Every FSA claim must be substantiated by an independent third party, or the whole cafeteria plan's benefits become taxable

Plain-English summary

This Chief Counsel Advice tells IRS employment tax policy staff how strict the
substantiation rules are for health and dependent care flexible spending
arrangements (FSAs) inside a Section 125 cafeteria plan. The core rule: every
claim must be fully verified by an independent third party (for example, an
insurer's explanation of benefits), for every dollar, before it is reimbursed.
The advice walks through six situations. A plan that verifies all claims that
way is fine (Situation 1). But shortcuts all fail: letting employees
self-certify expenses, checking only a random sample of claims, skipping
verification for small "de minimis" charges, waiving verification for favored
providers, or paying dependent care claims in advance before the care is
provided. When a plan uses any of these shortcuts, it stops being a valid
cafeteria plan. The consequence is severe and plan-wide: not just the
unverified claims, but all benefits any employee elects under the plan
(including properly documented reimbursements) become gross income and count
as wages subject to FICA, FUTA, and income tax withholding.

Ruling snapshot

• Question: Do FSA reimbursement shortcuts (self-certification, sampling, de minimis, favored providers, advance dependent care payment) satisfy the cafeteria plan substantiation rules, and what happens if they do not?
• Outcome: Advice given (the shortcuts fail; unsubstantiated claims cause all elected benefits to be taxable wages)
• Key authorities: IRC §§ 105(b), 125, 129, 213(d), 3121, 3306, 3401; Treas. Reg. § 1.105-2; Prop. Reg. §§ 1.125-1, 1.125-6; Rev. Rul. 2003-43; Notice 2006-69

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service

memorandum

Number: 202317020
Release Date: 4/28/2023
CC:EEE:EB
PRESP-100762-23

UILC: 105.00-00, 125.00-00, 129.00-00

date: March 29, 2023

to: Jay Jensen
SB/SE Employment Tax Policy

from: Laura Warshawsky
Deputy Associate Chief Counsel (Employee Benefits)
CC:EEE:EB

subject: Claims Substantiation for Payment or Reimbursement of Medical and Dependent
Care Expenses

This Chief Counsel Advice responds to your request for assistance. This advice may not
be used or cited as precedent.

ISSUES

(1) Are reimbursements of section 213(d) medical expenses to an employee from a
health flexible spending arrangement (health FSA) provided in a section 125
cafeteria plan included in an employee's gross income under section 105(b) if
any section 213(d) medical expenses of any employee are not substantiated in
accordance with proposed regulation § 1.125-6(b)?

(2) Will expenses be considered properly substantiated if employees self-certify
expenses, if the plan substantiates only some expenses "sampling", if only
amounts over a certain level (i.e., de minimis amounts) are substantiated, if
charges with favored providers are not required to be substantiated, or if
dependent care expenses are reimbursed before the expenses are incurred?

CONCLUSION

Reimbursements of section 213(d) medical expenses to an employee from a health
FSA provided in a section 125 cafeteria plan are included in the gross income of such
employee if any expense of any employee reimbursed by the health FSA is not fully
substantiated including if any expenses below a certain threshold are not substantiated.

If a section 125 cafeteria plan does not require an independent third party to fully
substantiate reimbursements for medical expenses (for example, by permitting self-
certification of expenses, "sampling" of expenses, or certification by favored providers),
does not require substantiation for medical expenses below certain dollar amounts, or
does not substantiate reimbursements for dependent care assistance expenses, then
the plan fails to operate in accordance with the substantiation requirements of Prop.
Reg. § 1.125–6(b) and is not a cafeteria plan within the meaning of section 125.
Therefore, the amount of any benefits that any employee elects under the cafeteria plan
must be included in gross income and is wages for Federal Insurance Contributions Act
(FICA) and Federal Unemployment Tax Act (FUTA) purposes subject to withholding.

In addition, an employer may not exclude reimbursements of dependent care expenses
from an employee's gross income if any expenses of any employee under the
dependent care assistance program are not substantiated after the expense has been
incurred.[1]

FACTS

Situation 1. An employer provides a section 125 cafeteria plan with a health FSA that
reimburses section 213(d) medical expenses incurred by employees. The plan only
reimburses section 213(d) medical expenses that are substantiated by information from
a third party that is independent of the employee and the employee's spouse and
dependents. In addition, the information from the third party describes the service or
product, the date of service or sale, and the amount of the expense.

In addition, the plan reimburses expenses based on information from an independent
third party such as an "explanation of benefits" from an insurance company. The plan
requires that information from the independent third party include (i) the date of the
section 213(d) medical care, and (ii) the employee's share of the cost of the medical
care (that is, coinsurance payments and amounts below the deductible). The plan also
requires the employee to certify that any expense paid by the plan has not been
reimbursed by insurance or otherwise and that the employee will not seek
reimbursement from any other plan covering health benefits.[2]

Lastly, the plan provides debit cards that can be used to reimburse section 213(d)
medical expenses that meet the requirements of Prop. Reg. § 1.125-6 (c), (d), (e), and
(f).

Situation 2. Self-certification. Instead of only reimbursing expenses that are
substantiated as described in Situation 1, the plan also reimburses employees for
medical expenses for which an employee only submits information describing the
service or product, the date of service or sale, and the amount of the expenses, but
does not provide a statement from an independent third party (either automatically or
after the transaction) to verify the expenses. Further, the plan does not substantiate
debit card charges (including charges that are not auto-substantiated[3] expenses for
recurring medical expenses incurred at certain providers that match the amount,
medical care provider, and time period of previously approved expenses) with a
statement from an independent third party.

Situation 3. Sampling. In addition to reimbursing expenses that are substantiated as
described in Situation 1, the plan reimburses all charges to the debit card and only
requires substantiation of a random sample of otherwise unsubstantiated charges to the
debit card (that is, charges that are not auto-substantiated) through third-party
information describing the service or product and the date of the service or sale.

Situation 4. De minimis. In addition to reimbursing expenses that are substantiated as
described in Situation 1 or expenses that are auto-substantiated, if a charge to the debit
card is less than a specified dollar amount, the plan does not require substantiation of
the charge to the debit card through additional third-party information describing the
service or product and the date of the service or sale.

Situation 5. Favored providers. In addition to reimbursing expenses that are
substantiated as described in Situation 1 or expenses that are auto-substantiated, if a
charge to the debit card is from certain dentists, doctors, hospitals or other health care
providers, the plan does not require substantiation of the charge to the debit card
through additional third-party information describing the service or product and the date
of the service or sale.

Situation 6. Advance Substantiation for Dependent Care Assistance Program. An
employer provides a section 125 cafeteria plan with a dependent care assistance
program under section 129 that reimburses dependent care expenses incurred by
employees. The plan allows employees to submit a form in advance of receiving the
dependent care, attesting to the amount of dependent care expenses they will incur in
the upcoming year. The plan requires employees to notify the plan sponsor if their
dependent care situation changes and they will not incur the amount of qualified
dependent care expenses to which they attested for that year. The employee is
automatically reimbursed every pay period a pro rata amount of the amount of
dependent care assistance expenses to which the employee attested.

[1] See Prop. Reg. § 1.125–6(b)(2) and Notice 2006–69, 2006-31 IRB 107, 109.
[2] See Prop. Reg. § 1.125-6(b)(3)(ii).
[3] The term auto-substantiated refers to medical expenses that may be approved without additional
substantiation under Prop. Reg. § 1.125-6(e)(4) Certain recurring medical expenses. This method of
substantiation allows a payment of a recurring expense that is for a medical expense incurred at certain
providers that matches the amount, medical care provider, and time period of previously approved
expenses to be automatically substantiated.

LAW AND ANALYSIS

Section 61(a)(1) of the Internal Revenue Code and Treas. Reg. § 1.61-21(a)(3) provide
that, except as otherwise provided in subtitle A, gross income includes compensation
for services, including fees, commissions, fringe benefits, and similar items.
In general, under section 105(b), an employee may exclude amounts received through
employer-provided accident or health insurance if those amounts are paid to reimburse
expenses incurred by the employee for medical care (of the employee, the employee's
spouse, or the employee's dependents, as well as children of the employee who are not
dependents but have not attained age 27 by the end of the taxable year) for personal
injuries and sickness.

In general, under section 129, an employee may exclude amounts received through a
dependent care assistance program if those amounts are paid to reimburse dependent
care assistance expenses incurred by the employee. Section 129(e)(9) generally
requires identifying information of the dependent care service provider to be included in
the employee's tax return for the amounts to be excluded under section 129.

Sections 3101 and 3111 impose FICA taxes on "wages," as defined in section 3121(a),
with respect to "employment," as that term is defined in section 3121(b). "Wages" is
defined in section 3121(a) for FICA purposes as all remuneration for employment, with
certain specific exceptions. Section 3121(b) defines the term "employment" as any
service, of whatever nature, performed by an employee for the person employing him,
with certain specific exceptions.

Section 3301 imposes FUTA taxes on wages paid with respect to employment. The
general definitions of the terms "wages" and "employment" for FUTA tax purposes are
similar to the definitions for FICA tax purposes. See section 3306(b) and (c).

Section 3402(a), relating to federal income tax withholding, generally requires every
employer making a payment of wages to deduct and withhold upon those wages a tax
determined in accordance with prescribed tables or computational procedures. The term
"wages" is defined in section 3401(a) for federal income tax withholding purposes as all
remuneration for services performed by an employee for his employer, with certain
specific exceptions.

Amounts excluded from gross income under section 105(b) are also excluded from
wages subject to income tax withholding under section 3401. In addition, amounts paid
to reimburse expenses incurred by the employee for medical care (of the employee, the
employee's spouse, or the employee's dependents, as well as children of the employee
who are not dependents but have not attained age 27 by the end of the taxable year) for
personal injuries or sickness are excepted from wages for FICA and FUTA tax purposes
under sections 3121(a)(2) and 3306(b)(2), respectively.

Section 3121(a)(5)(G) provides an exception from FICA wages for any payment to or on
behalf of an employee under a cafeteria plan (within the meaning of section 125) if such
payment would not be treated as wages without regard to such plan and it is reasonable
to believe that (if section 125 applied for purposes of section 3121) section 125 would
not treat any wages as constructively received. Section 3306(b)(5)(G) contains a similar
exception from wages for purposes of FUTA tax.

Treas. Reg. § 1.105-2 provides that the exclusion under section 105(b) does not apply
to amounts a taxpayer would be entitled to receive whether or not the taxpayer incurs
expenses for medical care.

Section 125 allows an employer to establish a cafeteria plan that permits an employee
to choose among two or more benefits, consisting of cash (generally, in the form of
salary reduction) and qualified benefits, including accident or health coverage.
Section 125 provides that the amount an employee contributes to the plan on a pre-tax
basis through salary reduction that is applied to purchase the coverage is not included
in gross income, even though it is available to the employees and the employee could
have chosen to receive cash instead. If an employee elects to participate in a health
FSA on a pre-tax basis through salary reduction under a section 125 cafeteria plan, the
value of the coverage by the health FSA is excludable from gross income under section
106 as employer-provided accident or health coverage, and the amounts reimbursed for
section 213(d) medical expenses are excludable from gross income under
section 105(b) as amounts reimbursed for section 213(d) medical expenses. If an
employee elects to participate in a dependent care assistance program paid for through
salary reduction under a section 125 cafeteria plan, the dependent care assistance
program benefits are excludable from gross income under section 129.

Prop. Reg. § 1.125–1(c)(7)(ii)(G) provides that a failure to comply with the
substantiation requirements of Prop. Reg. § 1.125–6 results in a failure of the cafeteria
plan to operate in accordance with section 125 and the Proposed Treasury Regulations
thereunder. In general, a cafeteria plan that fails to operate in accordance with these
requirements is not a cafeteria plan and employees' elections between taxable and
nontaxable benefits result in gross income to the employees.

Prop. Reg. § 1.125–6(b)(2) provides that all claims for reimbursement must be
substantiated. Prop. Reg. § 1.125–6(b)(2) provides that "[s]ubstantiating only a
percentage of claims, or substantiating only claims above a certain dollar amount, fails
to comply with the substantiation requirements of § 1.125–1 and this section." See also
Treas. Reg. § 1.105–2; Rev. Rul. 2003–43, 2003–21 IRB 935 (holding that sampling
techniques do not satisfy the substantiation requirements). Prop. Reg. § 1.125–6(b)(3)
provides that all claims for reimbursement must be substantiated by an independent
third party and may not be self-substantiated.

Specifically, Prop. Reg. § 1.125–6(b)(3) provides that "[a]ll expenses must be
substantiated by information from a third party that is independent of the employee and
the employee's spouse and dependents." All amounts paid under a health FSA that
permits self-substantiation are included in gross income, including amounts that are
reimbursed for medical expenses, whether or not substantiated. See Notice 2006–69,
2006–31 IRB 107, 109 (holding that self-certification does not satisfy the substantiation
requirements).

Flexible spending arrangements for dependent care assistance must follow the
substantiation rules applicable to health FSAs. Prop. Reg. § 1.125–6(g) provides
additional rules for reimbursing dependent care assistance through a debit card. If an
employee submits the dependent care expenses to the employer through a debit card,
these expenses must be substantiated by providing a statement from the dependent
care provider substantiating the dates and amounts for the dependent care services
provided.

Prop. Reg. § 1.125–6(a)(4) provides that reimbursements of dependent care expenses
may not be reimbursed before the expenses are incurred. Dependent care expenses
are incurred when the care is provided and not when the employee is formally billed or
charged for (or pays for) the dependent care.

Prop. Reg. § 1.125–6(b)(4) provides that reimbursing expenses before the expense has
been incurred or before the expense is substantiated fails to satisfy the substantiation
requirements of Treas. Reg. § 1.105–2, Prop. Reg. § 1.125–1 and Prop. Reg. § 1.125–
6(b)(4).

DISCUSSION

In Situation 1, the substantiation of all claims complies with the requirements of
section 105(b) and the proposed regulations under section 125 including the
substantiation requirements under Prop. Reg. § 1.125–6(b). Nothing in the way the plan
substantiates the claims will prevent the employer from excluding the amounts
reimbursed from the employee's income and wages for FICA and FUTA tax purposes.

In Situation 2, the self-certification of claims that are not otherwise substantiated does
not ensure that every claim be substantiated. Because the plan does not limit
reimbursements or payments of claims to medical expenses that are substantiated, the
plan does not satisfy the cafeteria plan substantiation requirements under section 125.
See Prop. Reg. § 1.125–6(b) requiring substantiation for all claims, regardless of the
amount, and Prop. Reg. § 1.125–6(b)(3) prohibiting self-substantiation of medical
expenses. See also Notice 2006–69, 2006–31, IRB 107 providing that all amounts paid
under a health FSA plan that allows self-substantiation of medical claims are included in
gross income.

In Situation 3, the sampling technique does not ensure that every claim is substantiated.
Because the plan does not limit reimbursements or payments of claims to medical
expenses that are substantiated, the plan does not satisfy the cafeteria plan
substantiation requirements under section 125. See Prop. Reg. § 1.125–6(b) requiring
substantiation for all claims, regardless of the amount and Rev. Rul. 2003–43 holding
that sampling techniques do not satisfy the substantiation requirements.

In Situation 4, the plan does not require employees to substantiate charges to the debit
card for claims below a dollar threshold. Because the plan does not limit
reimbursements or payments of claims to medical expenses that are substantiated
(including expenses that are auto-substantiated), the plan does not satisfy the cafeteria
plan requirements for substantiation under section 125. See Prop. Reg. § 1.125–6(b)
requiring substantiation for all claims, regardless of the amount.

In Situation 5, the plan does not require employees to substantiate charges to the debit
card from certain dentists, doctors, hospitals, or other health care providers. Because
the plan does not limit reimbursements or payments of claims to medical expenses that
are substantiated (including expenses that are auto-substantiated), the plan does not
satisfy the cafeteria plan requirements for substantiation under section 125. See Prop.
Reg. § 1.125–6(b) requiring substantiation for all claims, regardless of the amount.

In Situation 2, Situation 3, Situation 4, and Situation 5, the plan fails to satisfy the
requirement to substantiate medical expenses. Reimbursements for unsubstantiated
medical expenses under the cafeteria plan are not excludable from gross income under
section 105(b). Therefore, in Situation 2, Situation 3, Situation 4, and Situation 5 all
reimbursements made during the year, including amounts paid to reimburse
substantiated medical expenses, are included in the gross income of the employees.

In Situation 6, all claims for payment or reimbursement of the employee's dependent
care assistance program are not substantiated because they are claimed in advance
without additional verification. Because the plan does not limit reimbursements or
payments of claims to dependent care assistance expenses that have been incurred or
substantiated, the plan does not satisfy the requirements of section 129 and does not
satisfy the cafeteria plan requirements of section 125. Therefore, the reimbursements
for dependent care assistance expenses are not excludable from gross income under
section 129, and all payments made during the year under the dependent care
assistance program are included in the gross income and wages of the employees for
FICA and FUTA tax purposes.

Further, in Situation 2, Situation 3, Situation 4, Situation 5, and Situation 6, failure to
comply with the substantiation requirements of Prop. Reg. § 1.125–6(b) results in the
failure to operate in accordance with its written plan or the failure to operate in
accordance with section 125 and Prop. Reg. § 1.125–1(c)(7)(ii)(G).

Please call (202) 317-6700 if you have any further questions.