What Child is This Who, Laid to Rest… Defining “Dependents” in the Land of Employee Benefits

January 11, 2008

Consider the following situation:

A child is born in unusual circumstances in late December.  While the child’s parents are married, the natural mother is found to be a virgin; therefore, her husband is not the child’s natural father.

This situation creates one of the greatest mysteries and eternal questions of all time – can the husband claim the child as a “dependent” and cover the child under his (i) employer-sponsored health care plan, (ii) cafeteria plan, and (iii) flexible spending accounts for medical expenses and dependent care assistance?  

What / Whose Child Is This

This issue, to which scholars have dedicated their lives and which has been the genesis of much metaphysical debate, has been benefited somewhat from a recent revelation in the form of Notice 2008-5, issued by the Internal Revenue Service (“IRS”) on December 18, 2007 – remarkable timing in a country that generally adheres to a complete separation of church and state.

While employers are seldom, if ever, confronted with this exact fact pattern, they must cope with an ever-increasing number of unusual familial arrangements, such as second marriages, same-sex marriages, cohabitation, children living with non-parental relatives and non-relatives, and common law marriage.  Determining who should qualify as a dependent for various purposes involves both corporate culture and tax issues for employees.

While it is beyond the scope of this WorkCite to provide an in-depth analysis of the “dependent” problem, some background might prove helpful in applying Notice 2008-5 to an employer’s benefit programs that cover dependents.

General Rule

First, an employer may define “dependent” for purposes of its insured or self-insured health plans in any manner that does not violate applicable law.  However, to avoid creating federal taxable income for employees, either on the value of dependent-provided coverage or on the reimbursement of dependent-related medical expenses, dependents must qualify under the definition found in section 152 of the Internal Revenue Code (“Code”).  For this reason, employers will often make health plan coverage available to individuals who are not dependents under Code section 152, creating taxable income for the employee.  For example, same sex partners often fall in this category. 

Unlike employer-sponsored health plans, cafeteria plans and flexible spending accounts for medical expense reimbursement are completely tax driven.  Therefore, it is important to limit coverage under those plans to those dependents who meet the requirements of Code section 152.

Working Families Tax Relief Act

Prior to 2005, different definitions of dependent were used for employer-sponsored plans, the dependency exemption, the Dependent Care Credit, the Earned Income Credit, the Child Tax Credit, and head of household status.  To help to simplify this morass, Congress passed the Working Families Tax Relief Act of 2004 (WFTRA), which modified the definition in section 152 and cross-referenced all or part of the new definition in the Code sections describing the above credits, exemption, etc. 

While unintended, WFTRA also created complications for those employers that used a section 152 definition of dependent in their health plans.  Therefore, the IRS continues to issue guidance to assist employers in determining which dependents qualify under the new rules. 

Section 152 of the Code now provides that an individual is not a qualifying dependent if the individual is a “qualifying child” of another taxpayer.  This leads to the problem described above, where the child lives with and receives significant support from someone who is not the child’s parent, but remains the “qualifying child” of another taxpayer (e.g., the parent). 

  • If dependent status under the relevant plan is correlated with Code section 152, the child would no longer be eligible to participate, even where the parent has no health plan coverage on his or her own.
  • If dependent status under the relevant plan is not correlated with Code section 152, the child would be eligible to participate, but not on a tax-advantaged basis.
Notice 2008-5

IRS Notice 2008-5 provides some, albeit limited, relief.  The Notice applies to a situation where

  • The child is the “qualifying child” of another individual;
  • That individual is not required to file a tax return under Code section 6012 (usually due to negligible amounts of taxable income); and
  • That individual either: (a) does not file an income tax return, or (b) files an income tax return for the sole purpose of claiming a refund of withheld income tax.

Of course, if the individual who can claim the child as a “qualifying child” is required to file an income tax return, the child would not be a dependent of the taxpayer who would like to provide plan coverage on a tax-advantaged basis. 

Notice 2008-5 applies to tax years beginning on and after January 1, 2005.  It is not clear at this point what effect this retroactive application of the rule will have on coverage and reimbursement claims that might have valid tax and plan years that are now closed. 

We expect that the IRS will continue to issue guidance on this complicated topic, which is very important to many non-traditional families.  For example, it remains unclear what the implications would be if the family in our original hypothetical became ex-patriots or third country nationals following, for instance, a flight into Egypt.  Stay tuned for coming attractions.