On May 3, the Internal Revenue Service (IRS) released an advice memo (Memorandum Number 202317020) making clear that expenses to be paid from cafeteria plan funds must be documented. If they are not, the memo states, the funds used to pay unsubstantiated expenses will not be shielded from income or employment taxes.

The general rule, per the memo, is that if a cafeteria plan does not require an independent third party to fully substantiate health flexible spending arrangement (FSA) reimbursements for medical expenses, then the “plan fails to operate in accordance with the substantiation requirements and is not a cafeteria plan within the meaning of IRC Section 125.” That means employee deferrals into the FSA would have to be included in the employee’s gross income. Further, such FSA contributions would be characterized as wages subject to FICA and FUTA taxes.

The memo provides six examples—five of which illustrate situations where the substantiation (if any) is insufficient—of adequate substantiation (documentation). The first example involves a medical FSA and requires that to be reimbursable from a tax-free FSA, a medical expense must be substantiated by a third party independent of the employee. The substantiation must include a description of the service or product to be reimbursed, the date of service or sale, and the amount of the employee’s expenses.

The remaining five examples describe practices that fail the substantiation requirement—situations involving submission of a claim without any documentation other than the employee’s own information; situations where substantiation is required only on a random basis; failure to substantiate de minimis expenses, failure to require substantiation from certain “preferred” providers, and the rules regarding payment from a cafeteria plan’s dependent care FSA.

Prospects: Some experts question whether this advice memo—which states that it cannot be used or cited as precedent—will be enforced. It is based on a never-finalized regulation proposed more than 15 years ago. Still, it would likely take litigation—a costly and time-consuming endeavor—to clarify whether these substantiation rules are in fact enforceable law, and thus NAIFA members advising clients on cafeteria plan FSAs (medical and dependent care) should be aware of this advice memo and encourage their clients to proceed accordingly.

NAIFA Staff Contact: Jayne Fitzgerald – Director – Government Relations, at jfitzgerald@naifa.org.