On April 23, 2023, the IRS Office of Chief Counsel issued Memorandum Number 202317020 (Memorandum) addressing issues related to claims substantiation for reimbursement from Medical and Dependent Flexible Spending Accounts (FSA) that are part of a cafeteria plan  (Plan) within the meaning of Internal Revenue Code (Code) §125. The Memorandum details six (6) situations in which a Plan takes varying approaches to substantiation and concludes that five (5) of the six (6) do not meet Plan requirements.

Key takeaways

• The Memorandum revisits long-standing substantiation requirements and reinforces that maturity of the industry or its technology has not changed the requirement to substantiate all FSA claims via an approved third-party method.
• Plans that use shortcut methods to substantiation, including self-certification, substantiation of a sample of claims (sampling), or “de minimis” thresholds, do not satisfy the cafeteria plan substantiation requirements.
• Reimbursements for unsubstantiated expenses are to be included in the gross income of employees.
• Employers should take action to ensure that their provider is appropriately substantiating all FSA claims.

Background
Revenue Ruling 2003-43, released in May 2003, approved the use of debit cards for FSAs, with requirements. Claims incurred using a debit card for these plans require substantiation, just as with a claim submitted via other methodologies, such as a claim form or online submission. Substantiation requirements include validating the expense was incurred within the plan year, by an eligible recipient, for an eligible service. Valid documentation would be provided by an independent third-party, often in the form of a bill for services or insurer Evidence of Benefits (EOB).

For the card to be compatible, it must include participant certification that it will only be used for compliant spending. Card usage must be merchant restricted (i.e., medical, dental, vision and pharmacy providers), and every card transaction must be substantiated. There are three IRS approved methods of electronic substantiation permitted: copays, recurring expenses and expenses substantiated in real-time by merchants who use specific technology known as IIAS to ensure that transactions are eligible expenses.

Failure to pass through electronic substantiation results in a request to the employee for documentation. In this scenario substantiation is viewed as a disjointed spending experience for the consumer. Employees spend with the card and then subsequently are asked to validate the expense with additional documentation to be reviewed and approved or denied by a claims analyst. While burdensome, these hoops keep the plan compliant under cafeteria plan requirements, affording the employee the pre-tax benefit they’ve come to enjoy.

No New News
Through this Memorandum, the IRS has taken the opportunity to address requests for assistance and clarification about substantiation. The IRS specifically addressed: 1) traditional substantiation methods, 2) self-certification, 3) sampling, 4) de minimis transactions, 5) favored providers and 6) advance substantiation for Dependent Care plans.

The Memorandum addresses a variety of approaches:

1. Traditional substantiation through independent third-party documentation and validation meet requirements to exclude these reimbursements from the employee’s income and wages for FICA and FUTA tax purposes.
2. Self-certification, samples, de minimis and use of preferred providers does not meet requirements to substantiate all claims per Code §125.
3. Claims for reimbursement from a dependent care assistance program are not considered substantiated if reimbursed before the expense has been incurred and therefore do not comply with Code §125.

In summary, failure to comply with substantiation requirements will result in a failure of the plan to operate in accordance with Code §125 and therefore result in taxable wages for the employee. While this is not a change to existing IRS guidance, it represents a refocused analysis of the impact shortcuts will have on the Plan’s compliance and will discourage Plans and providers alike from considering them acceptable.

What you can do
Employers should take action to ensure their plan is compliant with the substantiation requirements. The Memorandum provides a conversation piece to be circulated with contracted FSA administrators. Engaged employers have a vested interest to understand the methods their FSA administrator is deploying to substantiate claims, their plan’s auto-substantiation performance and actions taken to rectify claims that are denied because of the substantiation process.

A compliant substantiation process will include:

1. Trusted electronic substantiation methods approved by the IRS, which include copay matching, recurring expense logic, IIAS merchant approval and third-party carrier data files.
2. A multi-step outreach process for non-electronically substantiated claims.
3. Integrity of documentation review by trained analysts to include analysis of the date of service, provider, recipient, amount and service.
4. Debit card suspension if substantiation initiatives (such as notice and outreach) have proven unsuccessful.
5. Recoupment protocols, including repayment and alternate expense collection.

Employers must ensure that their Plan adheres to the analysis provided in the Memorandum. Use this analysis to revisit the topic with your provider. This refocused attention about accepted substantiation eliminates the ability to plea ignorance related to the IRS’ position on the outlined approaches.

Baker Tilly Vantagen, through our myFlexDollars platform, is a flexible spending account administrator delivering exceptional auto-substantiation results through approved IRS methods. We strictly adhere to the long-standing substantiation guidelines, deliver employee education on substantiation requirements, optimize technology for documentation submission and leverage our dedicated team of claims analysts to ensure compliance while driving a positive consumer experience for our employer partners.

For more information on this topic, or to learn how Baker Tilly Vantagen can help, contact our team.