Employer-provided family health coverage is generally tax-free to employees so long as the employee’s covered family members can be claimed as dependents on the employee’s federal income tax return. A taxpayer may claim another individual as a “dependent” for federal income tax purposes only if that person is the taxpayer’s “qualifying child” or “qualifying relative” under Section 152 of the Internal Revenue Code.
If an employer-sponsored health plan provides coverage to an individual (such as an employee’s domestic partner or same-sex spouse) that is not a qualifying child or a qualifying relative under Code Section 152, the employer must report (and the employee must pay income tax on) the fair market value of the coverage provided to such individual, less the amount paid for such coverage (with aftertax dollars) by the employee. In addition, an employee cannot pay premiums for such health insurance coverage (or pay for the unreimbursed medical expenses of such an individual) with pretax dollars through the employer’s Section 125 cafeteria plan.
Since the beginning of the year, the IRS has issued two pieces of guidance clarifying which family members qualify as dependents for purposes of employer-provided health coverage. In Notice 2008-5, the IRS held that, although a taxpayer usually cannot claim as a dependent an individual who is another taxpayer’s “qualifying child,” this restriction does not apply if the other taxpayer is not required to file a tax return, and does not do so (or files solely to get a tax refund). In Revenue Procedure 2008-48, the IRS held that, when parents are divorced, separated, or live apart for the last six months of the year, their children can be treated as dependents of both parents for purposes of employer provided health plan coverage and medical expense reimbursements (meaning the children can receive tax-free health coverage through either parent’s health plan).
More recently, Congress passed legislation that modifies the statutory definition of “qualifying child” under Section 152. On October 7, 2008, Congress enacted The Fostering Connections to Success and Increasing Adoptions Act of 2008 (the “Adoption Act”), which is effective for taxable years beginning after December 31, 2008. The Adoption Act amends the definition of “qualifying child” under Section 152(c) by providing that, in addition to the existing requirements:
- The “qualifying child” must be younger than the taxpayer claiming the individual as his/her dependent;
- The “qualifying child” must not have filed a joint return (other than to claim a refund) for the taxable year beginning in the calendar year in which the taxable year of the taxpayer begins; and
- An individual may be claimed as a “qualifying child” by a non-parent in situations where the parents are eligible to, but do not, claim the individual as a qualifying child, but only if the non-parent’s adjusted gross income is higher than the highest adjusted gross income of any parent.
Therefore, effective in 2009, an employee may no longer claim an individual as a “qualifying child” if that individual is married, or is older than the employee. Thus, the value of health coverage provided to such an individual will be taxable to the employee unless that individual satisfies the requirements for a “qualifying relative” of the employee. (There is no age restriction for a “qualifying relative.”)
On the other hand, beginning in 2009, an employee who is a non-parent(such as a grandparent, aunt or uncle) may claim an individual as a “qualifying child” if the individual’s parents do not, so long as the employee’s adjusted gross income is higher than that of either parent. Consequently, health care benefits can be provided to such children without the value of such coverage being taxable to the non-parent employee.
Two days after Congress passed the Adoptions Act, President Bush signed into law another bill (referred to as “Michelle’s Law”) that will affect the tax treatment of certain health care benefits in 2010. Michelle’s Law, which is effective for plan years beginning on or after October 9, 2009, does not change the definition of “dependent” under Section 152. Instead, it extends the time period during which health coverage must be offered to certain college students who would otherwise lose coverage because of a medically necessary leave of absence.
In order to qualify, the student must be enrolled as an eligible dependent under a fully insured or self-funded health plan and must be a student attending a postsecondary educational institution. The student must be suffering from a serious injury or illness immediately before the first day of the medical leave, and must have written certification that the leave of absence is medically necessary.
If all requirements are met, the health plan must extend coverage for such student until the earlier of one year from the first day of the medical leave or the date coverage would otherwise terminate. The plan must continue coverage at the same level of benefits as the student had before taking the leave, and at the same cost as for other dependents under the plan.
Michelle’s Law, like certain state law health insurance mandates, may require a health plan to provide coverage beyond the time period that the student qualifies as a “dependent” under Section 152 (because a full-time student who is not permanently disabled must be under 23 for the entire year to be a “qualifying child”). In either case, the value of the employer-provided coverage will be taxable to the employee parent once the student no longer qualifies as a “qualifying child” under Section 152. Employers that fail to properly report such income could be subject to IRS penalties and interest for failure to withhold and pay federal employment and income taxes. Therefore, employers should take steps now to make sure that their payroll provider (or payroll system) is properly reporting the value of employer-provided health coverage to individuals who do not qualify as “dependents” under the tax code.