September 23, 2023

Volume XIII, Number 266


September 22, 2023

Subscribe to Latest Legal News and Analysis

September 21, 2023

Subscribe to Latest Legal News and Analysis

September 20, 2023

Subscribe to Latest Legal News and Analysis

IRS Issues Reminder that Claims Under Health and Dependent Care FSAS Must be Substantiated

In a recently issued Chief Counsel Advice memorandum, the Internal Revenue Service (IRS) reminded sponsors of health and dependent care flexible spending arrangements (FSAs) of their obligation to properly substantiate claims as a condition of ensuring favorable tax treatment under Section 125 of the Internal Revenue Code (the Code). The IRS’s advice is clear: the substantiation bar is high, and the failure to comply has serious, unwanted consequences for employers. The memorandum includes a useful summary of the applicable law as it applies in six example situations of claims practices.



Code Section 125 allows an employer to establish a cafeteria plan that permits an employee to choose among two or more benefits, consisting of cash (generally, in the form of salary reductions) and qualified benefits, including health coverage or accident insurance. If an employee elects to participate in a health FSA on a pre-tax basis through salary reductions, the value of the coverage by the health FSA and the amounts reimbursed for medical expenses are excludable from gross income up to the allowable limit. Similarly, if an employee elects to participate in a dependent care FSA, the dependent care assistance program benefits are excludable from gross income up to the allowable limit. In each case, however, claims for reimbursement must be properly substantiated.

Through these examples, the IRS clarifies that a health or dependent care FSA that fails to satisfy the applicable substantiation requirement is not considered a cafeteria plan and, consequently, will not receive favorable tax treatment under Code Section 125. As a result, the full amount of all employee elections between taxable and nontaxable benefits are included in gross income and treated as wages for payroll tax purposes. Substantiation generally requires that all expenses must be supported by information from a third party that is independent of the employee, the employee’s spouse, and dependents.

The IRS provided six examples of how sponsors have substantiated claims in the memorandum:

Situation 1: The plan only reimburses medical expenses that are substantiated by information from a third party that is independent of the employee and the employee’s spouse and dependents or from an explanation of benefits issued by an insurance company.

Situation 2: The plan allows for self-certification.

Situation 3: The plan uses sampling techniques.

Situation 4: The plan generally requires third-party certification, but it treats certain expenses paid with a debit card as auto-substantiated if the charge is less than a specified dollar amount.

Situation 5: The plan maintains a list of dentists, doctors, hospitals, or other healthcare providers, the charges from which are treated as auto-substantiated.

Situation 6: A dependent care assistance plan allows employees to submit a form in advance of receiving the dependent care, attesting to the amount of dependent care expenses they will incur in the upcoming year and to thereafter notify the plan sponsor only if the anticipated amount of expenses changes.

According to the memorandum, only Situation 1 complies with the applicable substantiation requirements of Code Section 125. The plans in Situations 2 through 6 fail to do so. Thus, all employee election amounts in Situations 2 through 6 are treated as taxable for both income and payroll tax purposes.

The IRS’s holdings are all based on the 2007 proposed regulations, which do not have the force of law. Nevertheless, plan sponsors and their advisors have long looked to these proposed rules for guidance. The memorandum itself also provides that it may not be used or cited as precedent. Therefore, employers that sponsor health and dependent care FSAs should review their vendor service agreements and plan administration to ensure the agreements and plan operations comply with the requirements of Code Section 125.

© 2023 McDermott Will & EmeryNational Law Review, Volume XIII, Number 153

About this Author

Jacob Mattinson Employee Benefits Attorney

Jacob M. Mattinson focuses his practice on employee benefits and matters related to 401(k), 403(b), pension, executive compensation, health care reform, and cafeteria and welfare plans.

Jacob assists clients in drafting employee benefit plan documents and amendments. He represents clients in matters before the Internal Revenue Service (IRS), US Department of Labor (DOL) and Pension Benefit Guaranty Corporation with respect to plan qualification issues. He also counsels privately and publicly held corporations and tax-exempt entities on a variety of benefits and Employee Retirement...

Sarah G. Raaii Employee Benefits Attorney McDermott Will & Emery Chicago, IL

Sarah G. Raaii focuses her practice on employee benefits and matters related to health care reform, data privacy and HIPAA compliance, executive compensation, and health and welfare, cafeteria, 401(k), 403(b) and pension plans.

Sarah has experience counseling clients on regulatory compliance with the Affordable Care Act (ACA), Health Insurance Portability and Accountability Act (HIPAA), Employee Retirement Income Security Act (ERISA), Consolidated Omnibus Budget Reconciliation Act (COBRA), Internal Revenue Code and related state and federal laws affecting employee benefit plans. She...


Alden J. Bianchi is an experienced Employee Benefits and Executive Compensation lawyer who advises corporate, not-for-profit, governmental and individual clients on a broad range of executive compensation and employee benefits matters, including qualified and non-qualified retirement plans, health and welfare plans.

Alden represented the Romney Administration in connection with the historic 2006 Massachusetts health care reform act, and he testified before the Senate Finance Committee in the lead-up to the Affordable Care Act. His published...


Teal Trujillo focuses her practice on employee benefits and executive compensation matters for public and private companies. She regularly leads due diligence and advises on liability related to retirement plans, health and welfare plans and executive compensation in stock purchase and asset purchase transactions.

A specialist on matters related to tax-qualified pension plans, health and welfare plans and deferred compensation arrangements, Teal also has experience handling correction and administrative matters before the Internal Revenue Service (IRS) and the Department of Labor (...