Chief Counsel's Office Explains Substantiation Requirements for Cafeteria Plan Payments

(Parker Tax Publishing May 2023)

The Chief Counsel's Office advised that reimbursements of Code Sec. 213(d) medical expenses to an employee from a health flexible spending arrangement (health FSA) provided in a Code Sec. 125 cafeteria plan are included in the employee's gross income if any expense reimbursed by the health FSA is not fully substantiated. The Chief Counsel's Office further advised that if a Code Sec. 125 cafeteria plan does not require an independent third party to fully substantiate reimbursements for medical expenses, 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. Sec. 1.125-6(b) and is not a cafeteria plan within the meaning of Code Sec. 125. CCA 202317020.

Background

The Office of Chief Counsel was asked to advise whether reimbursements of Code Sec. 213(d) medical expenses to an employee from a health flexible spending arrangement (health FSA) provided in a Code Sec. 125 cafeteria plan are included in an employee's gross income under Code Sec. 105(b) if any Code Sec. 213(d) medical expenses of any employee are not substantiated in accordance with Prop. Reg. Sec. 1.125-6(b). In addition, the Chief Counsel's Office was asked whether expenses will 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.

Situation 1: An employer provides a Code Sec. 125 cafeteria plan with a health FSA that reimburses Code Sec. 213(d) medical expenses incurred by employees. The plan only reimburses Code Sec. 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. The plan also 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 (1) the date of the Code Sec. 213(d) medical care, and (2) 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 Code Sec. 213(d) medical expenses that meet the requirements of Prop. Reg. Sec. 1.125-6(c), (d), (e), and (f).

Situation 2 (Self-certification): The plan 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 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): 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): 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): 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 Code Sec. 125 cafeteria plan with a dependent care assistance program under Code Sec. 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.

Under Code Sec. 105(b), an employee may exclude from income 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 tax year) for personal injuries and sickness. Code Sec. 129 allows an employee to exclude amounts received through a dependent care assistance program if those amounts are paid to reimburse dependent care assistance expenses incurred by the employee. Amounts excluded from gross income under Code Sec. 105(b) are also excluded from wages subject to withholding under Code Sec. 3401. In addition, amounts paid to reimburse expenses incurred by the employee for medical care for personal injuries or sickness are excepted from wages for FICA and FUTA tax purposes.

Code Sec. 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. 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. If an employee elects to participate in a health FSA on a pre-tax basis through salary reduction under a Code Sec. 125 cafeteria plan, the value of the coverage by the health FSA is excludable from gross income under Code Sec. 106 as employer-provided accident or health coverage, and the amounts reimbursed for Code Sec. 213(d) medical expenses are excludable from gross income under Code Sec. 105(b) as amounts reimbursed for Code Sec. 213(d) medical expenses. If an employee elects to participate in a dependent care assistance program paid for through salary reduction under a Code Sec. 125 cafeteria plan, the dependent care assistance program benefits are excludable from gross income under Code Sec. 129.

Prop. Reg. Sec. 1.125-6(b)(2) provides that all claims for reimbursement must be substantiated and further provides that substantiating only a percentage of claims, or substantiating only claims above a certain dollar amount, fails to comply with the substantiation requirements. Prop. Reg. Sec. 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. Prop. Reg. Sec. 1.125-1(c)(7)(ii)(G) provides that a failure to comply with the substantiation requirements of Prop. Reg. Sec. 1.125-6 results in a failure of the cafeteria plan to operate in accordance with Code Sec. 125 and the proposed regulations.

FSAs for dependent care assistance must follow the substantiation rules applicable to health FSAs. Under Prop. Reg. Sec. 1.125-6(g), 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.

Analysis

The Chief Counsel's Office advised that in Situation 1, the substantiation of all claims complies with the requirements of Code Sec. 105(b) and the proposed regulations under Code Sec. 125 including the substantiation requirements under Prop. Reg. Sec. 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. However, in Situation 2, the Chief Counsel's Office found that the self-certification of claims that are not otherwise substantiated does not ensure that every claim be substantiated, and in Situation 3, the sampling technique does not ensure that every claim is substantiated. Because the plans in Situations 2 and 3 do not limit reimbursements or payments of claims to medical expenses that are substantiated, the plans do not satisfy the cafeteria plan substantiation requirements under Code Sec. 125.

In Situation 4, the plan does not require employees to substantiate charges to the debit card for claims below a dollar threshold. 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 plans in Situations 4 and 5 do not limit reimbursements or payments of claims to medical expenses that are substantiated (including expenses that are auto-substantiated), the Chief Counsel's Office advised that the plans do not satisfy the cafeteria plan requirements for substantiation under Code Sec. 125.

In Situations 2, 3, 4, and 5, the Chief Counsel's Office found that 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 Code Sec. 105(b). Therefore, in Situations 2, 3, 4, and 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, the Chief Counsel's Office found that 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 Chief Counsel's Office advised that the plan does not satisfy the requirements of Code Sec. 129 and does not satisfy the cafeteria plan requirements of Code Sec. 125. Therefore, the reimbursements for dependent care assistance expenses are not excludable from gross income under Code Sec. 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 Situations 2, 3, 4, 5, and 6, the Chief Counsel's Office advised that the failure to comply with the substantiation requirements of Prop. Reg. Sec. 1.125-6(b) results in the plans' failure to operate in accordance with its written plan or the failure to operate in accordance with Code Sec. 125 and Prop. Reg. Sec. 1.125-1(c)(7)(ii)(G).

For a discussion of the substantiation rules for expenses paid or reimbursed by cafeteria plans, see Parker Tax ¶122,545.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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