Dependent Care FSA Debit Card Substantiation
By Brian Gilmore | Published June 6, 2023
Question: How can employers and their TPAs process dependent care FSA debit card expenses when most daycare providers require advance payment?
Short Answer: Dependent care FSA expenses are not considered incurred until the services for the period are fully provided (e.g., the end of the month). This makes it difficult to pay for such expenses with a debit card when the provider requires advance payment (e.g., the start of the month) before the FSA can permit payment. However, as a workaround the cafeteria plan rules permit a recurring daycare expense to be initially substantiated and used to load the FSA debit card to pay for each future service period at the same daycare provider.
Newly-Issued IRS Guidance Reiterates FSA Substantiation Rules
The IRS recently issued new guidance that again confirms the claims substantiation requirements for payment or reimbursement of both health FSA and dependent care FSA expenses. The guidance is a shot across the bow to employers and FSA third-party administrators (TPAs) that serves both as a warning and a reminder to follow the appropriate timing and method of substantiation in accordance with Section 125 regulations.
The guidance reiterates that dependent care FSA expenses cannot be reimbursed before they are incurred and properly substantiated.The prohibition on advance substantiation/reimbursement has always presented issues for dependent care FSA debit card arrangements because employees generally must pay for daycare services before the period of service is complete.However, this post walks through the workaround to that debit card timing predicament that the IRS reaffirmed in its latest guidance.
General Rule: Expense Must be Incurred and Substantiated Before Claim is Reimbursable
A dependent care FSA may not reimburse an expense before it is incurred. For these purposes, a dependent care expense is considered “incurred” when the care is fully provided for the service period.
In other words, the dependent care expense is not incurred when the employee is billed, charged, or pays for the dependent care. Rather, the expense is incurred (and therefore reimbursable) only when the actual service has been fully performed (e.g., the end of the month for most daycare providers).
Furthermore, the dependent care FSA may not reimburse any expense that has not been properly substantiated by an independent third-party, such as a daycare provider. The independent third-party must provide information describing the service, the date of the service, and the expense amount.
Only those substantiated expenses that have already been incurred (i.e., the dependent care services already provided) can be reimbursed. Reimbursing expenses before the expense has been incurred or before the expense has been substantiated is not permitted. Accordingly, the dependent care FSA cannot approve a claim as substantiated if that claim has not yet been incurred.
For more details: When FSA Expenses are Incurred
Practical Issues with Dependent Care FSA Debit Cards and the Substantiation Rules
As described above, the dependent care FSA cannot reimburse the employee’s daycare expenses before the end of the service period in which daycare services are provided. However, most daycare providers will charge an up-front amount that the employee must pay in advance of the services.
For example, a daycare provider charging $1,200 for the month of August will generally require that the employee pay the full $1,200 at or around the first of the month. This creates a practical problem because the employee will not be considered to have “incurred” the daycare services until they are fully performed (as of the last day of August in this example), but the employee needs to pay for those services well in advance of that date.
How then can employees use a dependent care FSA debit card to pay for daycare service expenses that are due before the expense is considered incurred and can be treated as substantiated? Fortunately, the cafeteria plan rules include an IRS-approved system for addressing this issue.
Using a Dependent Care FSA Debit Card to Pay for Recurring Daycare Expenses
The IRS-approved substantiation workaround for using a dependent care FSA debit card to pay a daycare provider is made possible by the fact that most daycare expenses are recurring. In other words, employees typically incur the same daycare expense on a regular basis (e.g., monthly, weekly) for a significant duration of time (e.g., six months-one year). While the prohibition on advance reimbursement still applies in this context, the workaround allows the employee to rely on a prior period’s substantiated daycare expense to substantiate the current period’s daycare expense—within certain limitations—and thereby permit use of the debit card to pay for the current period’s daycare expense.
There is a four-step process to using the debit card for recurring dependent care FSA expenses:
Initial Substantiation of Qualifying Dependent Care Expense
The process begins with employees paying for their qualifying dependent care expense without using the FSA debit card. At the beginning of the plan year or upon enrollment in the dependent care FSA, the employee will submit a statement to the FSA from the dependent care provider that substantiates the dates and amounts for the services provided.
Debit Card Funded, But Amounts Not Reimbursed
With a standard dependent care FSA claim, the employee would simply receive reimbursement for the eligible claim submitted. However, in this case the FSA will instead make the amount available through the debit card.
In response to the initial approved claim, the debit card is loaded with an amount equal to the lesser of:
a) The previously incurred and substantiated expense; or
b) The employee's total year-to-date dependent care FSA contribution amount.
To avoid violating the advance reimbursement rules, the amount funded on the debit card will not be available until the expenses are considered “incurred,” which is the end-date of the services provided by the daycare provider as listed on the initial statement (e.g., the end of the daycare service month).
Employee Uses Funds Loaded onto Debit Card to Pay Subsequent Daycare Expenses
With the funds that are loaded onto the dependent care FSA debit card from the initial substantiated expense, the employee can then use the card to pay for the next period of daycare services from the same (already approved) provider. In other words, the amount loaded onto the debit card from the first period of services (e.g., January) can be used to pay the same daycare provider for the next period of services (e.g., February).
Even though the subsequent period of daycare services (e.g., February) has not yet been completed and therefore the expense has not been "incurred" for FSA purposes, the employee can still use the debit card to pay for such services at the beginning of the subsequent period. This is made possible by the previously incurred expense from the initial period (e.g., January) that was loaded onto the debit card at the end of that initial period.
Employee Continues Paying Recurring Daycare Expense with FSA Debit Card
Using this approach, the employees can continue using the dependent care FSA debit card to pay for their ongoing dependent care FSA expenses with the same provider. Each period of expense can be paid when due, even though it is before the services are considered incurred (i.e., before the month or other period of service is complete). The rules permit this approach because the funds loaded onto the debit card will always derive from the previous completed period of daycare services.
Card transactions that match the same daycare provider and time period are treated as substantiated without further review as long as the amount charged is equal to or less than the initially substantiated expense. This rolling "look-back" approach will therefore continue to be considered automatically substantiated based on the initial claim until:
a) There is an increase in the previously substantiated amounts; or
b) The employee changes daycare providers.
In either case, the employee must restart the process by paying for the claim outside of the debit card and submitting a statement or receipt from the daycare provider substantiating the claimed expenses relating to the new cost. Once approved, the new amount may be added to the card and available to use in future periods of service (e.g., months) in the same way the process began initially.
Matthew and Marilla Cuthbert have an 11-year-old daughter Anne attending Avonlea After-School.
Avonlea After-School charges $500 per month for its dependent care services provided to Anne.
Matthew is a new participant in the Green Gables Farm's calendar plan year dependent care FSA, which offers a debit card, having elected $5,000 at open enrollment.
Matthew pays January's after-school bill (without using the debit card, which has no balance yet) on January 5, and submits the claim to the dependent care FSA the next day requesting use of the debit card going forward.
The TPA for the Green Gables Farm dependent care FSA substantiates and approves the claim as a valid daycare expense for Anne because the statement properly includes a description of the services, the amount of the services, and the dates of the services.
On January 31, the last day of the service period for January, the FSA claim is considered incurred and therefore the funds are loaded onto Matthew’s debit card.
Although the claim was for $500, Matthew has contributed only $416 ($208 per 24 pay periods) year-to-date, and therefore only that amount is loaded to the card.
For the month of February, Matthew uses the debit card to pay the same $500 Avonlea After-School expense for Anne on February 1.
Matthew has only $416 available on the card, so he pays the remaining $84 balance by check.
Matthew can continue to pay for all or a portion of Anne's monthly Avonlea After-School cost by using the debit card—until the cost increases or Anne attends a different after-school provider.
Failure to Follow Dependent Care FSA Substantiation Rules
The recent IRS guidance again confirms that in the event of an employer's (or their TPAs) failure to follow these cafeteria plan substantiation rules, the IRS could disqualify the entire cafeteria plan—thereby causing the plan to lose its tax-advantaged status (i.e., lose the safe harbor from constructive receipt)—if discovered on audit. That could result in all elections becoming taxable for all employees.
For more details:
The Section 125 Safe Harbor from Constructive Receipt
Newfront Section 125 Cafeteria Plans Guide
Employers and FSA TPAs received a wake-up call from the IRS recently as new guidance confirmed several substantiation methods are not valid under the cafeteria plan rules. These substantiation limitations have always made dependent care FSA debit cards particularly difficult to administer because expenses are typically incurred up-front for services not yet provided.
Fortunately, the IRS-approved workaround for dependent care FSA debit cards remains valid even following the recent guidance. By substantiating an initial expense incurred without using the debit card, the FSA can load prior-month expenses onto the card. The debit card can then be used to pay subsequent recurring dependent care expenses. Although it’s not a perfect system, it at least provides a sensible method for employees with cash-flow concerns to still take advantage of the FSA debit card.
Prop. Treas. Reg. §1.125-6(g):
(g) Debit cards used to pay or reimburse dependent care assistance.
(1) In general. An employer may use a debit card to provide benefits under its dependent care assistance program (including a dependent care assistance FSA). However, dependent care expenses may not be reimbursed before the expenses are incurred. See paragraph (a)(4) in this section. Thus, if a dependent care provider requires payment before the dependent care services are provided, the expenses cannot be reimbursed at the time of payment through use of a debit card or otherwise.
(2) Reimbursing dependent care assistance through a debit card. An employer offering a dependent care assistance FSA may adopt the following method to provide reimbursements for dependent care expenses through a debit card—
(i) At the beginning of the plan year or upon enrollment in the dependent care assistance program, the employee pays initial expenses to the dependent care provider and substantiates the initial expenses by submitting to the employer or plan administrator a statement from the dependent care provider substantiating the dates and amounts for the services provided.
(ii) After the employer or plan administrator receives the substantiation (but not before the date the services are provided as indicated by the statement provided by the dependent care provider), the plan makes available through the debit card an amount equal to the lesser of—
(A) The previously incurred and substantiated expense; or
(B) The employee's total salary reduction amount to date.
(iii) The card may be used to pay for subsequently incurred dependent care expenses.
(iv) The amount available through the card may be increased in the amount of any additional dependent care expenses only after the additional expenses have been incurred.
(3) Substantiating recurring dependent care expenses. Card transactions that collect information matching expenses previously substantiated and approved as to dependent care provider and time period may be treated as substantiated without further review if the transaction is for an amount equal to or less than the previously substantiated expenses. Similarly, dependent care expenses previously substantiated and approved through nonelectronic methods may also be treated as substantiated without further review. In both cases, if there is an increase in previously substantiated amounts or a change in the dependent care provider, the employee must submit a statement or receipt from the dependent care provider substantiating the claimed expenses before amounts relating to the increased amounts or new providers may be added to the card.
(4) Example. The following example illustrates the rules in this paragraph (g):
Example. Recurring dependent care expenses.
(i) Employer K sponsors a dependent care assistance FSA through its cafeteria plan. Salary reduction amounts for participating employees are made on a weekly payroll basis, which are available for dependent care coverage on a weekly basis. As a result, the amount of available dependent care coverage equals the employee's salary reduction amount minus claims previously paid from the plan. Employer K has adopted a payment card program for its dependent care FSA.
(ii) For the plan year ending December 31, 2009, Employee F is a participant in the dependent care FSA and elected $5,000 of dependent care coverage. Employer K reduces F's salary by $96.15 on a weekly basis to pay for coverage under the dependent care FSA.
(iii) At the beginning of the 2009 plan year, F is issued a debit card with a balance of zero. F's childcare provider, ABC Daycare Center, requires a $250 advance payment at the beginning of the week for dependent care services that will be provided during the week. The dependent care services provided for F by ABC qualify for reimbursement under section 129. However, because as of the beginning of the plan year, no services have yet been provided, F cannot be reimbursed for any of the amounts until the end of the first week of the plan year (that is, the week ending January 5, 2009), after the services have been provided.
(iv) F submits a claim for reimbursement that includes a statement from ABC with a description of the services, the amount of the services, and the dates of the services. Employer K increases the balance of F's payment card to $96.15 after the services have been provided (i.e., the lesser of F's salary reduction to date or the incurred dependent care expenses). F uses the card to pay ABC $96.15 on the first day of the next week (January 8, 2009) and pays ABC the remaining balance due for that week ($153.85) by check.
(v) To the extent that this card transaction and each subsequent transaction is with ABC and is for an amount equal to or less than the previously substantiated amount, the charges are fully substantiated without the need for the submission by F of a statement from the provider or further review by the employer. However, the subsequent amount is not made available on the card until the end of the week when the services have been provided. Employer K's dependent care debit card satisfies the substantiation requirements of this paragraph (g).
Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship. Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).
Lead Benefits Counsel, VP, Newfront
Brian Gilmore is the Lead Benefits Counsel at Newfront. He assists clients on a wide variety of employee benefits compliance issues. The primary areas of his practice include ERISA, ACA, COBRA, HIPAA, Section 125 Cafeteria Plans, and 401(k) plans. Brian also presents regularly at trade events and in webinars on current hot topics in employee benefits law.Connect on LinkedIn