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On April 28, 2023, the IRS’s Office of Chief Counsel published a recounting the existing claim substantiation requirements for medical and dependent care expense payments from flexible spending accounts (FSAs).  While this memorandum does not contain any new information, it serves as a useful reminder of the rules, particularly for employees who dislike having to provide receipts.  The IRS warns failure to abide by these rules disqualifies the entire plan, making all reimbursements from the FSA plan taxable for everyone.

A chief counsel letter provided back in gave a quick synopsis of the requirement for health FSAs to substantiate all medical claims except for certain debit card transactions meeting very specific rules for real-time substantiation or automatic substantiation (which we discuss below).  However, that letter was very brief and didn’t address dependent care expenses.  It’s therefore necessary to go back to IRS Notice to understand the details of debit card rules and dependent care substantiation.  That was 17 years ago, which provided lots of time for people to try “creative” shortcuts to some of those rules likely hoping the IRS wouldn’t notice.  It appears they did and thought it was high time to provide a refresher and address impermissible shortcuts head-on.

Below is a short summary of substantiation requirements and the impermissible shortcuts addressed in the memorandum.

Substantiation Requirements

All expenses must be substantiated by a third party.

Self-substantiation is never permitted (i.e., an employee cannot simply attest to the validity of the expense…third party proof is required).

Note: Bolded substantiation options below that rely on third party verification don’t require a receipt.

Medical FSA:

• Substantiation must include:
• Information describing the service or product,
• Date of the service or sale, and
• The employee’s share of the cost of the expense.

Real-time Substantiation Option:

• Employees may use FSA debit cards at retailers utilizing the Inventory Information Approval System (IIAS) without providing further receipts
• The IIAS system already pre-classifies every product sold in the store as to whether it’s a qualified medical expense or not in accordance with IRS rules
• Per IRS Notice 2006-69: “Card transactions using this method are fully substantiated without the need for submission of a receipt by the employee or further review”

Copayment Match Substantiation Option:

• If an employee uses an FSA debit card for “copayments in specific dollar amounts, and the dollar amount of the transaction at a health care provider (as identified by its merchant category code) equals an exact multiple of not more than five times the dollar amount of the copayment for the specific service…then the charge is fully substantiated without the need for submission of a receipt or further review”
• “In addition, if a health plan has multiple copayments for the same benefit, (e.g., tiered copayments for a pharmacy benefit), exact matches of multiples or combinations of the copayments (but not more than the exact multiple of five times the maximum copayment) will similarly be fully substantiated without the need for submission of a receipt or further review.”
• Note this only works for copayments matching the employer’s own health plan. If the employee has coverage through a spouse’s employer and their copayments are different, this copayment match method would only be available if the employer obtains substantiation of those copayment amounts from a third party and the employee’s FSA debit card is able to be programmed to recognize those copay amounts.

• Also note this wouldn’t work for copayments that are a percentage (e.g., coinsurance). Only flat dollar copay amounts can be programmed for a match.

Dependent Care FSA:

• Substantiation must include a statement from the daycare provider of the dates and amounts for daycare services previously provided (future expenses cannot be reimbursed in advance).

Daycare Down Payment Option:

• Employers could offer employees an option to pay initial expenses to the daycare provider out of their own pocket (not from the dependent care FSA) and submit the required substantiation to enable debit card use.
• Once the initial daycare service dates above have passed and the expense substantiated, the employer can then fund the debit card with the employee’s pre-tax contributions made thus far (not to exceed the amount of the recurring daycare expense previously substantiated).
• “Later card transactions that have been previously approved as to the dependent care provider and time period may be treated as substantiated without further review if the later card transactions are for an amount equal to or less than the previously substantiated amount.”
• If the daycare provider changes or amount changes, the employee must provide new substantiation.
• Basically, the debit card is funded as if it’s always reimbursing the employee for previous daycare expenses (because they prepaid first, then the debit card funding “reimburses” them for expenses already incurred and substantiated). However, rather than reimbursing the employee with cash and then the employee paying that cash to the daycare provider, the funds are loaded to the debit card instead to pay for daycare services about to be provided.

Impermissible Shortcuts Addressed by the IRS

With the understanding of what’s required and the options available to make third-party substantiation easier for some expenses, let’s explore the impermissible shortcuts the IRS addressed in their latest memorandum.  Consider this a cease-and-desist memo to FSA administrators who are attempting some form of these.

• Self-certification
  • We discussed above how third-party proof is required to substantiate expenses
  • Even optional substantiation methods require third-party proof
    • Real-time requires an IIAS system
    • Copay matching require having third-party proof of the health plan’s copays before programming the debit card to offer the match, and the provider must have a health care related merchant code to qualify
    • Daycare down payment requires having the daycare provider’s proof of the dates and amounts of recurring services
  • Self-certifying an expense is therefore not compliant
• Sampling
  • Every expense must be substantiated (with alternative options provided)
  • Requesting receipts for only random samples of expenses is not compliant
• De minimis
  • Every expense must be substantiated (with alternative options provided)
  • Only requesting receipts for expenses over a certain dollar amount is not compliant
• Favored providers
  • Every expense must be substantiated (with alternative options provided)
  • Only requesting receipts for expenses incurred at non-health care providers is not compliant…even expenses incurred at doctor’s offices, dentists, optometrists, and other health care providers must be substantiated (with alternative options provided)
• Advance substantiation for daycare expenses
  • Only daycare expenses already incurred are eligible for reimbursement
  • Providing a description of services to be provided in the future is not compliant
  • We discussed above the “down payment” option where the employee prepays the daycare provider and waits for the debit card to be funded after those services are rendered

IMA will continue to monitor regulator guidance and offer meaningful, practical, timely information. This material should not be considered as a substitute for legal, tax and/or actuarial advice. Contact the appropriate professional counsel for such matters. These materials are not exhaustive and are subject to possible changes in applicable laws, rules, and regulations and their interpretations.