Guest Article

(From the October 1, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

New IRC § 125 Proposed Regulations: Focus on Substantiation Requirements

The IRS on August 3, 2007 issued new proposed regulations for IRC § 125 cafeteria plans. This is the third in a series of articles on the proposed regulations, focusing on the substantiation requirements for payments or reimbursements by IRC § 125 plans. The second article focused on the rules for health, dependent care, and adoption assistance flexible spending arrangements (FSAs). A fourth article on using debit cards to access health and dependent care FSA balances will appear in a future edition of Washington Bulletin.

General Rule

The general rule is that IRC § 125 cafeteria plans may pay or reimburse otherwise eligible expenses only after they have been substantiated with information from an independent third party. The information provided by the third-party must describe the service or product, the date of the service or sale, and the amount. In no event will self-certification or self-substantiation by an employee be sufficient. If an IRC § 125 plan permits self-certification or self-substantiation, then all payments or reimbursements from the plan -- whether properly substantiated or not -- will be included in the employee's gross income.

The proposed regulations explicitly state that IRC § 125 plans must substantiate every expense as a precondition of payment or reimbursement. This rule will not be satisfied by substantiating only a percentage of claims, or substantiating only claims above a certain dollar amount.

Also, additional substantiation requirements may apply depending on the type of expense being paid or reimbursed -- i.e., expenses for health care, dependent care, or adoption assistance.

Special Substantiation Rules for Medical Expenses

An IRC § 125 cafeteria plan that pays or reimburses medical expenses, including health FSAs, must limit such payments to IRC § 213(d) medical expenses incurred by the employee, or the employee's spouse or dependents during the applicable period of coverage. In general, IRC § 213(d) medical expenses include expenses incurred "for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body." This generally includes health and long-term care insurance premiums, except these premiums may not be paid from a health FSA. The proposed regulations make clear that employers may not use other arrangements outside the IRC § 125 plan to get around this requirement. Such arrangements include adjusting employees' pay or other benefits based on medical expenses incurred or reimbursements received.

Additionally, only medical expenses incurred while the participant is covered by the health FSA or other accident and health plan -- including any period of COBRA coverage -- may be paid or reimbursed. (An expense is incurred when the employee (or the employee's spouse or dependents) receives the medical care, and not when the employee is formally billed, charged for, or pays for the care.) As a result, medical expenses incurred before the later of the plan's effective date and the date the employee is enrolled in the plan may not be paid or reimbursed. However, actual payment or reimbursement may occur after the period of coverage for expenses incurred during the period of coverage.

The proposed regulations include the following example of how these rules apply to terminated participants:

Substantiating Health FSA Claims with Insurance Company Explanation of Benefits

As noted, all expenses must be substantiated with information from an independent third party. According to the proposed regulations, this requirement can be satisfied if an insurance company provides an "explanation of benefits" (EOB) with the date the medical expense was incurred and the employee's payment responsibility (i.e., deductible, copay, etc.) to the employer. However, in addition to the EOB, the employee must certify that the medical expense has not been reimbursed from any other source and that s/he will not seek reimbursement from any other health plan. If these requirements are satisfied, the employer does not have to ask the employee for a receipt or seek further review of the claim.

Special Substantiation Rules for Dependent Care Expenses

Like medical expenses, an IRC § 125 cafeteria plan -- including a dependent care FSA -- may not pay or reimburse dependent care expenses until they have been incurred. Dependent care expenses are incurred when the care is provided and not when the employee is formally billed, charged for, or pays for the dependent care. Additionally, only dependent care provided during the applicable period of coverage may be paid or reimbursed.

The proposed regulations specifically address questions relating to paying or reimbursing nonrefundable deposits or fees for dependent care. An IRC § 125 cafeteria plan may not pay or reimburse the non-refundable deposits or fees until after dependent care services are provided. If an employee pays non-refundable deposits or fees that are not used to pay for dependent care services, the deposits or fees may not be reimbursed from the IRC § 125 cafeteria plan. The proposed regulations illustrate these rules with the following example:

A second example explains that the $500 non-refundable fee could not be reimbursed if the child care center never provided child care services to the employee's child.

The proposed regulations also clarify that IRC § 125 cafeteria plans may permit terminated employees to seek reimbursement of unused dependent care assistance benefits through the last day of the applicable plan year. However, plans do not have to offer this option.

The 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, Taina Edlund 202.879.4956, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.