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Understanding FSA Substantiation

Flexible Spending Accounts (FSAs) have long been a valuable tool for employees to save on healthcare and dependent care expenses. With these arrangements, the IRS often requires substantiation to verify that these funds are being used on eligible expenses. FSA substantiation refers to the process of providing documentation or proof that an expense claimed under an FSA or DCA is eligible and compliant with IRS guidelines. It helps prevent fraudulent claims and creates a paper trail, allowing employers and FSA participants to maintain accurate records of expenses and provide documentation if audited by the IRS.

Recently, the IRS issued a Chief Counsel memo regarding FSA and DCA substantiation requirements to remind employers of its importance. The memorandum addresses two main issues:

  1. Whether reimbursements of medical expenses from a health flexible spending arrangement (FSA) provided in a cafeteria plan should be included in an employee's taxable income if the expenses are not substantiated according to proposed regulations.
  2. Whether expenses will be considered properly substantiated if employees self-certify their expenses, if the plan only substantiates some expenses through "sampling", if only amounts over a certain threshold are substantiated, if charges with favored providers are not substantiated, or if dependent care expenses are reimbursed before they are incurred.

Key Points

  1. Reimbursements of medical expenses from a health FSA provided in a cafeteria plan are included in an employee's taxable income if any expense of any employee reimbursed by the health FSA is not fully substantiated, including expenses below a certain dollar amount.
  2. If a Section 125 cafeteria plan does not require independent third-party substantiation for medical expenses, does not substantiate expenses below specific dollar amounts, or does not substantiate reimbursements for dependent care expenses, it fails to comply with the substantiation requirements and is not considered a cafeteria plan. Consequently, any benefits elected under the cafeteria plan must be included in gross income and are subject to taxation.
  3. Reimbursements of dependent care expenses cannot be excluded from an employee's gross income if any expenses under the dependent care assistance program are not substantiated after the costs have been incurred.

The memo provides various scenarios illustrating different methods of substantiating expenses. It also discusses the tax implications of reimbursing medical and dependent care expenses through certain employee benefit plans, emphasizing the importance of proper substantiation to exclude these reimbursements from an employee's taxable income.

What Counts as Substantiation?

Participants typically need to provide relevant documentation for those expenses which are not auto-substantiated (e.g., IIAS merchants). Usually, receipts, itemized invoices, and even an Explanation of Benefits (EOB) from the insurance company can be used as substantiation. The specific requirements may vary based on the FSA administrator and the nature of the expense but typically should include the date of purchase, description of service/item, dollar amount, and the provider or store name.

If you are an FSA participant with Medcom and have any questions, you can reach us at 800-523-7542, option 1. Employers, if you have any questions or would like Medcom to help your company walk through the steps of FSA administration and how it can benefit your company and its employees, please don't hesitate to contact us.

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