When A Cafeteria Plan Mistake Is Discovered – The Solution Is Not Universal

Mistakes happen
Cafeteria plan mistakes happen. How are they corrected?

Regardless of how excellent an employer’s cafeteria plan administrative processes are, it’s not uncommon for oversights to occur. Whether it’s discovering the wrong amount of premiums being deducted during a payroll audit, an employee is enrolled in a benefit plan different from what they signed up for during open enrollment, or an HSA contribution was missed. Mistakes happen!

Unfortunately, neither IRS regulations nor the Code sections which govern cafeteria plans provide guidance. There are IRS publications and a Chief Counsel Advice memorandum which address correction for a few specific areas (e.g., Form W-2 corrections, improper health FSA reimbursements), however, other mistakes, in general, the IRS has not provided information nor a standardized process for correcting.

What Is An Employer To Do?

It is our experience, the best way to correct a mistake is to put the employee and the plan back into the position they would have been in had the mistake never occurred. Failure to do so could disqualify the entire cafeteria plan! This could mean employees’ pretax elections suddenly become gross income to employees, and they would be required to pay all the employment and income taxes that go along with it.

The specific correction will depend on the facts and circumstances (e.g., what type of mistake was made and was it discovered before, during, or after the plan year).

Example: Four months after open enrollment, an employer discovers an employee was enrolled in the correct benefits with the carriers, but somehow the wrong employee pretax deductions occurred and too little premium was withheld. The employer would want to let the employee know an oversight occurred and depending on the amount of the money needed to be made up, either ask for the employee to pay the entire amount or perhaps have double-premiums deducted until the shortfall is corrected.

Employers should make a reasonable good faith effort to correct past errors and document everything (e.g. date the failure was discovered, the decision made & why, the process to correct & steps to ensure won’t occur going forward). 

If an employer is audited, their documentation could explain how the mistake occurred, show it was an honest mistake, that once realized corrective steps were taken to fix it in the least disruptive way. It will also outline the procedures implemented to ensure the mistake didn’t occur again. This could show an employer acted in good faith and was never intentionally trying to circumvent the tax code.

Note: Correcting payroll errors involves a variety of federal & state laws. Prior to implementing corrections, be sure all federal & state wage/tax laws are considered. Contact an experienced benefits attorney before implementing corrective measures if uncertainty exists.

Do you wish you had someone to bounce your situation off of? We’re here to explain complex compliance issues in layman’s terms. Contact us today. Let’s discuss your compliance needs.

The Compliance Rundown is not a law firm and cannot dispense legal advice. Anything contained in this post or on their website is not and should not be construed as legal advice. If you need legal advice, please contact your legal counsel.

Unsubstantiated FSA card transactions

credit card

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.