In an information letter issued in December of 2020 to the office of then-Senator Kelly Loeffler,[1] the IRS explained why the Senator’s constituent was required to provide additional documentation to support that amounts paid with a debit card linked to her employer-sponsored health flexible spending account and that the employer had properly deactivated her card.

The letter explained the situation the constituent faced:

I am responding to your inquiry dated November 16, 2020, on behalf of your constituent, * * *. * * * explained that a plan administrator, * * * (* * *), requested documentation to substantiate medical expenses paid with a debit card linked to a health flexible spending arrangement (FSA) under a Section 125 cafeteria plan. * * * also explained that * * * deactivated his wife’s health FSA debit card after she did not provide the requested documentation. * * * asked if IRS can stop * * * from requesting documentation for medical expenses paid with the debit card linked to the health FSA.[2]

The letter notes that expenses paid from a health FSA must be substantiated by a third party—the employee’s assertion that the expenses were medical expenses is not sufficient:

Medical expenses paid or reimbursed from a health FSA are excludible from gross income. Medical expenses paid or reimbursed from a health FSA must be verified by an independent third-party that substantiates the expenses. Substantiation for medical expenses includes information describing the service or product, the date of the service or sale, and the amount of the expense.[3]

In support of this position, a footnote to the letter refers to Revenue Ruling 2003-43 and Notice 2006-69.

For a debit card linked to a Section 125 plan health FSA, the IRS outlines the rules as follows:

There are special rules for medical expenses reimbursed with a debit card. These rules take into account the information a debit card transaction provides. Some debit card transactions require additional information to fully substantiate that the expense is a medical expense. For example, a debit card transaction may collect information about the amount of the transaction, a general category of the merchant providing services, and the specific merchant providing the services, but may not identify the specific items or services provided in the transaction. If the information provided during the debit card transaction does not satisfy the substantiation requirements, the plan administrator must request additional information to substantiate the medical expense. The plan administrator must deactivate the debit card if the medical expense is not timely substantiated. For more information about debit card reimbursements, see IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans on IRS.gov at www.irs.gov/pub/irs-prior/p969--2019.pdf.[4]

The letter also notes that an employer may require stricter standards than those that are the minimum under the law:

An employer’s health FSA may impose more stringent standards to ensure that health FSAs are used only to pay or reimburse medical expenses. Also, your constituent may want to contact the employer or plan administrator to ask how his wife can submit a claim for reimbursement directly to the plan with the documentation that the plan requires.[5]

Although not discussed in the letter, it’s key to note that under Section 125 the sponsor is the one responsible for assuring that the Section 125 plan meets the requirements to maintain tax favored status under the law.

Contrast this with a health savings account under IRC Section 223. In that case, the individual is the owner of the account in question and is responsible for its proper operation. Thus, an HSA may be linked to a debit card issued in the account holder’s name without any need to substantiate the use of the funds for medical purposes to the custodian. Rather, the account holder is responsible, should the IRS come calling, to substantiate that the funds were used for medical purposes or face the tax consequences of being treated as taking a taxable distribution from the fund.

[1] Information Letter 2021-0003, December 14, 2020 (released June 25, 2021), https://www.irs.gov/pub/irs-wd/21-0003.pdf (retrieved July 9, 2021)

[2] Information Letter 2021-0003, December 14, 2020

[3] Information Letter 2021-0003, December 14, 2020

[4] Information Letter 2021-0003, December 14, 2020

[5] Information Letter 2021-0003, December 14, 2020