Question: How can employees and their third-party administrators correct improper payments (reimbursements/distributions) from the health FSA?

Short Answer: IRS guidance outlines a multi-step correction procedure to address improper FSA payments. Although the employer is the plan sponsor directly responsible for compliance, the FSA third-party administrator (TPA) may apply the correction procedures on the employer’s behalf. If all the available steps are unsuccessful in correcting the error, the final step is to include the amount of the improper payment in the employee’s taxable income in the year of the correction.

Improper Health FSA Payments: Overview

Health FSAs can reimburse only §213(d) qualified medical expenses that are incurred during the period of coverage. Nonetheless, employers will often encounter situations where they learn an employee has received an ineligible distribution from the health FSA.

For example, the health FSA TPA may inform the employer that an employee incorrectly received payment from the health FSA because an expense was not properly substantiated after using the FSA debit card, a processing error by the TPA that inadvertently approved a claim that does not qualify as a §213(d) medical expense, a mistaken reimbursement of an expense incurred outside the period of coverage, or a mistaken reimbursement of amounts that exceed the employee’s available balance (i.e., election amount for the plan year plus any amount subject to a grace period or carryover).

For more details:

• Newfront Section 125 Cafeteria Plan Guide

• When FSA Expenses Are Incurred

• 2024 Health FSA Limit Set at $3,200

The IRS-Approved Steps for Correcting an Improper Health FSA Payment

An IRS Chief Counsel Advice memorandum walks through the step-by-step process for employers to apply upon discovering an improper health FSA payment. This guidance is in part derived from similar steps outlined in the IRS proposed cafeteria plan regulations related to improper health FSA debit card payments.

Step 1: Deactivate Debit Card if Used to Make Improper Payment

Where a health FSA debit card was used for an improper payment to the employee, the employer must deactivate the card until it recovers the improper payment. Any claims incurred during the period would have to be submitted using the standard method without use of the debit card.

If a debit card was not involved in the erroneous payment, the correction process begins with Step 2.

Step 2: Three Steps in Any Consistent Order

IRS guidance provides that the next three steps can be followed in any order that is consistently applied for all participants in the employer’s health FSA.

1. Employer Demands Repayment. The employer should “demand” that the employee repay the cafeteria plan an amount equal to the improper payment. Any form of notice to the employee informing them of the obligation to repay the improper distribution should be sufficient for this purpose.
   
   If the employee repays the improper payment, the amount becomes available again for reimbursing other claims incurred in the plan year (or subsequent plan year via the carryover).

2. Employer Withholds Amount (Generally Not Recommended). This step directs the employer to withhold the amount of the improper charge from the employee’s pay “to the full extent allowed by applicable law”. However, state wage withholding laws often require that employees expressly authorize in writing any deduction from wages.
   
   Given that state wage withholding laws will often make this process infeasible, employers generally will take the position that there is no viable pathway to follow this step—and thereby exclude if from the process.

3. Offsetting Reduction to Subsequent FSA Claim. The final action item within Step 2 is for the plan to apply a claims substitution or offset to resolve the improper payment. This is accomplished by having the employee’s subsequent valid claim(s) incurred during the same coverage period applied to the amount of the improper payment, thereby reducing the amount of the FSA distribution for the valid subsequent claim(s) by the amount the employee needs to repay the plan for the improper payment.
   
   For example, if the improper FSA payment was $200 and the employee subsequently submits a qualifying expense for $250 incurred during the same coverage period, the plan would offset the $250 reimbursement by the $200 mistakenly paid previously. The result would that that the employee receives a $50 reimbursement ($250 valid claim - $200 improper payment) for the subsequent $250 eligible claim.

Step 3: Include Improper Payment in Employee’s Taxable Income

The final step in the improper FSA payment correction process directs the employer to “treat the improper payment as it would any other business indebtedness.” Apparently in recognition of the fact that employers are very unlikely to attempt bring a lawsuit against an employee or send an employee to collections to address an improper payment, the IRS clarifies that employers can accomplish this step by simply reporting the amount of the improper payment in the employee’s taxable income.

The amount included in income is reported by the employer to the employee as wages on the Form W-2, and it is subject to withholding for income tax, FICA and FUTA.

The guidance cautions that this Step 3 is available only after all other correction methods in the steps above have been pursued by the employer, and that Step 3 should be the exception rather than a routine process of correcting. Furthermore, the IRS notes that repeated inclusion in income of improper payments suggests that the plan does not have proper substantiation procedures in place or could lead to suspicions that the payments may actually be an impermissible backdoor method of cashing out unused FSA amounts (in violation of the use-it-or-lose-it rule).

Step 3 is Only Method Where Improper Payment Occurred in Prior Plan Year

The IRS Chief Counsel Advice memorandum further clarifies that in cases where the above steps were not completed during the plan year in which the improper payment was made to the employee, the employer should apply Step 3. In other words, the employer should report the amount of the improper payment in the employee’s taxable income. The amount included in income is reported by the employer to the employee as wages on the Form W-2, and it is subject to withholding for income tax, FICA and FUTA.

According to the guidance, the other previous steps are not available during subsequent plan years because they could have the effect of allowing compensation from one plan year to purchase a benefit in a subsequent plan year (in violation of the cafeteria plan prohibition of deferred compensation).

The good news is that the memorandum also confirms that the improper payment “is reportable in the taxable year of the employee in which the indebtedness is forgiven.” This means that employers do not have to go back and correct prior year Forms W-2 to address the correction. The amount of the improper payment from the prior year is simply included in the employee’s current year taxable income.

Although there may be a temptation for employers to delay addressing improper FSA payments until the end of the plan year to skip directly to this Step 3 approach, employers should keep in mind the IRS’s admonition that this final step should be the exception rather than a routine process of correcting.

TPA Can Correct FSA Payment Errors on Employer’s Behalf

As a practical matter, employers rarely are involved in the day-to-day operations of the health FSA. These administrative functions are almost always delegated to a TPA that assumes the role of processing claims. The TPA will therefore typically have been the entity that approved the improper payment.

As always, the employer as the health FSA plan sponsor is ultimately responsible for complying with the applicable law. That’s true regardless of whether the employer has delegated plan administration functions to the TPA, and regardless of whether the TPA made the error.

Nonetheless, the IRS recognizes that the employer may also delegate the responsibility to apply the improper payment correction procedures on behalf of the employer. In the same manner that the TPA processes claims on behalf of the employer and its plan, the TPA can also process the improper claims repayment process on behalf of the employer and the FSA.

Because the employer retains the ultimate liability in these scenarios regardless of the delegation to the TPA, the employer should ensure that the process is completed properly and consider contractual protections to avoid or limit liability. Furthermore, the employer has a fiduciary duty under ERISA to prudently select and monitor plan service providers, which includes the health FSA TPA. Employers should monitor whether a health FSA TPA is consistently allowing preventable payment errors and/or failing to properly correct those errors.

• For more details: Newfront ERISA for Employers Guide

Improper Health FSA Payment Examples

Example 1:

• Jack Sparrow participates in the health FSA of his employer, The Black Pearl.

• Jack submits a health FSA claim of $350 for a personal trainer (a dual purpose expense) he worked with to maintain his peak pirate-level physical fitness.

• The personal trainer expense was not incurred by recommendation of a physician to treat a disease or injury, and no letter of medical necessity was submitted.

• The Black Pearl’s FSA TPA Dutchman Administrators mistakenly approved the claim and paid the $350 to Jack.

• The Black Pearl has contractually delegated correction of any FSA payment errors to the FSA TPA.

Result 1:

• Dutchman Administrators should immediately deactivate Jack’s FSA debit card upon discovering the error if it was used to make the improper payment.

• Following any consistent order, Dutchman Administrators should demand repayment and attempt to apply a claims offset on Jack’s subsequent health FSA claim(s).

• If those TPA efforts are unsuccessful in recovering the amount, The Black Pearl must include the $350 improper payment in Jack’s taxable income subject to withholding and payroll taxes.

Example 2:

• Elizabeth (Swann) Turner is a participant in the Brethren Court’s calendar plan year health FSA administered by the TPA, Calypso Claims.

• Elizabeth submits a health FSA claim for $500 in egg freezing expenses to address the ten-year delay until she will see her husband Will again.

• Calypso Claims mistakenly approves and pays the claim in 2024 even though non-temporary egg freezing (generally cryopreservation beyond one year) is not a qualifying medical expense.

• The erroneous payment to Elizabeth is not discovered until 2025.

Result 2:

• The first correction steps are inapplicable because the improper payment occurred in the previous plan year.

• The Brethren Court must include the $500 improper payment in Elizabeth’s taxable income (subject to withholding and payroll taxes) in 2025.

• No correction is required to Elizabeth’s 2024 Form W-2 because IRS guidance confirms that the amount “is reportable in the taxable year of the employee in which the indebtedness is forgiven.”

What About Correcting Improper Dependent Care FSA Payments?

The IRS guidance does not directly address any benefit component other than health FSAs. However, in the absence of other clarifying guidance, it is reasonable for employers (and their TPAs) to follow the same correction methods in the context of an improper dependent care FSA payment.

• For more details: Dependent Care FSA Debit Card Substantiation

What About Correcting Improper HRA Payments?

Again, the IRS guidance only directly references health FSA improper payments. However, because both the health FSA and HRA are account-based health plans with similar substantiation and qualifying expense concerns, it is reasonable for employers (and their TPAs) to follow the same correction methods in the context of an improper HRA payment.

What About Correcting Improper Commuter Plan Payments?

It is somewhat more of a stretch to apply the health FSA guidance in this context to addressing an improper commuter benefit payment because §132 qualified transportation plans are neither a cafeteria plan component nor a health plan. However, given the scarcity of IRS guidance in the commuter area, employers should consider this health FSA guidance at least as a relevant reference point for an appropriate improper commuter payment correction process.

• For more details: Newfront Fringe Benefits for Employers Guide

What About Mistaken HSA Distributions?

HSAs are an individually owned account that employees, and any distributions are solely the employee’s personal income tax responsibility. Employees can avoid income taxes and the 20% additional tax on a mistaken HSA distribution where there is clear and convincing evidence that the amounts were distributed from an HSA because of a mistake of fact due to reasonable cause. In these situations, the employee will need to repay the mistaken distribution to the HSA no later than April 15 following the first year the employee knew or should have known the distribution was a mistake.

• For more details: Correcting Mistaken HSA Distributions

Summary

Mistakes in administration will occur in any type of employee benefit plan, and the health FSA is no exception. Although employers should make every effort to ensure their TPA minimizes the extent of improper payment errors, they occur frequently enough that the IRS has provided a playbook for employers and TPAs to follow.

The IRS-approved correction process is mostly straightforward. The plan must deactivate the employee’s FSA debit card (if applicable), then (in a consistent order as determined by the employer or TPA) demand repayment and attempt to offset the improper payment with a future claim. If these methods fail to recover the improper payments, the amount of the payment will be included in the employee’s taxable income as a last resort. Where the error is not discovered until the subsequent plan year, the employer will skip straight to the last step of including the improper amount in taxable income in the year of the correction.

Relevant Cites:

IRS Chief Counsel Advice Memorandum 201413006:

The employer may apply the rules of Proposed Treasury Reg. §1.125-6(d)(7)(ii) through (iv) in any order but the order must be consistently applied for all participants in the employer’s health FSA. However, the employer may apply the correction method in subsection (v) only after all correction methods in subsections (ii) through (iv) have been pursued by the employer. Forgiveness of improper payments as uncollectible business indebtedness should be the exception rather than a routine process. 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.

…

In cases in which the correction methods in Proposed Treasury Reg. §1.125-6(d)(7)(ii) through (iv) were not applied during the period of coverage during which the improper payment was made to the employee, the employer should apply Proposed Treasury Reg. §1.125-6(d)(v) in accordance with Issue 3 below.

…

In cases in which all other correction procedures have been exhausted by the employer and the employer treats the improper payment as business indebtedness in accordance with Prop. Treasury Reg. §1.125-6(d)(7)(v), the improper payment should be reported by the employer to the employee as wages on a Form W-2 to the extent the employer forgives the indebtedness after requesting payment consistent with collection procedures for other business indebtedness. The amount included in income is subject to withholding for income tax, FICA and FUTA, since the benefits are made available to the employee by the employer for the performance of services. The improper payment is reportable in the taxable year of the employee in which the indebtedness is forgiven.

California Labor Code §224:

The provisions of Sections 221, 222 and 223 shall in no way make it unlawful for an employer to withhold or divert any portion of an employee’s wages when the employer is required or empowered so to do by state or federal law or when a deduction is expressly authorized in writing by the employee to cover insurance premiums, hospital or medical dues, or other deductions not amounting to a rebate or deduction from the standard wage arrived at by collective bargaining or pursuant to wage agreement or statute, or when a deduction to cover health and welfare or pension plan contributions is expressly authorized by a collective bargaining or wage agreement.

Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship. Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).