Code §§105 and 125 require the substantiation (e.g., a receipt or bill) of all medical expenses paid or reimbursed from a health flexible spending account (FSA). Generally, substantiation occurs prior to funds being released, however, many FSAs allow access to the funds using a debit/credit card when the service is provided or item purchased.

When the card is swiped, IRS guidance allows certain purchases to be auto-adjudicated (i.e. they do not require further substantiation) while other purchases are allowed to be to be paid at the time of the swipe but require additional information to be submitted to the FSA administrator after-the-fact. This additional information is reviewed and then a determination is made whether the expense was/wasn’t eligible under the plan.

If employees use health FSA funds and the expenses weren’t verified, (i.e. additional information for proper substantiation is not subsequently provided) of if they used the money for an expense that was determined not to be eligible, then certain correction procedures need to be followed to recoup the money for the claims improperly paid. The employer’s FSA plan documents should contain substantiation rules and correction methods.

However, in general per Proposed Treasury Reg. §1.125-6(d)(7) the employer must ask that the employee repay the plan.  If the employee fails to repay the plan, the employer must withhold the amount from the employee’s pay, to the extent allowed by law.  If neither of the aforementioned methods results in full repayment, the employer must apply an offset against properly substantiated claims incurred during the same plan year.  As a last resort and after exhausting other required collection procedures, an employer may include unsubstantiated FSA expenses in an employee’s gross income.  The amount would be included in the year in which it was forgiven (e.g., included in the W-2 for 2019 if an amount owed from 2018 was forgiven in 2019).

However, imputed income should be the exception rather than the rule, and used as a last resort. Per, Chief Counsel Advice 201413006 (Feb. 12, 2014) “Repeated inclusion in income of improper payments suggests that proper substantiation procedures are not in place or that the payments may be a method of cashing out unused FSA amounts.”

Although employers generally are using a TPA for FSA administration and perhaps the contract/agreement with the TPA outlines whose role it is regarding claims substantiation, at the end of the day, it is the employer’s responsibility to ensure the plan is administered correctly.  {The term “administrator” in a cafeteria plan document equals employer. It is not the same as Third Party Administrator. (i.e. an employer can’t pass off the liability to a TPA. If the TPA doesn’t perform, it’s still on the employer.)}

If a plan fails to comply with the substantiation requirements, it’s an “operational failure” and the entire plan will be disqualified, with employees’ elections between taxable and nontaxable benefits resulting in gross income to the employees.