Improper FSA Payments

Plan sponsor inquiry:

Scenario 1: We learned of a qualified FSA expense incurred and made to a participant after date of employment separation due to lag time between the weekly file feed to FSA TPA with employment status changes and TPA updating their records. While we may sometimes know in advance of upcoming employment separations, that is not always the case. Our TPA is telling us that this is not necessarily a violation of FSA regulations and is comparing it to situations where participants use all their FSA funds prior to separation of employment and complete funding of their election. That doesn't sound right to me. Assuming it's not right, are we required to include the improper payment in the former employee's taxable income subject to withholding and payroll taxes in these scenarios? If yes, how is this done when there are no additional wages to take the withholding/payroll taxes from?

Scenario 2: FSA TPA fails to terminate FSA account upon receipt of file feed with separation date (error is caught several weeks later). TPA will refund us for any improper reimbursements, and is advising that because it is their error, we have no obligation to include improper reimbursements in the former employee's taxable income. Given our understanding that the plan sponsor has ultimate fiduciary responsibility for proper FSA administration, including monitoring the TPA, this, too, doesn't sound right to me. 

Scenario 1:

10 minutes ago, Christine Oliver said:

Our TPA is telling us that this is not necessarily a violation of FSA regulations and is comparing it to situations where participants use all their FSA funds prior to separation of employment and complete funding of their election. That doesn't sound right to me.

Yeah that's a red herring.  The issue is the cafeteria plan terms.  The plan terms could allow expenses to be incurred post-termination (e.g., through the end of the month in which they terminate to match the health plan), although that's fairly uncommon.

Here's a quick overview:

https://www.newfront.com/blog/cobra-for-the-health-fsa

The health FSA is a component of the employer’s Section 125 cafeteria plan.  Most cafeteria plans will provide that FSA coverage (i.e., the ability to incur reimbursable claims) ends as of the date of termination from employment or other event causing a loss of eligibility, such as reduction in hours. 

The cafeteria plan may provide that health FSA coverage continues through the end of the month in which the employee terminates, similar to many medical/dental/vision plans. However, extending health FSA coverage through the end of the month prior to starting the run-out period is not common. 

13 minutes ago, Christine Oliver said:

Assuming it's not right, are we required to include the improper payment in the former employee's taxable income subject to withholding and payroll taxes in these scenarios?

There is a multi-step process to follow here from IRS guidance.

Here's the IRS guidance: https://www.irs.gov/pub/irs-wd/1413006.pdf

Here's a full walkthrough: https://www.newfront.com/blog/correcting-improper-health-fsa-payments

14 minutes ago, Christine Oliver said:

If yes, how is this done when there are no additional wages to take the withholding/payroll taxes from?

If you get to that step, you'd simply include in their W-2 taxable income.  There won't be any withholding if there's no longer any stream of income (e.g., severance) to take it from, but you still report the taxable income.

Scenario 2:

17 minutes ago, Christine Oliver said:

Given our understanding that the plan sponsor has ultimate fiduciary responsibility for proper FSA administration, including monitoring the TPA, this, too, doesn't sound right to me. 

There's a step-by-step process to follow here.  It's pretty straightforward, and the TPA should be aware of it.  

The employer can contractually delegate that process to the TPA, but the employer always retains the ultimate responsibility.

You can find all this IRS guidance here: https://www.irs.gov/pub/irs-wd/1413006.pdf

Or here's my attempt to summarize:

https://www.newfront.com/blog/correcting-improper-health-fsa-payments

TPA Can Correct FSA Payment Errors on Employer’s Behalf

As a practical matter, employers rarely are involved in the day-to-day operations of the health FSA. These administrative functions are almost always delegated to a TPA that assumes the role of processing claims. The TPA will therefore typically have been the entity that approved the improper payment.

As always, the employer as the health FSA plan sponsor is ultimately responsible for complying with the applicable law. That’s true regardless of whether the employer has delegated plan administration functions to the TPA, and regardless of whether the TPA made the error.

Nonetheless, the IRS recognizes that the employer may also delegate the responsibility to apply the improper payment correction procedures on behalf of the employer. In the same manner that the TPA processes claims on behalf of the employer and its plan, the TPA can also process the improper claims repayment process on behalf of the employer and the FSA.

Because the employer retains the ultimate liability in these scenarios regardless of the delegation to the TPA, the employer should ensure that the process is completed properly and consider contractual protections to avoid or limit liability. Furthermore, the employer has a fiduciary duty under ERISA to prudently select and monitor plan service providers, which includes the health FSA TPA. Employers should monitor whether a health FSA TPA is consistently allowing preventable payment errors and/or failing to properly correct those errors.

Thanks, Brian. I follow and read your excellent compliance articles/blogs, including this particular one, which prompted my concern about the TPA's responses!  So, do I understand correctly that unless the cafeteria plan specifically allows for eligible expenses incurred through the end of the month in which the employment separation occurs, these situations are impermissible, and we must include improper reimbursements in the employee's taxable income as doing otherwise could risk IRS disqualification.

Oh cool, thanks Christine.

I think the problem is if the cafeteria plan specifically does not allow expenses incurred post-termination.  Then you would be operating contrary to plan terms (thereby jeopardizing the safe harbor from constructive receipt) if you didn't follow the improper payment correction process.  Keep in mind that including in income is just the last step in the improper payment correction process.

If the plan terms are silent on it, you might get comfortable taking the position that incurring claims post-termination (to some point) is permissible based on consistent plan administrative practice/interpretation.

Prop. Treas. Reg. §1.125-1(c)(7):

(7) Operational failure.

(i) In general. If the cafeteria plan fails to operate according to its written plan or otherwise fails to operate in compliance with section 125 and the regulations, the plan is not a cafeteria plan and employees' elections between taxable and nontaxable benefits result in gross income to the employees.

Yeah, not sure about taking that risk. What strikes me is that I can't imagine this is not a problem for plan sponsors and TPAs (i.e., eligible claims reimbursed between separation date and status update in TPA system). I suppose it may go unnoticed. I also can't think of a way to completely prevent it from happening. Thank you for your prompt responses.

Follow up question. The TPA is reimbursing the plan sponsor for the eligible reimbursement made on the day after the participant's date of employment separation. Based on my review of the IRS guidance, do I understand correctly that this is a sufficient "correction" and we do not have to apply the amount to the participant's taxable wages?

I don't see that as sufficient.  The TPA reimbursing the employer plan sponsor is not part of the correction process for an improper FSA payment.  If the employer demanded repayment from the employee, and the employee repaid the employer, that would be sufficient under the steps outlined in the guidance.