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IRS Chief Counsel Discusses Cafeteria Plan Substantiation Rules

by | May 3, 2023 |

The IRS Office of Chief Counsel has issued Memorandum Number 202317020 (the “Memorandum”) to explain the substantiation rules for claims made under health and dependent care FSAs by means of six commonly encountered factual situations, in five of which it concludes that the plan is not a cafeteria plan and the reimbursement is not shielded from income and employment taxes.

The Memorandum begins by noting that if a cafeteria plan does not require an independent third party to fully substantiate health FSA reimbursements (or debit card charges) for medical expenses, then the plan fails to operate in accordance with the substantiation requirements and is not a cafeteria plan within the meaning of Internal Revenue Code (“Code”) Section 125.  In that case, the amount of any salary reductions that an employee elects under the cafeteria plan health care FSA must be included in gross income and is wages for Federal Insurance Contributions Act (i.e., FICA) and Federal Unemployment Tax Act (i.e., FUTA) purposes, and is subject to tax withholding.

In addition, the Memorandum confirms that an employer may not exclude expense reimbursements by a dependent care FSA from an employee’s gross income if the expense is not substantiated after it has been incurred.

Situation 1 of the Memorandum describes a cafeteria plan that reimburses medical expenses only if they are substantiated by information from a third party that is independent of the employee. The information must describe the service or product, the date of service or sale, and the amount of the employee’s expenses.  The plan reimburses expenses based on information from an independent third party such as an “Explanation of Benefits” from an insurance company. The plan also requires the employee to certify that any expense paid by the plan has not been reimbursed by insurance or otherwise, and that the employee will not seek reimbursement from any other plan covering health benefits. The Memorandum concludes that this plan complies with the claim substantiation requirements and, assuming other requirement are met, plan payments are excluded from the employee’s gross income.

In Situation 2, instead of only reimbursing expenses that are substantiated (as described in Situation 1), the plan also reimburses medical expenses for which employees submit only their own information describing the service or product, the date of service or sale, and the amount of the expenses, without a statement from an independent third party to verify the expense. The Memorandum concludes that because the plan does not limit reimbursements or payments of claims to medical expenses that are independently substantiated, the plan does not satisfy the cafeteria plan substantiation requirements under Code Section 125, and reimbursements are included in income.

Similarly, the Memorandum explains that a plan fails to meet the Code’s substantiation requirements if it: (i) reimburses all claims and only requires substantiation of a random sample of otherwise unsubstantiated charges (Situation 3); (ii) does not substantiate de minimis charges (Situation 4); or (iii) does not substantiate charges from certain “favored” providers (Situation 5).

In Situation 6, an employer provides a cafeteria plan with a dependent care FSA.  The plan allows employees to submit a form in advance of receiving the dependent care services, attesting to the amount of dependent care expenses they will incur in the upcoming year.  The plan requires employees to notify the plan sponsor if their dependent care situation changes and they will not incur the amount of qualified dependent care expenses to which they attested for that year.  The employee is automatically reimbursed every pay period a pro rata amount of the amount of dependent care assistance expenses to which the employee attested.

The Memorandum concludes that all claims for payment or reimbursement of the employee’s dependent care FSA are unsubstantiated because they are claimed in advance without additional verification. Because the plan does not limit reimbursements or payments of claims to dependent care assistance expenses that have been substantiated after being incurred, the plan does not satisfy the Code’s substantiation requirements. Therefore, the reimbursements for dependent care assistance expenses are included in the gross income and wages of the employees for FICA, FUTA and income tax purposes.

Employer Takeaway. The Memorandum is based largely on proposed regulations issued over 15 years ago that were never finalized. In addition, the Memorandum itself says that, “This advice may not be used or cited as precedent.” Consequently, the extent to which this Memorandum will be enforced is open to question. Nevertheless, employers should be aware of the cafeteria plan substantiation requirements.

The Memorandum is available at: