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Correcting Improper Health FSA Payments

By Brian Gilmore | Published February 5, 2024

Question: How can employees and their third-party administrators correct improper payments (reimbursements/distributions) from the health FSA?

Short Answer: IRS guidance outlines a multi-step correction procedure to address improper FSA payments. Although the employer is the plan sponsor directly responsible for compliance, the FSA third-party administrator (TPA) may apply the correction procedures on the employer’s behalf. If all the available steps are unsuccessful in correcting the error, the final step is to include the amount of the improper payment in the employee’s taxable income in the year of the correction.

Improper Health FSA Payments: Overview

Health FSAs can reimburse only §213(d) qualified medical expenses incurred during the period of coverage. Employers may encounter situations where an employee has received an ineligible distribution from the health FSA.

For example, the health FSA TPA may inform the employer that an employee incorrectly received payment from the FSA due to:

• An expense not properly substantiated after using the FSA debit card.
• A processing error by the TPA that approved a non-qualifying claim.
• A mistaken reimbursement for an expense incurred outside the coverage period.
• A mistaken reimbursement exceeding the employee's available balance.

For more details:

• Newfront Section 125 Cafeteria Plan Guide
• When FSA Expenses Are Incurred
• 2024 Health FSA Limit Set at $3,200

The IRS-Approved Steps for Correcting an Improper Health FSA Payment

An IRS Chief Counsel Advice memorandum walks through the correction process for employers upon discovering an improper health FSA payment.

Step 1: Deactivate Debit Card if Used to Make Improper Payment

If a health FSA debit card was used for an improper payment, the employer must deactivate the card until the improper payment is recovered. Claims incurred during this period have to be submitted without using the debit card. If a debit card was not involved, move to Step 2.

Step 2: Three Steps in Any Consistent Order

The next three steps can be followed in any order consistently applied to all participants in the health FSA.

1. Employer Demands Repayment: The employer should demand that the employee repay the improper distribution. A notice informing the employee of this obligation suffices.

2. Employer Withholds Amount (Generally Not Recommended): This step advises withholding the improper charge from the employee’s pay, though state laws often require written authorization.

3. Offsetting Reduction to Subsequent FSA Claim: The plan can apply a claims substitution, using subsequent valid claims to offset the improper payment.

Step 3: Include Improper Payment in Employee’s Taxable Income

The final step directs the employer to treat the improper payment like other business debts, reporting it as wages on the Form W-2 for income tax withholding.

The amount is reported in the year of the correction and should be the last resort after all other correction methods have been pursued.

TPA Can Correct FSA Payment Errors on Employer’s Behalf

Employers generally delegate health FSA administration to a TPA. Even if the TPA made the error, the employer is ultimately responsible for compliance.

Improper Health FSA Payment Examples

Example 1:

• Jack Sparrow participates in the health FSA of his employer, The Black Pearl, and submits a claim of $350 for a personal trainer (not qualifying). The TPA mistakenly pays Jack.
  _Result: The TPA should deactivate Jack's debit card and demand repayment.

Example 2:

• Elizabeth (Swann) Turner, a participant in the Brethren Court’s FSA, submits a claim for $500 for egg freezing expenses. The claim was mistakenly approved in 2024.
  _Result: The improper payment should be included in her taxable income in 2025.

What About Correcting Improper Payments in Other Plans?

The IRS guidance primarily addresses health FSAs, but similar methods can be employed for dependent care FSAs and HRAs. For commuter benefits, guidelines differ slightly, given their nature with §132 transportation plans.

Summary

Mistakes will occur in any employee benefit plan, including health FSAs. The IRS has provided a correction process involving deactivating debit cards, demanding repayment, and including payments in taxable income as a last resort. Employers should address errors promptly rather than delaying corrections until the end of the plan year.