Life Style Spending Account Compliance Considerations
We do more that lifestyle spending accounts (LSAs) at Maxwell, but since it is at the core our solution to deliver an employee experience that delivers joy and teams that stick around, we often get asked questions about how to stay compliant.
Fortunately, compliance for LSAs is relatively simple compared to tax-advantaged account-based offerings such as HSAs, FSA, and HRAs. The main LSA compliance concerns employers should keep in mind are taxation of the LSA and ensuring the LSA does not inadvertently trigger group health plan or other unintended legal requirements. This blog explores the most common considerations employers need to keep in mind when offering an LSA to their employees.
Lifestyle Spending Accounts: An Quick Overview
The LSA concept is flexible enough that there is no uniform definition of LSAs or what they offer. The purpose of an LSA varies by employer, but at their core they are employer-funded accounts that employees use to support their individual needs. Employers can design LSAs to be used for most types of expenses or can target their use for very specific purposes.
The way that employees can spend their funds can also look different, depending on the solution that employers are using. At Maxwell our approach is a single LSA that empowers employees to choose how to be supported, and one where employees and HR admins don’t have to deal with reimbursements and reconciliations.
LSAs are attractive for a several reasons:
- First, they are incredibly flexible so employers can design the program to best fit their culture.
- Second, LSAs are a great way to address solutions overload. Rather than investing in another well-being initiative or benefit that employees may or may not use, employers can help subsidize a variety of solutions to fit the unique needs of each employee.
- Third, they are a tangible way to support their diversity, equity and inclusion efforts, as we talked about in a previous blog post is a key aspect of any modern benefits program. They can use an LSA as a way to address benefits gaps for female employees, LBGTQ+ individuals, specific racial ethnic groups, or even populations with unique life needs (e.g. employees that cannot work remotely).
- F*inally, it is a way to increase compensation without permanently increasing base pay***, which can escalate over time.
Everything You Need to Know about LSAs.
Taxation: LSAs are Not Tax-Advantaged
LSAs are purposefully designed not to be a tax-advantaged account to avoid the strict limitations associated with those arrangements. Therefore, employees do not enjoy an exclusion from income with respect to LSA benefits.
Most employers take the position that LSA benefits are taxable to employees upon reimbursement or usage in the case of those that have a debit card solution like Maxwell. Under this standard approach, the employer includes in the employee’s gross income (and subject to withholding and payroll taxes) the amount that they spend. Any amount made available to the employee but not spent (e.g.., carried over or forfeited) is therefore not included in the employee’s taxable income.
There is an argument that employers should include in employees’ taxable income the value of the amount made available to employees for reimbursement regardless of the actual amount reimbursed to the employee. This approach is based on the doctrine of “constructive receipt,” which Treasury regulations broadly define as follows: “Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given.” (Treas. Reg. §1.451-2(a))
The basic principle of constructive receipt that you cannot “turn your back on taxable income” to escape income taxes. Under this theory, employees are treated as being in constructive receipt of the full amount made available under the LSA—and thereby taxed on the value of that full LSA amount made available—regardless of whether they utilize the full balance.
At Maxwell we recommend employers consult with their Tax Experts to determine what is the best approach for their particular circumstances.
Avoiding Medical Benefits
The primary compliance consideration beyond taxation employers should keep in mind is avoidingn medical benefits.
Many employers offer various forms of wellness programs that provide reimbursement for a wide array of expenses that are beneficial to employees’ health.
Reimbursement of a §213(d) health expense creates a group health plan, which would trigger the full array of group health plan laws (ERISA, COBRA, HIPAA, ACA, HSA eligibility, §105(h), etc.). Therefore, employers should avoid providing reimbursement for any §213(d) medical expenses outside the health plan unless it is part a HRA or wellness program that is integrated with the health plan.
Employers should carefully monitor the expenses eligible under a LSA that is solely intended to be a taxable, non-group health plan benefit. These arrangements need to exclude any §213(d) medical expenses to avoid application of the onerous group health plan requirements. At Maxwell we make this easy by blocking the merchant code categories that could be considered medical expenses.
For example, expenses such as smoking cessation programs, mental health therapy, acupuncture, and chiropractic treatment are generally medical expenses that would need to be excluded from an LSA. Such expenses could be included in a separate medical wellness program arrangement designed to comply with applicable group health plan law.
- IRS Publication 502 provides a useful summary of expenses that qualify as §213(d) medical expenses.
Note that some expenses are “dual purpose” expenses that are generally non-medical but can be considered medical where incurred upon the advice of a medical practitioner to treat a specified medical condition. Examples include gym membership, massage, and nutritionist expenses. A health FSA will generally reimburse these expenses only if the employee provides a letter of medical necessity from a treating physician. There should be no issue with an LSA including such dual purpose expenses that are overwhelmingly non-medical as long as the LSA does not condition the benefit on the employee’s medical status. In that case, the employer is in a very strong position that the benefit is non-medical and does not trigger these group health plan concerns.
Other Tax Considerations
As discussed above, LSAs are purposefully designed not to be a tax-advantaged account to avoid the strict limitations associated with those arrangements. This provides employers with the flexibility to include virtually any (non-medical) expense as reimbursable by the LSA.
Employers may want to maximize tax-advantaged benefits in some instances such as Dependent Care Expenses, Student Loan Reimbursements, Tuition Assistance, or Commuter Benefits. Employers and employees could benefit from tax savings by contributing to these type of expenses.
It is important though to consider the fact that these offerings fit only the needs of some, therefore employees that don’t have dependents or student loans, for example, might feel like they are receiving less than their peers. At Maxwell we have seen employers take a modern approach by creating a defined budget per employee, and then giving employees the choice between a contribution to a Dependent Care Flexible Account, or more money on their LSA.
Summary
Lifestyle spending accounts (LSAs) are not taxed-advantaged and while employers need to make sure to exclude any §213(d) medical expenses from the LSA (e.g., smoking cessation programs, mental health therapy, acupuncture, and chiropractic treatment) to avoid inadvertently triggering the vast array of group health plan laws, it is well worth it as they offer great advantages such as:
- Great flexibility for employers to meet the needs of their diverse workforce
- Very few compliance rules and no limits on the amount of fund provided
- A great way to address solutions overload and ballooning costs by consolidating a multitude of wellness solutions into a single defined budget
- Can be customized and leveraged to fit the employer’s specific wellness and employee culture goals
- A solid way to help employees deal with increasing costs without permanently increasing base pay, which can escalate over time
- In the case of an LSA via Maxwell a reduction in administrative work for HR teams and a an opportunity to leverage behavioral science to elevate the Employee Value Proposition employers have worked hard to build