New IRS Guidance Requires FSA and DCAP Fund Substantiation

The Internal Revenue Service (IRS) recently issued guidance specifying the criteria for certifying the use of funds from account-based plans structured under the Internal Revenue Code Section 125, like health flexible savings arrangements (FSAs) and dependent care assistance plans (DCAPs).  The memorandum addresses whether a Section 125 “cafeteria plan” sponsor will be considered to have properly certified account-based plan expenses under the following conditions: (1) if employees self-certify expenses; (2) if the plan substantiates only some expenses (“sampling”); (3) if only amounts over a certain level (i.e., de minimis amounts) are substantiated; (4) if charges with favored providers are not required to be substantiated; and/or (5) if dependent care expenses are reimbursed before the expenses are incurred.

The guidance clearly concludes if a Section 125 plan does not require an independent third party to substantiate reimbursements expenses, such as by permitting self-certification of expenses, “sampling” of expenses, or certification by favored providers, then the plan does not meet federal fund substantiation requirements and will cease to operate within the meaning of Internal Revenue Code Section 125. Any money an employee elects to set aside in an improperly substantiated FSA and/or DCAP must be included in gross income and be subject to Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) withholdings.

What does this mean for employers groups? First, those whose Section 125 plans include access to FSAs and/or DCAPs must ensure they are using an appropriate third-party vendor for substantiating expenses, and if not, such groups are advised to find a reputable partner to assist them in adjusting these processes. Second, the guidance suggests the IRS may be targeting cafeteria plans for future audits; as such, taking action to revisit all employer-required compliance (again, with a trusted vendor partner) is highly advised.