the problem with independent third party substantiation

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The problem with the “independent third party substantiation” tax  regulation in small business health plans

by Tony Novak, CPA, MBA, MT
,published 6/14/2004, revised 11/28/11

The IRS requires employers who pay for employee health expenses outside of a health insurance policy or a health savings account to hire an independent third party to substantiate that the claims are valid. This requirement has become known as “independent third party substantiation” referring to language used by the IRS in recent Revenue Rulings. The penalties for failure to adhere to this procedure could be severe – the payments would be treated as untaxed earnings and subject to underreporting penalties.

This relatively new law bothers business owners for obvious reasons. The administrative burden adds to the cost of providing attractive health benefits for employees. This law bothers tax advisers for a different reason.

“Independent third party substantiation” sets a precedent of prohibiting taxpayers to calculate and report their own income. In all other areas of taxation, income tax depends on the taxpayers own accounting and calculation of income. This is called a “voluntary compliance tax system”. The “independent third party substantiation” requirement disregards the voluntary compliance principle of our tax system. It essentially says that a business taxpayer must prove the validity of a deduction before taking the deduction on a tax return.

As an illustration, consider a fictitious example what would happen if this same law were applied to business travel expenses. An executive goes on a trip and charges it to the company’s credit card. She turns in a travel expense voucher that meets the firm’s normal accounting requirements. The executives records are impeccable, and every expense item on the report is well documented with original receipts. The expense is treated the same as any other normal business expense. But under this strange new law, the travel expenses are determined to be taxable income in a subsequent tax audit because the expenses were not substantiated by an independent third party accountant. The executive and the employer both own substantial taxes, penalties and interest. Silly? Yes, but the exact same thing could happen to thousands of firms who pay employee health expenses without an outside verification of the claims.

While the IRS may be correct in assuming that there is widespread tax abuse in these types of health plans, the end does not justify the means. It is important to the stability of our tax an legal system that income tax filing be based solely on the taxpayer’s calculated and reported income and not a discriminatory reliance on outside auditors. The principle of independent income reporting is more important to the long term stability of our nation’s tax system than the risk of short term revenue loss caused by the recent evolution of employer health plans.

I feel confident that the law will eventually be modified to conform with the position presented, but the time frame is completely unpredictable. In the meanwhile, employers must adhere to the law as it exists now and use an independent auditor to review medical claims at least as often as wage taxes are reported.

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