IRS Substantiation Rules Update

The IRS’s Chief Counsel released a memorandum that confirmed the IRS’s position on the substantiation of medical and dependent care expenses. See IRS Chief Counsel Memorandum 202317020. The guidance addressed two questions: (1) How are medical reimbursements treated if they are not properly substantiated and (2) Whether plans can adopt short-cuts to the substantiation rules, such as “sampling,” self-certification, de-minimis rules, or treating certain providers as “favored.” While the latest IRS guidance did not break any new ground, it’s important for trustees, administrators, and plan professionals to be aware of both the rules and their consequences.

In addressing these questions, the IRS reiterated that any amounts which are not substantiated in accordance with the cafeteria plan regulations are considered “wages.” That means those reimbursements would be includable in the employee’s gross income and subject to both Federal Insurance Contributions Act (“FICA”) and Federal Unemployment Tax Act (“FUTA”) taxes and withholding.

The IRS also maintained its position that all expenses must be substantiated to be eligible for tax free treatment under Section 125. In taking this stance, the IRS Chief Counsel specifically addressed five (5) substantiation approaches that plans have taken in the past:

  1. Self-Certification – A process by which employees verify expenses without an independent third-party review;
  2. Sampling – A process where the plan only requires additional documentation for a random sample of unsubstantiated expenses;
  3. De-Minimis Rules – A rule set by the plan where amounts below the dollar threshold are not subject to the substantiation process;
  4. Favored Providers – A plan rule that does not require substantiation from certain trusted providers, such as a physician’s or dentist office, hospital, or medical equipment supplier; and
  5. Advance Substantiation (Dependent Care Expenses) – A plan feature that reimburses anticipated childcare expenses before they actually occur.

Unsurprisingly, the IRS rejected each of these approaches because they do not ensure that each expense is verified. The memo also points out that advance day care expenses fail since the regulations require expenses to have been incurred prior to reimbursement. Under those rules, an expense is “incurred” when the care is provided and not when the individual is billed for, or pays for, the dependent care.

Importantly, the IRS notes that when a plan fails to comply with the Section 125 regulations, then “all reimbursements made during the year, including amounts paid to reimburse substantiated medical expenses, are included in the gross income of the employees.” In other words, the failure to verify some reimbursement requests jeopardizes the tax-exempt status of all payments to all participants.

While the IRS Chief Counsel memorandum specifically addresses flexible spending account plans, the Section 125 regulations apply to reimbursements from Health Savings Accounts and Health Reimbursement Accounts. Therefore, fiduciaries and plan professionals responsible for any medical reimbursement plan should be aware of these rules since the consequences for noncompliance are so severe.