IRS Confirms Claim Substantiation Requirements


In a recent memorandum (TAM 202317020) from the Office of Chief Counsel, the IRS addressed claims substantiation requirements for reimbursement of medical and dependent care expenses from FSA accounts. The memo also described the tax consequences of not complying with claims substantiation requirements.

This memo is vital for FSA administrators because it confirms the IRS’s position that ALL medical and dependent care claims must be substantiated in order to avoid major tax penalties resulting from non-compliant plans. The fact that the IRS felt the need to issue the memorandum is seen as a signal that they may intend to focus on substantiation rules in employee tax audits.

Substantiation Requirements

The memorandum reiterates the acceptable methods of claims substantiation (adjudication) – manual substantiation and auto-substantiation – and the necessity of pursuing pay-and-chase mechanisms for all non-adjudicated claims prior to including them as W-2 employee income.

MANUAL SUBSTANTIATION: The memorandum reiterates the long-standing manual substantiation rules for payment of claims, including:

  • Third-party review of the itemized provider receipt
  • Statement by the employee that the expense has not been reimbursed and will not be submitted elsewhere for reimbursement

AUTOMATED SUBSTANTIATION: The memorandum also provides an overview of the limited electronic substantiation of debit card transactions as described in IRS Notice 2003-43 (now codified in the 2007 proposed regulations) and IRS Notice 2006-69:

  • Auto-adjudication by certain MCC providers in the presence of a co-pay match, real-time match, or EOB rollover
  • Real-time IIAS substantiation for providers employing approved technology

NON-COMPLIANT PRACTICES: The memorandum also describes instances where auto-adjudication did not apply, in which TPAs employed practices that did not meet substantiation requirements, including:

  • Employee self-certification of claims
  • Certification based on claims sampling
  • De minimis claims substantiation levels
  • Automatic substantiation for certain providers
  • Advance approval of dependent care claims

Consequences of Non-Compliance

If a medical or dependent care FSA plan does not follow the claims substantiation rules, the entire plan may be non-compliant with IRS Code Section 125. In that case, all employee salary reduction contributions would be subject to income, FICA, and FUTA taxes, and all claims paid by the non-compliant plan (even those that were otherwise validly substantiated) would also become taxable.

IMPORTANT: The above is for informational purposes only and should not be construed as legal advice. Consult your qualified benefits counsel for more information.

For 40 years, DataPath has been a pivotal force in the employee benefits, financial services, and insurance industries. The company’s flagship DataPath Summit platform offers an integrated solution for managing CDH, HSA, Well-Being, COBRA, and Billing. Through its partnership with Accelergent Growth Solutions, DataPath also offers expert BPO services, automation, outsourced customer service, and award-winning marketing services.

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