What is required for FSA substantiation and what steps should the employer/administrator follow if substantiation is not provided?

May 14, 2019

The Section 125 health FSA regulations require all health FSAs offered through a Section 125 cafeteria plan to have adequate claims substantiation to ensure that it pays only for legitimate health and medical expenses. This means that reimbursements must: 1) Be substantiated by an independent third party (describing the service/product, the date of service/sale, and the amount of the expense), and 2) have a statement from the participant that the medical expense has not been reimbursed by any other health coverage (and that he/she won't seek reimbursement).

If the substantiation requirements are not satisfied, the IRS could potentially treat all health FSA reimbursements as taxable, whether or not they were properly substantiated. In addition, the health FSA and the Section 125 cafeteria plan that funds it could be disqualified, causing a loss of favorable tax treatment for the employer and the employees.

So, when an employee has not provided adequate claims substantiation (including claims that qualify for after-the-fact-substantiation but for which proper substantiation is not subsequently provided), employers and administrators should ensure that there are collection procedures in place to recoup these improper payments. These recoupment procedures should be addressed in the governing plan document. Most plan documents have general provisions regarding the powers of the employer, but the best practice is for the plan document to expressly provide for recoupment of improper benefit payments. The SPD should also explain that the employer will recoup improper payments from the participant.

As to the specific procedures to follow, the IRS guidance provides multiple steps for recoupment. These initial steps, outlined below, can be taken in any order, as long as they are consistently applied for all participants.

Step one, the administrator should first follow the debit card correction procedures (if applicable), and deactivate the debit card until the amount of the improper payment is recovered. This step ensures that no further violations will occur.

The next step is to attempt to correct the error by “demanding” repayment from the participant. This generally involves a letter being sent to the participant as soon as possible that identifies the amount to be displayed, the reasons for requiring repayment, and the timeframe in which repayment must be made. The participant can write a check to the employer (or to the plan, if the plan is funded) in the amount of the mistaken reimbursement, or if properly authorized and allowed under state law, the employer can withhold that amount from the participant’s pay or other compensation on an after-tax basis. If the employer seeks to withhold the amount from pay or other compensation, the plan document must provide for this action and the administrator must be mindful that the withholding is compliant with the applicable state wage withholding laws. It is also important to keep in mind that, if the amount to be recouped is large (or the participant’s pay rate is low), repayment may need to occur in installments to avoid a cash-flow hardship to the participant.

Alternatively, the administrator could apply a substantiation or offset approach against subsequent valid FSA claims, up to the amount of the improper payment. The IRS has informally commented (in the context of the debit card correction procedures) that improper health FSA payments can be offset against other health FSA claims. The recouped amounts can be used for other eligible expenses incurred before the end of the plan year (or other period of coverage).

If the above steps are unsuccessful, the IRS guidance states that the improper payment should be treated as any other business indebtedness. Under this step, the employer must request payment consistent with its collection procedures for other business debts (depending on the amount, this might even include a lawsuit). If the improper payment is not recovered, it should generally be treated as a forgiven debt and reported as wages on Form W-2 for the year in which the indebtedness is forgiven, so that the reported amount becomes subject to withholding for income tax, FICA, and FUTA.

Please keep in mind that the IRS has indicated that treating improper payment as uncollectible “should be the exception, rather than a routine process” and that repeatedly including such payments in participants’ income suggests the plan lacks proper substantiation procedures or may be cashing out unused health FSA amounts. So, the steps detailed above should be the normal practice for recoupment and treating the payment as a business debt a last resort.

If the improper payment occurred in a prior year, then guidance from the IRS and Treasury Department is conflicted as to the available options for recoupment. In 2010, a Treasury Department representative indicated that an improper health FSA reimbursement could be offset against future claims in the second plan year (in which the overpayment was discovered). However, in 2014, the Office of Chief Counsel issued an Advice Memorandum which indicated that if an offset of claims could not be accomplished in year one (the year the overpayment occurred), the offset could not be done in year two. So, in light of the conflicting guidance, the conservative position would likely be to treat the improper payment as business indebtedness and that, if forgiven, must be reported as wages and an amended Form W-2 be made for the year in which the debt is forgiven (as described above).

For additional information regarding health FSAs, NFP has an informational webpage.