McGuireWoods Healthcare Reform Guide: Installment No. 3 – Health Benefit Tax Exclusion for Adult Children

McGuireWoods Healthcare Reform Guide: Installment No. 3

April 28, 2010

This is the third in a series of WorkCite articles concerning the recently enacted Patient Protection and Affordable Care Act (PPACA) and its companion bill, the Health Care and Education Reconciliation Act of 2010 (referred to collectively as the Act).

Under the Act, group health plans and insurers that offer coverage covering dependent children must make that coverage available to adult children until they reach age 26. The IRS has issued guidance about changes under the Act for the tax treatment of health coverage and reimbursements for these older children. See IRS Notice 2010-38 (the Notice). The Act amends Section 105(b) of the Internal Revenue Code (Code), effective March 30, 2010, to extend the general exclusion from gross income for employer-provided medical care to any employee’s child who has not attained age 27 as of the end of the employee’s taxable year (Adult Child).

The income exclusion rules for Adult Children are a consequence of, but not parallel to, the rules of extending health plan dependent coverage to many of these Adult Children. However, it is important to note that the extension of dependent coverage applies to children under age 26 and is effective for the first plan year beginning on or after Sep. 23, 2010, while the amendments to the Code addressed in the Notice apply to children who have not attained age 27 as of the end of the taxable year and are effective March 30, 2010.

In an upcoming WorkCite we will discuss the new rules under the Act for extending health plan dependent coverage to children who have not reached age 26.

Who Qualifies as an Adult Child?

A “child” is defined as an individual who is the son, daughter, stepson, or stepdaughter of the employee. The term also includes an individual who is legally adopted by the employee, an individual who is lawfully placed with the employee for legal adoption by the employee, and an “eligible foster child,” defined as an individual who is placed with the employee by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction.

An Adult Child is a “child” who has not attained age 27 as of the end of the employee’s taxable year. The Notice provides that employers may rely on an employee’s representation as to the child’s date of birth and may assume that the employee uses a calendar tax year.

Therefore, only for this purpose, the exclusion from gross income applies to an Adult Child of the employee who is not necessarily the employee’s dependent within the meaning of Code Section 152(a).

Tax Exclusion of Employer-Provided Medical Care Reimbursements

Under the Code, employer-provided reimbursements made directly or indirectly to the employee for the medical care of the employee, the employee’s spouse, and the employee’s dependents (as defined in Code Section 152) are generally excluded from an employee’s gross income. Reimbursements include direct payments to providers of health care, like doctors and hospitals. Under the Act, the exclusion from gross income is extended to employer-provided reimbursements for the medical care of the employee’s Adult Child.

Tax Exclusion of Employer-Provided Accident or Health Coverage

Separately, the Code also excludes the value of employer-provided accident or health plan coverage as parallel to the exclusion for reimbursements. However, the Act itself does not include a parallel expansion of the tax exclusion for employer-provided accident and health plan coverage. Nonetheless, the IRS and Treasury intend to amend the regulations so that, on and after March 30, 2010, both coverage under an employer-provided accident or health plan and reimbursements under a plan for medical care expenses of an Adult Child are excluded from the employee’s gross income.

Cafeteria Plans, Flexible Spending Arrangements, and Health Reimbursement Arrangements

The Code’s cafeteria plan rules permit employees to elect between cash and certain qualified benefits, including accident or health plans and health flexible spending arrangements (health FSAs). An Adult Child will be treated the same as other dependents for cafeteria plans, including health FSAs.

A cafeteria plan may permit an employee to revoke an election and make a new election only in limited circumstances, such as a change in status event. While the regulations currently do not permit election changes for Adult Children, the Notice provides that IRS and Treasury intend to amend the regulations, effective retroactively to March 30, 2010, to include change in status events affecting Adult Children, including circumstances where an Adult Child becomes newly eligible for coverage or eligible for coverage beyond the date on which the Adult Child otherwise would have lost coverage.

Cafeteria plans may need to be amended to include employees’ Adult Children. However, under the current proposed cafeteria plan regulations, cafeteria plan amendments may be effective only prospectively. Under the Act, as of March 30, 2010, employers may permit employees to make immediate pre-tax salary reduction contributions for accident or health benefits under a cafeteria plan (including a health FSA) for Adult Children, even if the cafeteria plan has not yet been amended to cover these individuals. However, a retroactive amendment to a cafeteria plan to cover Adult Children must be made no later than Dec. 31, 2010 and must be effective retroactively to the first date in 2010 when employees are permitted to make pre-tax salary reduction contributions to cover Adult Children (but in no event before March 30, 2010).

The same rules apply to Adult Children under health reimbursement accounts.

FICA, FUTA, and Income Tax Withholding Treatment

Coverage and reimbursements under an employer-provided accident and health plan for employees and their dependents are generally excluded from wages for Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) tax purposes. For these purposes, a child of the employee is a dependent. No age limit, residency, support, or other test applies for these purposes. Therefore, coverage and reimbursements under such a plan for employees and their dependents that are provided for an Adult Child are not wages for FICA or FUTA purposes. Such coverage and reimbursements are also exempt from income tax withholding.

VEBAs, Code Section 401(h) Accounts, and Code Section 162(l) Deductions

A VEBA is a tax-exempt entity providing for the payment of life, sick, accident, and other benefits to employee members, their dependents, and designated beneficiaries. As amended by the Act, for purposes of providing for the payment of sick and accident benefits to employee members of the VEBA and their dependents, the term “dependent” includes the employee member’s Adult Children.

Code Section 401(h) provides that a pension plan may establish and maintain a separate account to provide for the payment of benefits for sickness, accident, hospitalization, and medical expenses of retired employees, their spouses, and their dependents. As amended by the Act, Code Section 401(h) now provides that the term “dependent” includes any individual who is a retired employee’s Adult Child.

Code Section 162(l) generally allows a self-employed individual to deduct amounts paid during the taxable year for insurance that constitutes medical care for the taxpayer, his or her spouse, and dependents, if certain requirements are satisfied. As amended by the Act, Code Section 162(l) now covers medical insurance for any Adult Child.

Because the new rules regarding the tax exclusion of health coverage for Adult Children are now effective, the IRS and Treasury recognized that employers may wish to take action quickly to enable their employees to take advantage of the new rules. The timely guidance provided by the Notice is extremely helpful in understanding and implementing these new provisions.

Visit the Healthcare Reform section for additional updates and resources.