A IRS Chief Counsel recently addressed an inquiry whether unsubstantiated medical expenses reimbursed by a health Flexible Spending Account (FSA) may be excluded from gross income (IRS Chief Counsel Advice 202317020, 3/29/2023, released 4/28/2023).
Background — Code Sec. 125 cafeteria plans.
A cafeteria plan is defined as a written plan maintained by an employer under which all participants are employees, and all participants may choose among two or more benefits consisting of cash and qualified benefits.
Background—Health care FSAs.
Health care FSAs are benefit plans established by employers to reimburse employees for health care expenses, such as deductibles and medical expenses such the cost of prescriptions or medical devices. FSAs qualify for tax advantages as a Code Sec. 125 “cafeteria plan.” They are usually funded by employees through salary reduction agreements, although employers may contribute as well. Contributions to and withdrawals from FSAs are tax-free if the expenses are substantiated.
Background – Dependent care assistance benefits.
Amounts paid or incurred by the employer for dependent care assistance benefits provided to the employee are excluded from the employee’s income if the assistance is furnished pursuant to a dependent care assistance program (DCAP). Under Code Sec. 129, the amount of dependent care assistance benefits that can be excluded is subject to an annual limit (the “annual limit”) of $5,000 ($2,500 in the case of a separate return filed by a married taxpayer).
Unsubstantiated medical expenses.
The CCA clarifies if unsubstantiated Code Sec. 213(d) medical expenses are reimbursed through an FSA, those amounts must be included in the gross income of the employee. Further, the CCA goes on to explain if the cafeteria plan does not require substantiation, accepts “sampling” of expenses, permits self-certification, or establishes a threshold dollar amount where substantiation is not required, the plan fails to meet the requirements under Prop Reg. § 1.125-6(b) and therefore the plan is not a cafeteria plan. Such reimbursements are taxable for federal withholding tax, FICA, and FUTA taxes.
Dependent care reimbursements prior to use.
The IRS also explains where dependent care expenses are reimbursed before the expenses are incurred, such reimbursements may not be excluded from gross income if the expenses are not subsequently substantiated after being incurred.
For further information regarding cafeteria plans, see Payroll Guide ¶ 3500 et seq.
For further information regarding FSAs, see Payroll Guide ¶3510.
For further information regarding dependent care assistance programs, see Payroll Guide ¶3655.
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