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Guest Article

Deloitte logo

(From the April 14, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Flexible Spending Account Administrator Breached ERISA by Applying IRC § 125 Requirements


In a decision that underscores the importance of complying with ERISA's Title I requirements, the U.S. District Court of New Jersey held that the administrator of a Flexible Spending Account violated ERISA by applying the IRC § 125 definition of when a medical expense is "incurred" when the relevant plan documents were silent on the issue. O'Meara v. _________, Civil Action No. 07-CV-4429 DMC (April 1, 2008).

After finding that the Summary Plan Description did not define when a medical expense is "incurred," the court reasoned that the employee's belief that she incurred medical expenses when she pre-paid for the services was reasonable under the facts. The court granted summary judgment in favor of the plaintiff-employee, holding that the plan administrator (i.e., the employer) breached its fiduciary duty by providing misleading benefit documents.

Pre-Payment for Orthodontia Work

At the time of her hire in August 2005, the employee was in need of orthodontia work. She elected to have $3,000 deducted from her paycheck in 2005 to be deposited in a Flexible Spending Account (FSA) for this purpose. The Summary Plan Description and related FSA Guide said only that, "You must incur your eligible expenses by December 31 of the calendar year in which your contributions are made." After enrolling in the FSA, the employee commenced her orthodontic treatment and paid $4,878.25 to the orthodontist in December 2005. She applied for reimbursement from the FSA and received only $623.63, the amount that the third-party claim administrator -- and the plan administrator on review -- determined applied to the dental services the employee had actually received in 2005. The remaining $2,377.77 was forfeited as provided under the FSA.

The employee appealed the decision to both the claims administrator and the plan administrator and, nearly 1-1/2 years after her initial request for reimbursement, was finally denied her claim. She filed suit in Federal district court alleging breach of fiduciary duty under ERISA, negligent misrepresentation and equitable estoppel.

IRC § 125 Requirements

Proposed Treasury Regulations under IRC § 125, which govern FSAs, provide that:

...medical expenses are incurred when the employee (or the employee's spouse or dependents) is provided with the medical care that gives rise to the medical expenses, and not when the employee is formally billed, charged for, or pays for the medical care.

Prop. Treas. Reg. § 1.125-6(a)(2)(ii).

The requirement that medical care be provided before an employee becomes entitled to reimbursement from an FSA is consistent with the long-standing justification for providing non-taxable benefits under FSAs: that an FSA functions essentially as an insurance-type product and, as a result, the benefits it provides should be non-taxable. Both the employer and the employee are "at risk" for the elected coverage amount, similar to that under elected health insurance coverage. The employee bears the risk that all of the elected coverage may not be used even though the employee has fully paid the premium contributions. The employer bears the risk that the employee may claim 100 percent of the elected coverage before paying the premium contributions.

Basis of the Misunderstanding

In O'Meara, the employee believed that her payment for future services would "incur" a claim for which she could be reimbursed by the FSA. According to the court:

When Plaintiff elected to deposit money into the FSA, it was her understanding that, if an employee signs a contract for orthodontic treatment, has the initial evaluation performed, x-rays taken, molds created and the braces fitted and applied to her teeth, and pays in full for that work in the given year, she has 'incurred' an eligible expense for that year, even if some of the treatment extends over into the following year.

The court then examined IRS Publication 502 -- Medical and Dental Expenses, which was referenced in the FSA Guide to clarify the definition of "medical expenses" used by the FSA. Publication 502 itself addresses an individual's eligibility for claiming an IRC § 213 deduction for medical expenses, althoughthe definition of "medical expenses" generally is the same for both that purpose and FSAs. Unfortunately, the definition of when a medical expense is "incurred" is different for personal deductions and FSAs. Apparently, the FSA Guide failed to clarify this distinction. As the court noted, Publication 502 states, "You can include the medical and dental expenses you paid this year, regardless of when the services were provided."

The court, citing the U.S. Supreme Court decision in In re Unisys Corp., 57 F.3d 1255 (1995), held that the plaintiff-employee met the burden of proof necessary to establish that the employer-administrator had breached its fiduciary duty under ERISA. She showed that: (1) the employer-administrator was acting in a fiduciary capacity when the challenged representation was made, (2) the representation constituted a material misrepresentation, and (3) the plaintiff-employee relied on the misrepresentation to her detriment. The court granted summary judgment in her favor on the ERISA claim, and dismissed the state law claims of negligent misrepresentation and equitable estoppel on the basis of ERISA preemption.

Lessons and Observations

Department of Labor Regulations make clear that a Summary Plan Description must accurately reflect the terms of the plan and must contain the various specific items listed in DOL Reg. §2520.102-3. Of particular concern from a practical perspective is disclosure of the "requirements respecting eligibility for participation and for benefits," which seem to be at the heart of most court cases. With FSAs in particular, employees need to be fully aware of the risk of forfeiture, and that they cannot "pre-pay" their way out of that risk. This court was particularly sensitive to the fact that FSAs contain the employee's own money:

...[T]here is good argument to be made that the law pertaining to FSAs should be interpreted even more favorably to the employees because the employee is simply requesting his or her own money.

Why this particular FSA was determined to be an ERISA-covered plan was not addressed in the opinion. Commentators have opined that, where the underlying benefits are provided by separate ERISA plan(s), the FSA would be providing merely a tax benefit and would not be subject to ERISA. ERISA would only cover FSAs that are "employee welfare benefit plans" as defined under ERISA § 3(1). Under this analysis, to be subject to ERISA, the FSA would need to provide at least one of the following "welfare" benefits that is not included in a separate ERISA plan:

  • (A) medical, surgical, or hospital care or benefits, or benefits in the event of sickness, accident, disability, death or unemployment, or vacation benefits, apprenticeship or other training programs, or day care centers, scholarship funds, or prepaid legal services, or
  • (B) any benefit described in section 302(c) of the Labor Management Relations Act, 1947 (other than pensions on retirement or death, and insurance to provide such pensions).

The tax-benefit nature of FSAs also raises the issue of how damages or denied benefits would be provided in cases such as O'Meara. Presumably, the employee will be provided taxable cash compensation grossed up for the lost tax benefit and interest. Providing payments from the FSA in violation of IRC § 125 could potentially disqualify the plan and cause benefits to be taxable to the other employees.


Deloitte logoThe information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2008, Deloitte.


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