordance with their written plans and the cafeteria plan rules.
EBIA Comment: The IRS’s latest reminder of the substantiation requirements for health FSAs and DCAPs does not break any new ground—the rules have been in place for many years and the prohibition on substantiation shortcuts is well known (for example, see our Checkpoint article and our Checkpoint Question of the Week). Nevertheless, it serves as a helpful review of the rules, while also underscoring the potential problems with some current arrangements and making it even more difficult for plans that are not in compliance to say they “didn’t get the memo.” We find it interesting that the memo is directed to the employment tax policy division, perhaps signaling direction for audit activity. Employers and plan service providers may want to take this opportunity to check their expense review and approval practices to ensure compliance with applicable rules. For more information, see EBIA’s Cafeteria Plans manual at Sections XX.J (“Health FSAs: Adequate Claims Substantiation Must Be Received From the Participant and an Independent Third Party”), XXI.G (“Electronic Payment Card Programs for Health FSAs”), and XXIV.M (“DCAPs: Adequate Claims Substantiation Must Be Received”).
Contributing Editors: Thanks to attorney John R. Hickman for his contributions to this article, with final editing by EBIA staff. Mr. Hickman is a partner in the Employee Benefits Practice Group with Alston & Bird in Atlanta, www.alston.com, and is a Contributing Author of EBIA’s Cafeteria Plans, Consumer-Driven Health Care, and Health Care Reform manuals.
