FSA admin companies say “No, you can’t spend over $260 a month on transit pass.” But the payroll deduction itself is the “tax event” not the subsequent purchase of a transit pass. So why would IRS care?
How are you even using an FSA for a transit pass? FSA are, as far as I'm aware, used for medical expenses or child care.
The reason the FSA administrator cares is that the FSA must follow IRS regulations. You can't get a tax benefit that is not allowed. For example, a medical FSA can't allow you to withdraw money for unallowable expenses like non-prescription drugs or diet meals. The IRS regulation on transit passes is that the employer can provide up to $260 per month as a non-taxable employee benefit. (This is so that employees who use mass transit can get a tax break similar to employees who pay for parking, since parking costs can be deducted pre-tax.) The employer could buy the pass for you and it would be non-taxable income, or the employer can allow you to buy the pass with a tax-free FSA apparently. But, if the employer bought you a transit pass that was more than $260, the difference would have to be included on your W-2 as taxable income since it exceeds the allowable amount of the employee benefit. In the same way, the FSA administrator can only allow you to spend $260 per month to receive a tax benefit.