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Taxation of Dependent Coverage After Health Care Reform

By now, most people involved in the administration of group health plans are familiar with the requirement that plans offering dependent coverage make that coverage available to adult children until they attain age 26. This new requirement applies to both insured and self-insured plans (regardless of the plan’s status as a “grandfathered” plan), and is effective for plans years beginning on or after September 23, 2010 (January 1, 2011, for calendar-year plans). Many of us, however, are not as familiar with the corresponding change to the Tax Code that allows these benefits to be provided on a tax-free basis.

For periods after March 30, 2010, a covered employee’s child who is under age 27 as of the end of the taxable year may receive employer-paid health coverage on a tax-free basis (and the employee may pay for some or all of such coverage with pre-tax dollars under a cafeteria plan), even if the child does not qualify as the covered employee’s Tax Code dependent (i.e., even if the child is not a qualifying child or qualifying relative under Code Section 152, and therefore cannot be claimed as a dependent on the employee’s federal income tax return). In other words, even though plans are only required to offer dependent coverage until the child’s 26th birthday, the covered employee’s child may receive tax-free coverage (or tax-free reimbursements) through the end of the calendar year in which the child turns age 26.

This tax change also applies to the reimbursement of qualifying medical expenses under health reimbursement arrangements (“HRAs”) and health flexible spending accounts (“FSAs”) (but not to health savings accounts (“HSAs”)). Accordingly, plan sponsors that have not already done so, may wish to amend their Section 125 cafeteria plans to allow for the payment of health care premiums and/or FSA reimbursements on behalf of adult children who will not attain age 27 by the last day of the year. Plan sponsors may also want to amend their HRAs for the same reason.

For purposes of this change in the tax treatment of dependent coverage, a “child” is an individual who is the employee’s son, daughter, stepson or stepdaughter, and includes both a legally adopted individual and an individual lawfully placed with the employee for adoption. The term “child” also includes an eligible foster child—defined as a child placed with the employee by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction. As a result of this tax change, traditional dependency requirements involving age limits, residency, support and other tests that would otherwise need to be satisfied for an individual to qualify as a tax dependent do not apply for purposes of the tax-favored treatment of health reimbursements and coverage for adult children who are younger than 27 for the entire tax year.

This tax change significantly eases the burden associated with analyzing the taxability of dependent coverage for a covered employee’s adult children. Now, under Code Section 105(b), a covered employee may be reimbursed (without tax consequences) for amounts expended for medical care of the employee’s children who are under age 27 as of the end of the employee’s taxable year (generally, the calendar year). It is important to note that not every state follows the federal taxation scheme, and thus some benefits that are not taxable for federal income tax purposes may be taxable for state income tax purposes.

If, however, a covered employee’s adult child receives coverage or benefits after the end of the year in which the child turns age 26, the value of the coverage or reimbursements will be taxable to the covered employee unless the child is a “qualifying child” or “qualifying relative” under Code Section 152. This situation could arise in a plan that voluntarily provides extended dependent coverage, or in an insured plan that is required (by a state insurance law) to provide coverage beyond age 26.

Who is a Qualifying Child? Under Code Section 152, a qualifying child is an individual who (1) bears a specified relationship to the employee; (2) has the same principal place of abode as the employee for more than half of the year; (3) meets certain age requirements; (4) has not provided more than half of his or her own support for the year; and (5) has not filed a joint tax return with his or her spouse for the year. The qualifying child relationship requirement is satisfied if the individual’s relationship to the covered employee falls within any of the categories described above under the definition of “child,” or if the individual is a descendant of an employee’s “child” (e.g., a grandchild). Additionally, the relationship requirement may be met if the individual is the employee’s sibling, half-sibling, step-sibling, or a descendent of any such individual (e.g., a nephew or niece). A qualifying child must be younger than the employee and under age 19 (or under age 24 if a full-time student) as of the close of the calendar year in which the employee’s taxable year begins.

Who is a Qualifying Relative? Under Code Section 152, a qualifying relative is an individual (1) who bears a specified relationship to the employee; (2) whose gross income is less than the exemption amount in Code Section 151(d); (3) with respect to whom the employee provides over half of the individual’s support; and (4) who is not anyone’s qualifying child. The qualifying relative relationship requirement is quite broad. It is satisfied if the individual’s relationship to the covered employee falls within any of the categories described above under the qualifying child relationship requirement. The relationship requirement may also be satisfied if the individual is the employee’s parent, grandparent, aunt, uncle, in-law, or other individual (other than a spouse) if the relationship does not violate local law. The Code Section 151(d) income limitation does not apply for health coverage purposes.

In summary, status as a qualifying child or qualifying relative remains relevant for determining the tax treatment of health coverage and reimbursements for individuals who do not qualify as the employee’s “spouse” or “child.” Fortunately, such status is relevant only for purposes of determining the taxability of coverage or reimbursements for an employee’s adult child when the child receives coverage after the end of the year in which he or she turns age 26. Thus, for the majority of group health plans, the new coverage mandate and corresponding tax change should simplify the process of determining when health benefits for dependents create taxable income for employees, and should provide much needed relief to plan sponsors.