He Ain’t Heavy…He’s My 25-Year-Old, Married, Employed and Non-Dependent Child
Unless you’ve just awakened from a 10-month coma, you know that last year’s health reform bill requires most group health plans to provide coverage for an employee’s adult child, to the child’s 26th birthday. That mandate took (or takes) effect as of the first day of the plan year that began (or begins) on or after September 23, 2010.
But a modification to the law, a week after the original bill was signed, addressed the tax implications of that coverage. The modification provides that the coverage is nontaxable for federal tax purposes, even if the child is no longer the employee’s tax “dependent,” as long as the child is the employee’s natural, step, foster or adopted child.
Three twists on this tax provision have caused considerable confusion. The first two have easy answers. The third, not so much. While we have dealt with these issues in prior writings and webcasts we continue to receive questions about them; hence this Compass.
Early Effective Date
The first of the three “twists” relates to the effective date of the non-taxability provision. Most mandates under the health reform law took (or take) effect as of the first day of the plan year commencing on or after September 23, 2010. However, the special tax rule became effective immediately upon signature by the President, on March 30, 2010.
The Compass February 2011 page 1The early effective date is inconsequential if on that date the plan was not providing coverage to non- dependent children, or if the plan did not adopt the “adult child coverage” mandate prior to January 1 of this year (some plans, particularly fully insured plans, adopted this change early, prior to the mandated effective date).
On the other hand, if the plan provided coverage to non-dependent adult children in 2010, that coverage triggered some tax issues the employer’s payroll vendor might not have identified. Although those same tax issues apply for 2011, there is time to deal with them for this year. Tax issues for 2010 pose thornier issues.
Disconnect Between the Coverage Mandate and the Tax Rule
Here’s the second twist: For federal tax purposes, the new tax provision treats coverage of a natural, step, foster or adopted child as nontaxable to the end of the calendar year in which the child attains age 26, even though the coverage mandate ends upon the child’s 26th birthday.1 Many employers have wondered whether they are required to cover the adult child to the end of such calendar year.
The answer is no, unless the plan is insured or not subject to ERISA, and state law compels the coverage.2 The federal tax provision simply means that if the employer continues coverage beyond the child’s 26th birthday, the coverage remains nontaxable under federal law to the end of the year in which the child’s 26th birthday occurs. Whether coverage provided beyond that point is nontaxable under federal law depends on whether the child is, in fact, the employee’s “dependent” for federal tax purposes.
Example: John is the 25-year-old child of Jane, and his birthday is September 1. John is married, gainfully employed, lives apart from Jane, and is not Jane’s “dependent” for tax purposes. Jane’s group health plan covers employees and other members of employees’ families. Assuming Jane has enrolled him, the plan must cover John (but not his spouse or children) up to next September 1, when he attains age 26.3 The coverage is nontaxable to Jane, for federal tax purposes.
Suppose the plan continues coverage of adult children to age 27? The coverage of John remains nontaxable to Jane, for federal tax purposes, through the end of 2011 because that’s the year in which John attains age 26. Because John is not Jane’s dependent, his coverage becomes taxable to Jane, for federal tax purposes, beginning January 1, 2012.
How does the plan know whether John is a dependent or not? It will have to ask. For example, Jane’s employer might require covered employees to identify the family members they enrolled, and indicate (with respect to children, domestic partners and children of domestic partners) whether such individuals are the employees’ “dependents” for federal tax purposes. The forms should describe the test for “dependency” status.4
State Tax Issues…Ugh
The example above is confusing enough. But there’s a third and nastier wrinkle. Although the coverage to a non-dependent natural, step, foster or adopted child is nontaxable at the federal level to age 26, it might be taxable at the state level, and if so might have to be included in the employee’s state taxable wages for withholding purposes and on the Form W-2 issued to the employee.
The Compass February 2011 page 2
Most states have income tax rules that largely follow the federal tax code with respect to the taxability of certain fringe benefits. But many of those states’ laws refer to or incorporate a version of the federal tax code that pre-dated health reform, when children had to be the employee’s “dependent” for their coverage to be nontaxable.
The upshot is that in about half the states, health coverage supplied to a non-dependent natural, step, foster or adopted child, while nontaxable for federal purposes through the end of the year in which the child attains age 26, is taxable for state purposes. A chart that lists these states is attached.
What to Do?
There are no good or easy solutions to this imbroglio. To attempt to solve the riddle the employer must first identify the non-dependent adult children on its health plan roles. Happily, we suspect most enrolled children actually are “dependents” of their employee-parents. The test for dependency status is described in endnote 4.
Where an employer finds non-dependent children on the plan, it must determine if the employee (the child’s parent) is working in a state that treats the coverage as taxable. The challenge here is that we expect many or most of these states to pass laws this year, conforming to the federal rule. California legislators just recently introduced a bill to treat the coverage as nontaxable to the same extent as under federal law. So as employers prepare to issue 2011 Forms W-2 to employees, this issue may have largely evaporated, at least for the 2011 year.5 But if the state legislatures don’t make the fix retroactive all the way back to 2010, an employer that supplied coverage to non-dependent children in 2010 will have some challenges if its payroll vendor did not alert the employer to the tax issue. For example, the Form W-2 issued to the child’s employee-parent will be incorrect, insofar as state taxable wages are concerned.
Assuming the employer identifies these non-dependent adult children in a state that taxes the coverage, and the state does not get around to conforming to the federal rule, the thorniest issue remains: What’s the fair market value of the coverage supplied to the non-dependent adult child?
In the context of taxing coverage supplied to non-dependent domestic partners, the IRS has said an employer may value the non-dependent’s coverage as the COBRA rate (minus 2 percent), but has left open the possibility that other approaches might also be reasonable.
It’s easy to identify approaches that might be considered reasonable. For example, if the non-dependent child is the only child enrolled under the employee’s “family” coverage, it might be reasonable to view the step-up in cost from employee-plus-spouse to employee-plus-family as the value of the child’s coverage. But what if the non-dependent child is one of two, three or six children covered by the employee? Then what?
What if an employee pays one rate for “employee plus family” coverage, so that the addition of a non- dependent adult child (as one of several enrolled children of the employee) adds no additional cost to the employee? Is the value of the child’s coverage zero? That seems unreasonable, although intuitively appealing. But California recently gave a nod to the practicalities and announced this is precisely the way it’s viewing the issue. Other states might follow suit.
If the value isn’t zero, what is it? The step-up in premium from employee-plus-one to employee-plus-family, divided by the number of covered children? That also makes some sense intuitively, but it’s illogical because
The Compass February 2011 page 3
the value of the same coverage would fluctuate within different family units simply on the basis of the number of enrolled children within the unit.
There are simply no great answers here. All we can encourage employers to do is to settle upon an approach that seems reasonably justifiable.
These Issues Are Not New
These issues, by the way, are nothing new. They have been brought into the spotlight by the health reform rules, but the issues have existed for as long as employers have maintained group coverage. Even prior to the health reform law, employers that were supplying coverage to non-dependent children should have been treating the coverage as taxable, for both state and federal purposes. Several states—including New Jersey and Florida—require insured plans to continue coverage of adult children into their late twenties and even beyond, without regard to the child’s dependency status. These state laws have triggered the same tax issues.
Employers who supply domestic partner coverage have had to wrestle with these issues for years because coverage supplied to a non-dependent domestic partner or non-dependent same-sex spouse is taxable at the federal level, although not always at the state level.6 Coverage supplied to a domestic partner’s children may or may not be taxable to the employee, depending on whether the children meet the definition of “dependent” with respect to the employee.
A Bonus Twist
Here’s another twist on the taxability issues that is even more annoying. Employers widely permit health flexible spending accounts or health reimbursement accounts to supply reimbursement for expenses incurred by non-dependent adult natural, step, foster and adopted children to age 26. Must they consider the state tax implications of those reimbursements? We’ve seen very little written or said about this issue. Perhaps this wrinkle will go away as state legislatures begin to conform their state income tax rules to the federal rule, insofar as coverage of adult children is concerned.
Prehaps the only practical way to grapple with this issue, where necessary, is to identify the non-dependent children, and have the FSA and HRA vendors identify the claims submitted for medical expenses incurred on behalf of these children. The employer would then include those reimbursements in the employee’s state wages, on the Form W-2. But it’s not entirely clear whether this is even the appropriate remedy.
Reaching Out to the Payroll Vendor and Trusting in Widespread Ambivalence
Employers who have not done so already should reach out to their payroll vendors to discuss these tax issues, and determine what systems the vendors have in place or assistance they can provide to help employers get their arms around the issues. Although one never wants to rely on a taxing authority’s ambivalence toward enforcement, we suspect most states will have little appetite for conducting widespread audits to identify an employer’s coverage of non-dependents. They have not done so in the past, the federal- state disconnect created by health reform will be mended by many states over the coming months, and attempts by employers to address the issue are so burdensome and hassle-prone that many employers might simply weigh the risks and rewards, and carry on as they always have.
The Compass February 2011 page 4
1 Of course, foster children typically cease to be foster children when they attain age 18, making moot the issue of their coverage beyond that point. 2 Some states require insurers to cover adult children to advanced age, for example, to age 30 or even 31. 3 If the plan is grandfathered, and John has an offer of coverage through his or his spouse’s employer, Jane’s group plan is not required to cover John. Grandfathered plans may avail themselves of this exception until they lose grandfathered status, or until their 2014 plan year, whichever comes first.
4 Most adult children of an employee can be considered the employee’s “dependent” for federal tax purposes if the employee supplies the majority of the child’s support. Specifically, the federal tax code says that a natural, step, foster or adopted child of an employee is the employee’s “dependent” if the child satisfies one of two tests. Either (1) the child is a “qualifying child,” to wit, has not reached age 19 (age 24 for full-time students) as of the end of a calendar year, and does not supply more than half of his or her own support; or (2) the child (regardless of age) relies upon the employee for more than half the child’s support, and is not treated as a “qualifying child” of the employee or anyone else. In addition, the child cannot be married and filing a joint return, or be a nonresident alien (unless residing with the employee). Special rules apply in some cases involving divorced or separated parents.
5 Or maybe not. California authorities say the state will lose more than $90 million in additional tax revenue if the state adopts the tax change. It and other cash-strapped states might find it difficult to wave goodbye to those dollars. 6 California, for example, treats coverage supplied to a non-dependent registered domestic partner as non-taxable for California income tax purposes.
Lockton Benefit Group Compliance Services
Edward Fensholt, JD Mark Holloway, JD Janae Schaeffer, JD Sara Roy, RP
Not Legal Advice: Nothing in this Alert should be construed as legal advice. Lockton may not be considered your legal counsel and communications with Lockton’s Compliance Services group are not privileged under the attorney-client privilege.
Circular 230 Disclosure: To comply with regulations issued by the IRS concerning the provision of written advice regarding issues that concern or relate to federal tax liability, we are required to provide to you the following disclosure: Unless otherwise expressly reflected herein, any advice contained in this document (or any attachment to this document) that concerns federal tax issues is not written, offered or intended to be used, and cannot be used, by anyone for the purpose of avoiding federal tax penalties that may be imposed by the IRS.
©2011 Lockton, Inc. All rights reserved.
Lockton Benefit Group
Revised February 10, 2011
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