Received a refund of FSA funds from 3 years ago, how should I handle this?

[Enigmatic]

I have an FSA that rolls over up to $500 per year. In very early 2016, I used my FSA at a hospital to pay toward the cost of some tests my doctor had ordered. The imaging department was running a couple hours behind the evening of my appointment; eventually, I rescheduled the tests and went home. I ended up not needing the tests and requested a refund. As time passed, I simply forgot about the money that had been used. Then, this weekend, I received a refund check from the hospital for the amount that had been paid toward the testing. I’m not sure why it took the hospital over three years to send a refund check.

What do I need to do? This FSA money is from 2016 – some of the amount could be from 2015. Do I send the check to my plan administrator? Do I cash and report miscellaneous income on my 2019 return? Do I need to amend multiple tax returns? If the check is simply not cashed, would that change anything? 

[Anonymous]

you have  a complicated situation.     generally the IRS and the plan  have a use it or lose it rule.  money in a 2016 FSA not used by year end is forfeit back to the employer.    However, there could be complications.  some plans, under IRS rules, allow a carryover to the following year   either an amount not to exceed $500 or  the money can be used no later the 2.5  months after the year end  to pay either 2016 or 2017 medical bills. 

in the worse case scenario, the IRS would say you have taxable income because the FSA contribution reduced  your taxable wages.      If you still have the same employer, you may want to talk to the Human Rsource  Department or perhaps the administrator. 

[BMcCalpin]

This situation is indirectly discussed in IRS Revenue Proc 2004-43 at https://www.irs.gov/pub/irs-drop/rr-03-43.pdf .

On page 3 in the paragraph starting with "Under Employer N’s card arrangement, a few of the claims that have been reimbursed are subsequently identified as not qualifying for reimbursement" the paragraph suggests that if you received funds that turned out not to be for a qualified medical expense, then you owe the money back to the employer. Thus, you would need to turn the $300 over to your employer. This would have no tax consequence for you. Why? Because if your employer had not paid the money in 2016, the amount would have been forfeited at the end of the year as unused (yes, I am aware of the 2 1/2 month grace period and the $500 carryover in some plans - let's don't make this more complicated than it already is).

Elsewhere, the revenue proc suggests that FSA payments which are not for valid medical expenses must be added back to the employee's income. However, in this case, the reimbursement of the funds took place three years later, which probably makes it difficult to update paperwork properly both for you and your employer. For example, it wouldn't make sense to amend your return for 2016 to declare this as income when you didn't even receive the money until 2019.

For this reason, I would agree with the previous comment that you should go your employer's HR department and offer to pay the money back. If by some chance you can't go back to your employer, then cash the check and declare it as Other Income on your 2019 return. In any case, you should avoid receiving the $300 AND getting a tax benefit for it.