Benefits compliance: Considerations for Lifestyle Spending Accounts
Learn about essential compliance rules and considerations for Lifestyle Spending Accounts (LSAs), including tax implications & eligible expenses.
Compliance considerations for LSAs
As more and more plan sponsors consider offering Lifestyle Spending Accounts (LSAs) as part of a comprehensive benefits package that helps attract and retain talent, employers are recognizing the advantages. LSAs are flexible - allowing companies to augment employee compensation without making a permanent salary commitment and giving them significant control over plan design elements, such as eligible expenses, eligible employees, maximum reimbursement amounts, funding frequency, and more. This flexibility is aided by the relatively few benefits compliance rules applicable to LSAs.
By now, plan sponsors are accustomed to the laundry list of benefits compliance issues applicable to traditional benefits, such as medical, dental, vision, disability, life, and other spending account plans. Plan sponsors are all too familiar with the alphabet soup of acronyms representing the laws regulating these benefits. On the other hand, LSAs are subject to a relatively small number of compliance considerations. But while they are few, the compliance issues applicable to LSAs are important to understand.
LSA benefits are taxable
We start generally with the proposition that all compensation employers provide to employees for services rendered is taxable unless a specific section of the Internal Revenue Code (the “Code”) excludes the compensation from taxation. Plan sponsors are familiar with many common exclusions (e.g., medical, dependent care, HSA, tuition, and adoption expenses). However, LSAs are designed to reimburse expenses that do not receive favorable treatment in the Code. This means employers should tax LSA funds the same way they would any other taxable compensation, such as salary. Employees do not recognize any income or payroll tax savings when receiving the benefits. However, what the LSA loses in tax savings it gains in flexibility, as eligible expenses are not limited to those enumerated in the Code. With few limitations, LSAs can reimburse many different types of expenses not available to tax-advantaged plans.
There is an open question about LSA taxation based on the doctrine of “constructive receipt.” Under this doctrine, all compensation is taxable to an employee when it is constructively received, even if not reduced to the taxpayer’s possession. Compensation is constructively received in the taxable year during which it is credited to the employee’s account, set apart for the employee, or otherwise made available so that the employee may draw upon it at any time, or so that the employee could have drawn upon it during the taxable year if notice of intention to withdraw had been given - unless the funds are subject to “substantial limitations or restrictions.”
As it relates to LSAs, the IRS’s position on when the funds are received is not clear. There is an argument that LSA funds are received whenever they first become available to an employee, and the employee should be taxed on the full value of the LSA whether the employee uses the LSA benefit or not. However, most employers take the position that LSA funds are taxable to the employee only when they are used by the employee to reimburse an eligible expense, and not before. Generally, employers include the amount of each LSA reimbursement in the employee’s gross income and apply income and payroll taxes to these amounts at the time of reimbursement. Such employers may argue the limitation on eligible expenses and reimbursement rules amount to “substantial limitations or restrictions” on the funds, such that they are not constructively received immediately upon availability. Guidance from the IRS would be helpful, and we encourage LSA sponsors to work with their tax counsel in the meantime.
Exclude medical expenses from reimbursement
Employers generally should avoid reimbursing expenses from an LSA that can be reimbursed with a tax-advantaged account, particularly medical expenses. Plans that provide medical expenses are subject to several group health plan laws and regulatory requirements, such as ERISA, COBRA, HIPAA, ACA, and HSA eligibility rules. LSAs generally are not able to satisfy these requirements, at least not without significantly impacting the practical administration of the plan. Therefore, LSA plans should just exclude medical expenses altogether, eliminating many restraints on plan design. Reimbursement of medical expenses is best left to Health FSAs, HRAs, or HSAs.
Some expenses, such as fitness subscriptions, activity trackers, massage therapy, and professional dieticians, are known as “dual-purpose expenses.” These expenses are generally considered non-medical, although they could qualify as medical expenses if they are recommended by a medical practitioner to treat a specific diagnosis. Employers can include dual-purpose expenses in the LSA as long as employees can receive reimbursement for these expenses without having to show any diagnosis of a medical condition. In addition to dual-purpose items, common eligible LSA expenses fall into broad categories, such as physical, mental, or financial wellness expenses, food and entertainment expenses, work-from-home expenses, utilities, hobby and leisure expenses, and many more.
Ensuring your LSAs meet requirements
These few compliance considerations are critical to offering and maintaining a compliant LSA for the benefit of your employees. Although small in number, noncompliance with the rules applicable to LSAs can have significant consequences, just like traditional benefits plans.
For more information on LSA requirements, <span class="text-style-link text-color-blue" fs-mirrorclick-element="trigger" role="button">schedule a consultation</span> with one of our experts. We’d be happy to help you.