IRS Memo Addresses Claims Substantiation of Medical and Dependent Care Expenses

On March 29, 2023, the IRS Chief Counsel’s office published a memorandum that addresses the claim substantiation requirements for health FSA and dependent care assistance program (DCAP) expenses. The memo illustrates the situations when an expense fails to be properly substantiated in accordance with IRS rules. The memo affirms that any health FSA and DCAP expense, regardless of the amount, must be fully substantiated. Otherwise, the expense must be included in an employee’s gross income and is considered wages subject to applicable payroll tax withholding.

Furthermore, Section 125 cafeteria plans that do not require an independent third party to fully substantiate all medical expense reimbursements fail to operate in accordance with IRS rules. Thus, any benefits that any employee elects under the cafeteria plan must be included in gross income. The examples of impermissible claim administration processes provided in the memo are when a plan:

• Allows employees to self-certify their health FSA and DCAP expenses.
• Substantiates only some expenses (sampling).
• Substantiates expenses below a “de minimis” dollar amount or from “favored providers.”

Additionally, the memo reaffirms that dependent care expenses must be substantiated after the expense is incurred and should not be reimbursed before the expenses are incurred in order for the benefits to be excluded from the employee’s gross income.

The memo provides examples of six situations. The first situation illustrates the best practice for employers where all claims are substantiated in accordance with IRS rules. In this situation, the Section 125 cafeteria plan only reimburses eligible medical expenses (generally, as defined by Section 213(d)) that are substantiated by information from an independent third party of the employee and the employee’s spouse and dependents that describes the service or product, the date of service or sale, and the amount of the expense. Additionally, the plan reimburses expenses based on information from an independent third party, such as an “explanation of benefits (EOB)” from an insurance company. Further, the plan requires employees to certify that expenses have not been reimbursed by insurance or otherwise and that they will not seek reimbursement from any other plan covering health benefits and provides debit cards that can be used to reimburse eligible medical expenses under IRS rules.

The other situations (2 – 6) exemplify plans with different claim processing practices that reimburse unsubstantiated medical expenses under the cafeteria plan. Therefore, any unsubstantiated medical expenses are not excludable from gross income. These situations involve plans allowing employee self-certification of expenses (rather than an independent third party’s substantiation), a “sampling” approach where only a random sample is substantiated, the omission of substantiation for de minimis amounts or a favored provider approach for debit card charges. Accordingly, all reimbursements made during the year, including amounts paid to reimburse substantiated medical expenses, are included in the employees' gross income.

Though the memo did not introduce new guidance, it reminds employers who sponsor health FSA plans and/or DCAPs of the importance of ensuring all claim reimbursements are fully substantiated in accordance with IRS rules. Employers should review these substantiation rules with their health FSA and DCAP vendor(s) to ensure that the proper claims processing and substantiation systems are set up and communicated to employees.

IRS Chief Counsel Memorandum »