health FSA and HSA - how does IRS know

Let's say an employee enrolls in an HDHP with family coverage and contributes to an HSA. Their spouse contributes to a general purpose health FSA, which we know is disqualifying coverage for purposes of the HSA. But how would the IRS know this? It doesn't seem that health FSAs are reported to the IRS (whereas dependent care benefits, like dependent care FSA contributions, are reported on W-2). What am I missing? 

This might be one of many things about which it would be difficult, perhaps extraordinarily difficult, for the IRS to detect a tax return’s claim of a tax benefit the law doesn’t provide.

The hard questions are about whether it’s professionally or ethically proper for an adviser to inform one’s advisee about nonenforcement and nondetection.

You are correct that a General-Purpose Health FSA are considered disqualifying coverage for HSA eligibility and that it would be difficult for the IRS to know.  However, there are few things that could occur, leading to the IRS knowing.

1. Employer Records - employers track these contributions.  If the employee is audited, the IRS could request these records.

2. HSA Contribution Form 5498-SA - the institution that holds the HSA funds report contributions to the IRS.

3. Dependent Care FSA information - is reported on W-2.

4. IRS Form 8889 - employees with HSA contributions must file form 8889.  Part of this form is a certification for eligibility.

5.  Random IRS audits.

Imagine you are teaching your child to drive.  You reach an intersection with a red light with absolutely no sign that anyone else is around.  You child asks "Why can't we go through the light? How will the police know we did that?"  How would you respond? 

I don't think you're missing anything.  The IRS could always audit and find it, but it would be quite difficult because (as you said) there is no W-2 reporting of the health FSA.  In theory it would have to involve review of paystubs or interaction with the employer to confirm.  But as noted above, there are many aspects like this in tax liability where it would be difficult to discover the issue.  A rolling 6% excise tax on the ineligible HSA contributions that could apply is also no joke.

Building on what Peter said, depending upon the profession of the advisor, there may be strict ethical considerations -- essentially, if you merely tell the advisee to ignore it and it will not get picked up by the IRS, you are aiding and abetting the advisee in breaking the law and could have your license to practice suspended or revoked. In addition, the risk of getting caught should never be the basis for providing professional advice.

Perhaps a better way to handle this is, tell the advisee, "As your [name of your profession], fed eral tax law specifically prohibits you from having the HSA if your spouse has a general purpose health FSA. As a business person, however, given the circumstances that there is no reporting of the amount of health FSA contributions or distributions, it is unlikely, unless the IRS conducted an audit of your tax return, that the IRS would detect this. My advice to you is that either you or your spouse needs to either stop contributing to the HSA or stop contributing to the health FSA as soon as possible. What you ultimately decide to do is up to you, but I have provided you the benefit of my advice.  If you decide to follow my advice, I will be glad to be of any assistance you need to help you implement that advice."

This will not necessarily sit well with your client, but it will help keep you out of trouble, and maybe, the client will decide to listen.

Under lawyers’ professional-conduct rules, “[a] lawyer shall not counsel a client to engage, or assist a client, in conduct that the lawyer knows is criminal or fraudulent[.]” Rule 1.2(d) https://www.pacodeandbulletin.gov/Display/pacode?file=/secure/pacode/data/204/chapter81/s1.2.html.

But a professional might distinguish between advising a client to do the bad thing and informing a client about what consequences could or seem likely to result if a person did or does the bad thing (without the professional’s involvement in it).

Here’s a bit of the law professors’ debate:

Jamie G. Heller, Legal Counseling in the Administrative State: How to Let the Client Decide, 103 Yale L.J. 2503 (1994) (suggesting a lawyer educate her client with full-picture counseling about the law’s provisions, practical application, potential nondetection, potential nonenforcement, and purposes so the client can make fully informed choices).

Stephen L. Pepper, Counseling at the Limits of the Law: An Exercise in the Jurisprudence and Ethics of Lawyering, 104 Yale L.J. 1545 (1995) (suggesting modes of reasoning about whether it is appropriate for a lawyer to advise a client about potential nondetection or nonenforcement).

Different standards apply if one is a paid preparer of an individual’s tax return.

“Imagine you are teaching your child to drive. You reach an intersection with a red light with absolutely no sign that anyone else is around. Your child asks ‘Why can’t we go through the light? How will the police know we did that?’ How would you respond?”

Reflecting on Chaz’s illustration and considering an adviser’s role about a query of the kind casey72 describes, there might be some differences between them that matter for how one thinks and feels about each situation.

There might be differences between serving as a parent or teacher responsible for a child’s formation, and as an adviser providing information to a mature adult ordinarily presumed to have autonomy to make one’s decisions.

I won’t here recount the debate between those who suggest an adviser provide full information and those who suggest holding back information that would help a principal know what it can do without getting caught. But I think it’s important to recognize who’s the principal. And who’s an adviser, who, although she might have powers about her role, is not (unless so engaged) the principal’s decision-maker

Chaz, thank you, again, for helping me think about this. In the summer semester, I teach Professional Conduct in Tax Practice; may I use your example and its great metaphor?