Question: What are the health FSA claim substantiation requirements?

Short Answer: The Section 125 cafeteria plan rules require that all health FSA claims be substantiated by an independent third party, such as an explanation of benefits from a health plan or an itemized receipt from a merchant. The substantiating document must include information describing the service or product, the date of the service or sale, and the amount of the expense.

Eligible Health FSA Claims: Overview

Health FSAs can reimburse only §213(d) qualified medical expenses that are incurred during the period of coverage and not reimbursed by another plan. Medical expenses are the costs of diagnosis, cure, mitigation, treatment, or prevention of disease, and for the purpose of affecting any part or function of the body. These expenses include medical services rendered by medical practitioners, medicines and drugs, as well as the cost of equipment, supplies, and diagnostic devices for medical purposes.

The best general IRS overview of what constitutes a §213(d) medical expense is IRS Publication 502. The FSAFEDS program for federal employees also has a useful searchable database of whether specific expenses qualify for reimbursement under the federal government’s health FSA.

For more details:

• Newfront Section 125 Cafeteria Plan Guide

• When FSA Expenses Are Incurred

Health FSA Claims Must be Substantiated by an Independent Third-Party

While employers almost universally delegate the FSA claims administration process to third-party administrators (TPAs), employers should be aware of the substantiation rules their TPAs are required to follow. The IRS outlines the health FSA claims substantiation requirements in multiple areas of guidance. The primary area addressing this is in Proposed Treasury Regulations §1.125-6(b). Those rules set that as a precondition of payment or reimbursement of expenses for qualified benefits, the health FSA must require substantiation by an independent third-party.

The independent third-party substantiation must include the following elements:

1. Information describing the service or product;

2. The date of the service or sale; and

3. The amount of the expense.

The prototypical form of substantiation is an explanation of benefits (EOB) from a health plan or insurance company showing the employee’s cost-sharing responsibility for the item or service (i.e., deductible, copay, coinsurance). Employees often misunderstand the substantiation rules as requiring that they include a receipt, a statement from the provider, or other proof of payment with them in connection with EOB to confirm that the employee paid the bill. However, IRS guidance confirms that the EOB by itself (along with the employee certifications described below) is sufficient substantiation without the need for any receipt or further review.

Otherwise, an itemized receipt containing the three required elements above from a merchant, pharmacy, provider, etc. will also always be sufficient to substantiate the expense. The third party providing the information to substantiate the claim must be independent of the employee’s spouse and dependents to qualify. Most FSA TPAs will also require that the EOB or itemized receipt used to substantiate the claim include the patient’s name and the provider’s name.

Self-Substantiation Not Permitted

Self-substantiation or self-certification of claims is not permitted. A recent IRS Chief Counsel Memorandum addresses in detail the various impermissible avenues that would be considered impermissible self-certification. For example, a health FSA cannot reimburse an expense based on information without the verification of an independent third-party, and the health FSA cannot rely on “sampling” to randomly sample certain claims to verify substantiation. Furthermore, there is no “de minimis” threshold under which substantiation is not required, and the health FSA cannot choose to skip the substantiation process for certain “favored providers”.

Dual Purpose Expenses: Letter of Medical Necessity Required

Medical expenses must be primarily to alleviate or prevent a physical or mental disability or illness. They do not include expenses that are merely beneficial to general health. This presents an issue for so-called “dual purpose” expenses that may have been incurred for medical or simply personal (general health) purposes.

To determine if a dual purpose expense was incurred primarily for medical care, most health FSA TPAs will require that the employee submit a “letter of medical necessity” whereby the employee’s physician or other medical practitioner verifies the expense was incurred at the practitioner’s recommendation to treat a specific medical condition. IRS guidance provides that the practitioner’s diagnosis of a medical condition and recommendation of the item as a treatment or mitigation for the condition can be used to substantiate that the expense is eligible because it was incurred primarily for medical care.

Examples of common dual purpose expenses include gym membership, massage, nutritionists, exercise equipment, health clubs, fitness trackers, and personal trainers. These are personal expenses for the general health of the employee that do not qualify for health FSA reimbursement unless the employee’s medical practitioner recommended the item or service to treat a specific medical condition. The IRS recently issued FAQ guidance addressing many of these nutrition/wellness types of expenses and clarifying when they might qualify as a medical expense.

• Note: Some vendors have recently been promoting the ability to acquire a letter of medical necessity for wellness expenses (e.g., gym membership, nutritious meals) based on a short online survey whereby a nurse practitioner completes the letter for a small charge (e.g., $30). This aggressive approach to soliciting and acquiring such letters will likely invite additional IRS scrutiny as to whether the process truly is being used to verify the individual’s medical necessity for such wellness expenses.

There is no specific format required for a letter of medical necessity. Different health FSA TPAs will take different approaches for how to substantiate the treating physician or practitioner’s recommendation for the expense. The FSAFEDS program has a good example of a “Letter of Medical Necessity” document used for this purpose with respect to the health FSA for federal employees.

Required Employee Certification: No Double-Dipping

The IRS imposes a blanket prohibition against using any account-based health plan (i.e., health FSA, HRA, HSA) for an expense that has been reimbursed from another health plan (a.k.a. “double-dipping”). The guidance stems from Section 105, Section 125, Section 213, Section 223, as well as IRS Notices, Information Letters, and Publications. For example, using both the account-based plan and the major medical plan to reimburse an expense is the classic prohibited form of “double-dipping.”

• For more details: The IRS Prohibition of Double-Dipping

A recent IRS Information Letter confirms that employees must therefore certify that any health FSA expense being reimbursed has not already been reimbursed, and that the employee will not seek reimbursement from any other health benefit plan.

This prohibition also extends to tax deductions. Generally, individuals can deduct §213(d) medical expenses on their individual tax return (Schedule A, Form 1040) to the extent they exceed 7.5% of adjusted gross income. However, individuals who have an expense reimbursed by a health plan (whether account-based or traditional) cannot claim that same expense as a deduction on their individual tax return.

Employee Certification Example:
“To the best of my knowledge, my statements in this claim are true and complete. I certify that these expenses have not previously been reimbursed under this or any other plan, and that I will not seek reimbursement for these expenses under any other benefit plan (including a plan through my employer or through a spouse, domestic partner, or parent). I further acknowledge that federal tax law prohibits me from claiming a deduction or credit for the expenses reimbursed by this arrangement.”

Health FSA Debit Cards: Additional Certifications

Where the health FSA TPA offers employees the ability to use a debit card to access plan benefits, the plan must require employees to certify in writing that:

1. They will only use the card for §213(d) qualifying medical expenses;

2. The medical expense will be limited to themselves and their qualifying dependents;

3. They will not use the debit card for any medical expense that has already been reimbursed;

4. They will not seek reimbursement under any other health plan for any expense paid for with the card; and

5. They will acquire and retain sufficient documentation (including invoices and receipts) to substantiate any expense paid with the debit card.

The rules further require there be a statement providing that the employee is treated as reaffirming these certifications every time they use the debit card. These initial and recurring certifications as a precondition to use the health FSA debit card are better thought of as putting the employee on notice than satisfying the substantiation requirements. In other words, these certifications are not a replacement for the standard substantiation rules above, which continue to apply.

Health FSA Debit Card: Additional Substantiation Considerations

To avoid the potential for abuse, health FSA debit card transactions are limited to:

1. Physicians, dentists, vision care officers, hospitals, other medical care providers (identified by merchant category code (MCC));

2. Stores with the MCC for drugstores or pharmacies for which 90% of sales are medical expenses; and

3. Stores that have implemented the inventory information approval system (IIAS).

Many of these transactions must be substantiated in the same manner as described above. The difference with the debit card is that the substantiation by submitting the itemized receipt will occur after the payment has processed. This creates a higher risk of improper payments from the health FSA when the employee fails to substantiate that the expense was a qualifying medical expense. In those situations, there is a formal IRS procedure to correct the improper health FSA payment (see below).

On the other hand, certain debit card transactions are treated as fully substantiated without the need for submission of a receipt by the employee or further review. These include where the amount of the expense matches the health plan’s copay (or a multiple of up to 5x thereof), certain recurring medical expenses that match expenses previously approved, expenses that are substantiated as a §213(d) medical expense in real-time at the point of sale, and expenses incurred at merchants that have IIAS. The IIAS system is designed to ensure that only qualifying medical expenses can be purchased with the debit card, and therefore the system itself substantiates the expense. The rules direct employers to ensure that their health FSA follows these requirements for any such purchase, and employers will rely on their TPAs to ensure such compliance.

How Employers/TPAs Correct Improper Health FSA Payments

Where the health FSA mistakenly makes an improper health FSA payment for an unsubstantiated expense, IRS guidance provides for a multi-step process for employers or their TPA to apply. To summarize, 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 only option for the employer is to include the improper amount in the employee’s taxable income in the year of the correction.

• For more details: Correcting Improper Health FSA Payments

Enforcement

There is no option for employers or TPAs to make exceptions to these substantiation requirements. The Section 125 rules provide that the IRS could cause the entire cafeteria plan to lose its tax-advantaged status (i.e., lose the safe harbor from constructive receipt) if failures to complete the required substantiation process were discovered on audit. That could result in all elections becoming taxable for all employees.

• For more details: The Section 125 Safe Harbor from Constructive Receipt

What About Dependent Care FSA Claim Substantiation?

The same substantiation rules above for health FSA claims also apply to dependent care FSA claim substantiation. The IRS describes this succinctly as: “Flexible spending arrangements for dependent care assistance must follow the substantiation rules applicable to health FSAs.” The main difference is the TPA will be reviewing claims for whether they substantiate a qualifying daycare expense. The best general IRS overview of what constitutes an eligible daycare expense under §129 and §21 is IRS Publication 503.

Note that there are special rules that apply to dependent care FSA debit card substantiation that are distinct from the health FSA debit card substantiation rules. Debit cards can only be used for the dependent care FSA for recurring daycare expenses by following a four-step process outlined by the IRS.

• For more details: Dependent Care FSA Debit Card Substantiation

What About HRA Claim Substantiation?

The IRS guidance in this area is generally focused on the health FSA and does not directly address HRAs. The limited guidance available in the HRA context provides simply that “[e]ach medical care expense submitted for reimbursement must be substantiated.”

However, because both the health FSA and HRA are account-based health plans with similar substantiation and qualifying expense concerns, employers (and their TPAs) should follow the same substantiation methods for HRAs as are applicable for the health FSA. This is the only reasonable position in the absence of other clarifying guidance.

What About HSA Expense Substantiation?

Unlike a health FSA or HRA, the HSA can be used for both medical and non-medical expenses. The HSA is an account owned by the employee with no administrative gatekeeper to limit HSA distributions. However, HSAs can reimburse only IRC §213(d) qualified medical expenses on a tax-free basis. The general rule is that a non-medical HSA distribution is includible in gross income and subject to a 20% additional tax.

For any tax-free medical expense distributions, IRS guidance provides that individuals must keep records sufficient to show that:

1. The distributions were exclusively to pay or reimburse qualified medical expenses;

2. The qualified medical expenses have not been paid or reimbursed from another source; and

3. The medical expenses have not been taken as an itemized deduction in any year.

The HSA owner must report non-medical distributions on the Form 8889(Lines 14a, 16, and 17b), which is included with the individual income tax return (Form 1040). Failure to properly report non-medical distributions is subject to IRS audit.

For more details:

• Correcting Mistaken HSA Distributions

• The HSA Shoebox Rule

Summary

One of the key functions of the health FSA TPA is to ensure proper substantiation of claims eligible for reimbursement. While this can prove to be a point of contention for employees who often consider the substantiation rules to be a hassle, the process is crucial to ensure the cafeteria plan meets the Section 125 requirements to preserve its tax-advantaged status.

Relevant Cites:

Prop. Treas. Reg. §1.125-6(b):

(b) Rules for claims substantiation for cafeteria plans.

(1) Substantiation required before reimbursing expenses for qualified benefits. This paragraph (b) sets forth the substantiation requirements that a cafeteria plan must satisfy before paying or reimbursing any expense for a qualified benefit.

(2) All claims must be substantiated. As a precondition of payment or reimbursement of expenses for qualified benefits, a cafeteria plan must require substantiation in accordance with this section. Substantiating only a percentage of claims, or substantiating only claims above a certain dollar amount, fails to comply with the substantiation requirements in §1.125-1 and this section.

(3) Substantiation by independent third-party.

(i) In general. All expenses must be substantiated by information from a third-party that is independent of the employee and the employee's spouse and dependents. The independent third-party must provide information describing the service or product, the date of the service or sale, and the amount. Self-substantiation or self-certification of an expense by an employee does not satisfy the substantiation requirements of this paragraph (b). The specific requirements in sections 105(b), 129, and 137 must also be satisfied as a condition of reimbursing expenses for qualified benefits. For example, a health FSA does not satisfy the requirements of section 105(b) if it reimburses employees for expenses where the employees only submit information describing medical expenses, the amount of the expenses and the date of the expenses but fail to provide a statement from an independent third-party (either automatically or subsequent to the transaction) verifying the expenses. Under §1.105-2, all amounts paid under a plan that permits self-substantiation or self-certification are includible in gross income, including amounts reimbursed for medical expenses, whether or not substantiated. See paragraph (m) in §1.125-5 for additional substantiation rules for limited-purpose and post-deductible health FSAs.

Prop. Treas. Reg. §1.125-1(c)(7):

(7) Operational failure.

(i) In general. If the cafeteria plan fails to operate according to its written plan or otherwise fails to operate in compliance with section 125 and the regulations, the plan is not a cafeteria plan and employees' elections between taxable and nontaxable benefits result in gross income to the employees.

(ii) Failure to operate according to written cafeteria plan or section 125. Examples of failures resulting in section 125 not applying to a plan include the following—

…

(G) Failing to comply with the substantiation requirements of § 1.125-6;

IRS Information Letter 2016-0048:

In addition, the employee must certify that any expense being reimbursed has not already been reimbursed and the employee will not seek reimbursement from any other health benefit plan.

IRS Publication 969:

You must provide the health FSA with a written statement from an independent third party stating that the medical expense has been incurred and the amount of the expense. You must also provide a written statement that the expense hasn’t been paid or reimbursed under any other health plan coverage. The FSA can’t make advance reimbursements of future or projected expenses.

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).