In Chief Counsel Advice (CCA) 202317020[1], the IRS examines the consequences of specific reimbursement policies adopted as part of an IRC §125 cafeteria plan's health flexible spending account (FSA) and/or dependent care account. Specifically, in some cases, the IRS determines that the policy leads to the inclusion of reimbursements in the employee's income.

The IRS Explanation of the Underlying Law

In the Law and Analysis section of the advice, the IRS discusses various IRC provisions and regulations that affect the administration of IRC §125 cafeteria plans. The analysis begins by examining the exclusion from an employee’s income of various medical reimbursements paid by an employer under a qualified program that is not part of a cafeteria plan.

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.

…

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.[2]

However, to qualify for this exclusion, the program must not apply to amounts a taxpayer could receive regardless of whether the employee incurs medical expenses:

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.[3]

A similar set of rules applies to dependent care benefits provided by an employer:

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.[4]

Cafeteria plans under IRC §125 are a special case that allows an employer to establish a program where the employee can choose to defer a portion of their compensation in exchange for certain fringe benefits specifically permitted by §125. Such deferrals are excluded from an employee's income if the deferral is made to a plan that complies with IRC §125:

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.[5]

However, strict rules apply to the operation of the cafeteria plan in order to obtain the desired tax benefits for the employees. A key requirement for health FSAs and dependent care program relates to the requirement for the employee to provide adequate substantiation:

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.[6]

The plan must require all claims to be substantiated and cannot accept substantiation for only a percentage of claims:

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.[7]

A failure to follow these rules will require all amounts paid under the FSA to be included in the employee's income, not just the amounts that are not 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).[8]

Similar substantiation rules apply to dependent care assistance programs under cafeteria plans:

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.[9]

In both programs, expenses cannot be reimbursed until the actual expenses have been incurred:

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).[10]

Issues

The memorandum then examines two 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?[11]

The IRS reaches the following conclusions:

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.[12]

The IRS then addresses six situations to apply these conclusions.

Situation 1 – Detailed Substantiation Required for All Expenses

The first situation is outlined as follows:

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.

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).[13]

As expected, the IRS concludes that the requirements of this program, assuming they are enforced, will allow for the exclusion of reimbursements from the employees’ income.

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.[14]

Situation 2 – Self-Certification of Claims

Situation 2 is described as follows:

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-substantiated3 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.[15]

The IRS does not find this self-certification program acceptable, meaning all amounts reimbursed will be included in the employees’ income.:

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.[16]

Situation 3 – Substantiation by Sampling

In Situation 3, the IRS describes a program that uses a sampling technique to examine some otherwise unsubstantiated expenses:

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.[17]

The IRS does not approve of this technique either:

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.[18]

Situation 4 - De Minimis Amounts Not Substantiated

Situation 4 examines a case where the plan stipulates that charges below a certain amount do not need to be substantiated:

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.[19]

Once again, the IRS does not accept allowing no substantiation for small amounts:

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.[20]

Situation 5 – No Substantiation Required for Amounts Paid to Favored Providers

In Situation 5, the plan specifies that if certain “favored providers” are paid, the employee is not required to submit substantiation.:

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.[21]

This provision is also deemed unsatisfactory by the IRS:

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.[22]

Full Inclusion in Income Under Situation 2, 3, 4 and 5

The IRS highlights the consequences of using the flawed reimbursement schemes in Situations 2-5:

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.[23]

Situation 6 – Advance Substantiation for Dependent Care Assistance Program

The final situation examines a dependent care assistance program and the requirement of obtaining substantiation before the service is rendered:

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.[24]

The IRS points out that obtaining substantiation before the service is rendered is also a violation of the regulations.:

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.[25]

Situations 2-6 Are Also Plan Operational Issues

The IRS also observes that the last five situations could create potential plan qualification issues due to operational failures.:

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).[26]

[1] Chief Counsel Advice 202317020, April 28, 2023, https://www.taxnotes.com/research/federal/irs-private-rulings/legal-memorandums/fsa-medical-expense-reimbursements-are-includable-in-income/7gl6j (retrieved May 5, 2023)

[2] Chief Counsel Advice 202317020, April 28, 2023

[3] Chief Counsel Advice 202317020, April 28, 2023

[4] Chief Counsel Advice 202317020, April 28, 2023

[5] Chief Counsel Advice 202317020, April 28, 2023

[6] Chief Counsel Advice 202317020, April 28, 2023

[7] Chief Counsel Advice 202317020, April 28, 2023

[8] Chief Counsel Advice 202317020, April 28, 2023

[9] Chief Counsel Advice 202317020, April 28, 2023

[10] Chief Counsel Advice 202317020, April 28, 2023

[11] Chief Counsel Advice 202317020, April 28, 2023

[12] Chief Counsel Advice 202317020, April 28, 2023

[13] Chief Counsel Advice 202317020, April 28, 2023

[14] Chief Counsel Advice 202317020, April 28, 2023

[15] Chief Counsel Advice 202317020, April 28, 2023

[16] Chief Counsel Advice 202317020, April 28, 2023

[17] Chief Counsel Advice 202317020, April 28, 2023

[18] Chief Counsel Advice 202317020, April 28, 2023

[19] Chief Counsel Advice 202317020, April 28, 2023

[20] Chief Counsel Advice 202317020, April 28, 2023

[21] Chief Counsel Advice 202317020, April 28, 2023

[22] Chief Counsel Advice 202317020, April 28, 2023

[23] Chief Counsel Advice 202317020, April 28, 2023

[24] Chief Counsel Advice 202317020, April 28, 2023

[25] Chief Counsel Advice 202317020, April 28, 2023

[26] Chief Counsel Advice 202317020, April 28, 2023