Health Care FSA: Reimbursement of Domestic Partners

[rocknrolls2]

Company X maintains Cafeteria Plan M providing for a health care FSA among other benefits. Domestic partners and civil union spouses of participants are permitted to participate in the regular medical coverage but they are not permitted to participate in the health care FSA. During the year, it is discovered that the new vendor has been reimbursing claims incurred by domestic partners/civil union spouses from the health care FSA. The vendor has been directed to stop making reimbursements to such individuals. However, in determining the tax treatment of the participant for the amounts that were reimbursed, I have a question on the appropriate tax treatment.

I know that with medical coverage for such persons, the employer's share of the premiums must be imputed into the employee's gross income and the employee's share of the premiums must be made on an after-tax basis, while the benefits reimbursed to such individuals are considered tax free. With a health care FSA, however, the problem is that it is not possible to ascertain the amount of claims by which the domestic partner/civil union spouse must be reimbursed. Therefore, would it be appropriate to impute into the employee's gross i ncome the amounts actually reimbursed to the domestic partner/civil union spouse or should the amounts withheld from the employee's pay for contributions to the FSA be divided pro rata among the employee and all dependents with the pro rata portion attributable to the domestic partner/civil union spouse be treated as made on an after-tax basis?

[QDROphile]

There is not an answer that is supported by specific guidance. I would choose to include the reimbursements for the domestic partner in the employee's income. My second choice would be to include all of the FSA amount in the employee's income. Part of the reason is punitive -- the claimant should be certifying that the expenses are eligible. Part of the reason is principle. As you have observed, you cannot know in advance how much of the FSA amount would go to the domestic partner (unlike cost of core health coverage). Therfore, expenses of the the domestic partner could have consumed the entire amount. To enable the domestic partner to have so much covereage, the entire FSA amount could be treated as the cost of coverage. In most FSAs, the cost of coverage is equal to the benefits. If you choose the most gentle approach (my first choice), you are doing nothing to discourage gambles on cheating, which reflects badly on the sponsor and administrator.

I vote strongly against the pro rata approach. I don't see any principle behind it. Sounds like an old adage from law school: If we can't be fair or correct, we must be arbitrary.

[LRDG]

Medical FSA reimbursements for ineligible claims paid on behalf of civil union/domestic partners should be reversed from each eligible participant's Medical FSA. Offset the ineligible amounts from future claims.

The individuals should be notified in writting, explain how the error occured and how it will be corrected. Benefit statements, FSA EOBs and all other mid year communication pieces should include a written explanation to DP/CU participants of the necessity to correct the administrative error. If it's necessary to 'motivate' participants to cooperate, stress the importance of correcting the error due to adverse IRS consequences of accepting ineligible FSA reimbursements.