Improper reimbursements from a medical flexible spending account.

[Guest ssiewert]

What are the specific consequences if an employee is reimbursed from a medical flexible spending account for an unqualified expense such as vitamins? Will it affect the entire cafeteria plan? Will the employee have to pay taxes on the amounts, or will the employer be liable? Will there be penalties for failing to withhold taxes? What will the employer's liability be to the employee? Will the employer be able to reimburse the employee for contributions to the plan if the employee was lead to believe that the unqualified expenses were qualified?

[papogi]

If a 125 plan fails non-discrimination tests, only HCE's or key employees are affected. If a plan fails to adhere to 125 rules, such as in your example, all participants can be affected. The IRS almost never audits 125 plans (I say almost, although I've never seen an 125 audit). Theoretically, if they did, and found yours to be out of compliant, then all benefits that were otherwise available in cash would be taxable. Basically, all pre-tax amounts would suddenly have to be taxed. Employees would pay this tax, and employers would have to pay FICA, FUTA, and any applicable state and local taxes. A penalty could also be levied against the employer for failing to withhold income tax and FICA. In the real world, the IRS has inferred that, even if an audit did take place, they would be likely to use the experience only as an educational exercise for the employer. That still scares me, since there's no guarantee. The best thing to do is notify the employee of the incorrect reimbursement, and ask that a check representing the wrong reimbursment be submitted.

In Grande vs. Allison Engine Company, a court found that flex expenses which were otherwise not eligible in the year in question were payable because of the employer's reference to Publication 502, which states a couple things contrary to FSA rules. If employees can prove that they were mislead, preferably in writing, concerning eligible reimbursements, I could see that a court just might allow the reimbursements. I am doubtful of this, however. I think the employer cannot return contributions, and the employees are stuck.

[Guest ssiewert]

Thank you for the fast response papogi. I have also heard that the IRS can be lenient in cases like this. Do you know of any IRS releases that support this? I have been attempting to call the IRS Office of Chief Counsel (Harry Becker) to get an answer but have not had any luck yet.

You said that if a plan is out of compliance, then all benefits that were otherwise available in cash would be taxable. Does that mean all employees or just the one who received the unqualified reimbursement?

As far as liablity to the employee, would the employer or plan administrator be liable for giving the employee bad informatioin as a fiduciary under ERISA (I believe that a medical FSA qualifies as a wellfare benefit plan)?

[E as in ERISA]

The IRS does audit 125 plans. But the audits are being conducted by payroll tax reviewers. See their training at http://www.irs.gov/pub/irs-utl/lesson4.pdf. My understanding is that they don't look at discrimination issues -- the main focus is whether there is a plan document authorizing the pretax deductions.

[GBurns]

Unless the audit (and they do take place) shows a pattern of abuse or mismanagement, occasional errors such as these or even frequent but rationalizable errors, that can easily be corrected within the plan year are not cause for disallowing the plan or affecting other plan participants.

The usual position taken by the IRS in training and in public comments has always been as Mr. Beker restated at the March ECFC Conference:

==> WHAT TO DO WHEN AN EMPLOYEE IS REIMBURSED FOR AN EXPENSE THAT SHOULD NOT HAVE BEEN REIMBURSED. If a health FSA reimburses an expense and it is later determined that the expense should not have been reimbursed (e.g., the expense was not for medical care, or the expense exceeded the employee's limit), the IRS says that the employer cannot just report the excess reimbursement amount on the employee's Form W-2 as imputed income. Rather, the employee must repay the amount to the employer with after-tax dollars (e.g., by writing a check).

[Kirk Maldonado]

If that's what Harry said, I think he's wrong. You can't have both reportable income and an obligation to repay. You have to have one or the other.

[mbozek]

I agree with Kirk. The employee can have either imputed income or return the money but not both under the claim of right doctrine. If an employee returns a payment that he is not entitled to receive before the end of the tax year then the employee will not include the payment as taxable income. See Rev Rul 79-311.

Also the IRS does not test for non discrimination in a 125 plan because there are no standards.

[papogi]

Harry is not saying you can have both. He is saying you have to repay the money, nothing else. Employers have always toyed with the idea of simply reporting the "errors" as income to the employee. The IRS is clarifying that employers shouldn't do that. Instead (not in addition to), they should have the employee send the money back to the employer.

While I agree that IRS guidance is almost non-existent with regard to some areas of non-discrimination, a good faith effort to satisfy the rules decided upon by the industry (such as the repealed Section 89(e)), is the safest way to go. Some areas, such as the Concentration Test for Key Employees, are relatively clear cut. I wouldn't dismiss the entire area of 125 non-discrimination simply because the IRS's own lack of auditing and testing has given us little court guidance (standards). There was an intent when the legislation was written, and it should be deciphered and followed as best as possible.