Question: What are the compliance issues associated with the (increasingly popular) employer-sponsored lifestyle spending account?
Short Answer: Fortunately, compliance for LSAs is relatively simple compared to tax-advantaged account-based offerings such as HSAs, FSA, and HRAs. Employers’ main LSA compliance concerns will be taxation of the LSA and ensuring the LSA does not inadvertently trigger group health plan or other unintended legal requirements.
Lifestyle Spending Accounts: An Overview
The purpose of an LSA is for employers to offer employee access to funds to reimburse the cost of common and beneficial expenses incurred during ordinary life. The LSA concept is flexible enough that there is no uniform definition of LSAs or what they offer. Employers have full discretion over what expenses will be eligible for reimbursement.
If it is possible to generalize as to a “typical” LSA, employers frequently offer roughly $500-$1,000 annually for reimbursement of expenses that generally fall under the non-medical wellness umbrella.
Examples of common eligible expenses include:
- Athletic equipment and accessories
- Exercise equipment
- Gym, health club, spa, and fitness studio memberships
- Recreational sport expenses such as rock climbing, martial arts, tennis
- Fitness class expenses such as yoga, pilates, cycling
- Sport lesson expenses such as golf, swimming, tennis, dance
- Personal trainers
- Fitness trackers
- Nutritional supplements
- Entry fees such as races or leagues
- Passes such as ski, snowboard, golf, swimming
- Home purchase costs such as down payment, closing costs
- Financial advisor and planning services
- Financial seminars and classes
- Estate planning costs
- Meditation classes
- Non-medical counseling services such as marital counseling, life coaching, parental skill counseling, executive coaching
- Retreats such as leadership and spiritual retreats
- Personal development classes such as art and cooking
- Pet care such as walkers, day care, grooming
- Camping such as equipment and fees
- Park passes
- Licenses such as for fishing or hunting
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 as they would for other account-based offerings such as HSAs, FSAs, and HRAs.
Most employers take the position that LSA benefits are taxable to employees upon reimbursement. Under this standard approach, the employer includes in the employee’s gross income (and subject to withholding and payroll taxes) the amount of each LSA reimbursement. Any amount made available to the employee but not reimbursed (i.e., 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.
Although employers rarely take the position that the full value of the amount made available in (as opposed to reimbursed from) the LSA to employees is included in taxable income, it is not clear whether the IRS agrees with that industry standard.
For more details on the topic of constructive receipt:
- The Section 125 Safe Harbor from Constructive Receipt
- ABD Office Hours Webinar: Section 125 Cafeteria Plans
- The Tax Advisor: The Tax Consequences of Point-Based Employee Reward Programs
Key Areas to for LSAs Avoid: 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 for reimbursement 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.
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.
For more details on avoiding inadvertent group health plan status:
- Employers Should Not Reimburse Medical Expenses Outside of the Plan
- Taxation of Gym Reimbursement Arrangements
- 2021 ABD Wellness Program Guide
Key Areas to for LSAs Avoid: Tax-Advantaged Benefits
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.
However, it generally does not make sense for employers to include in an LSA any expense that could otherwise be provided on a tax-free basis by the employer outside the LSA. In other words, inclusion of a potentially tax-advantaged benefit in the LSA has the effect of providing a taxable benefit that could have been provided as non-taxable.
Examples of potentially tax-advantaged expenses (in addition to medical expenses) that employers would want to exclude from an LSA are:
- Dependent care expenses: Employers can provide up to $10,500 (increased 2021 limit) in tax-free dependent care costs through §129.
- Student loan reimbursement: Thanks to changes made by the CARES Act and the CAA, employers can provide up to $5,250 in annual student loan repayment assistance benefits to employees on a tax-free basis through 2025 under §127.
- Tuition assistance: Employers can provide up to $5,250 in qualified educational assistance tax-free under §127 and an unlimited amount of tax-free work-related educational assistance under §132.
- Commuter benefits: Employers can provide up to $270/month (2021) in tax-free transit pass/vanpool and/or parking assistance through a §132(f) commuter benefit account.
- Identity theft protection: The IRS now permits employers to exclude from income the value of identity protection services, including credit reporting and monitoring services, identity theft insurance policies, identity restoration services, and other similar services.
Employers and employees would generally prefer that these benefits be offered through a separate vehicle designed to take advantage of the opportunity to provide them tax-free.
Lifestyle spending accounts (LSAs) have some clear advantages and disadvantages when compared to traditional tax-advantaged account-based employer offerings.
- Very few compliance rules associated with LSAs because they are not tax-advantaged or subject to group health plan laws;
- Flexibility for employers to include virtually any non-medical expense as eligible for reimbursement;
- No limits on the amount of employer funds made available for reimbursement;
- Employers can use very simple communication pieces to describe the program;
- The employer’s FSA TPA will often also offer to administer the LSA for a relatively low cost;
- Can be customized to fit the employer’s specific wellness and employee culture goals; and
- Novelty of the concept can create employee excitement and an easy/low-cost morale boost.
- LSAs are not tax-advantaged;
- Employers face competing theories on how to best approach taxation of LSAs;
- Employers need 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;
- Employers will generally want to exclude any other form of potentially tax-advantaged benefit (e.g., dependent care expenses, student loan reimbursement, tuition assistance, commuter benefits, identity theft protection) to utilize the exemption from income in a separate offering;
- LSAs are exclusively employer-funded, which means they add cost to the employer’s budget.
Treas. Reg. §1.451-1(a):
(a) General rule. Gains, profits, and income are to be included in gross income for the taxable year in which they are actually or constructively received by the taxpayer unless includible for a different year in accordance with the taxpayer’s method of accounting.
Treas. Reg. §1.451-2(a):
(a) General rule. 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. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.
(a) Group health plan.
For purposes of this part—
(1) In general. The term “group health plan” means an employee welfare benefit plan to the extent that the plan provides medical care (as defined in paragraph (2) and including items and services paid for as medical care) to employees or their dependents (as defined under the terms of the plan) directly or through insurance, reimbursement, or otherwise. Such term shall not include any qualified small employer health reimbursement arrangement (as defined in section 9831(d)(2) of the Internal Revenue Code of 1986).
(2) Medical care. The term “medical care” means amounts paid for—
(A) the diagnosis, cure, mitigation, treatment, or prevention of disease, or amounts paid for the purpose of affecting any structure or function of the body,
(B) amounts paid for transportation primarily for and essential to medical care referred to in subparagraph (A), and
(C) amounts paid for insurance covering medical care referred to in subparagraphs (A) and (B)
The term “medical care” means amounts paid—
(A) for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body,
Treas. Reg. §1.213-1(e)(1)(ii):
(ii) Amounts paid for operations or treatments affecting any portion of the body, including obstetrical expenses and expenses of therapy or X-ray treatments, are deemed to be for the purpose of affecting any structure or function of the body and are therefore paid for medical care. Amounts expended for illegal operations or treatments are not deductible. Deductions for expenditures for medical care allowable under section 213 will be confined strictly to expenses incurred primarily for the prevention or alleviation of a physical or mental defect or illness. Thus, payments for the following are payments for medical care: hospital services, nursing services (including nurse’s board where paid by the taxpayer), medical, laboratory, surgical, dental and other diagnostic and healing services, X-rays, medicine and drugs (as defined in subparagraph (2) of this paragraph, subject to the 1-percent limitation in paragraph (b) of this section), artificial teeth or limbs, and ambulance hire. However, an expenditure which is merely beneficial to the general health of an individual, such as an expenditure for a vacation, is not an expenditure for medical care.
Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship. Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).