September 15, 2010 – Health Care Reform’s Impact On The Tax Treatment Of Medical Benefits Provided To Children
Authors:
Darcy L. Hitesman, Esq. , HitesmanLaw, P.A.
Paige McNeal, Vice President, Educators Benefit Consultants
Scott A. Law, Esq. , HitesmanLaw, P.A.
As “interested parties” in the health care industry (e.g., employers, HR Professionals, administrators, accountants, attorneys, brokers, consultants, etc.), many of us are familiar with the requirement that employment-based major medical coverage be made available to children until age 26 for plan years beginning on and after September 23, 2010. And many of us are also familiar with the separate expansion of the federal tax exclusion, effective March 30, 2010, that excludes from an employee’s taxable income the value of medical coverage provided to children who have not reached age 27 by the end of the tax year.
But many of us may not have paid sufficient attention to state tax laws. The tax changes attributable to Health Care Reform at the federal level do not necessarily trickle down to the state level.
States have their own definitions of “income” for purpose of calculating state income taxes. For example, Minnesota’s1 state definition of taxable income does not currently match the federal definition of taxable income. This difference creates an immediate problem with respect to the tax treatment of various medical coverages (e.g., major medical coverage, dental coverage, vision coverage, wellness, etc.) and reimbursement programs (e.g., health flexible spending arrangements (“health FSAs”) and health reimbursement arrangements (“HRAs”)). Wisconsin faces a similar situation.2
The 2010 Tax Year
As noted above, the change in definition of taxable income for federal tax law purposes was effective March 30, 2010. Therefore, for federal income tax purposes, the definition of taxable income from January 1, 2010 through March 29, 2010 is different from the definition used beginning with March 30, 2010.
In addition, state definitions need to be reviewed. Some states may have automatically absorbed the change in the federal definition. For example, North Dakota defines income for purposes of state income taxes in terms of the federal definition.3 When the federal definition changed, the state definition also changed, automatically. For states with definitions that match the federal definition, as with the federal income tax calculation, state income taxes will be based upon two definitions; the definition that existed prior to March 30, 2010, and the definition that applies beginning with March 30, 2010.
What about states that prior to March 30, 2010, had definitions of taxable income that matched the federal definition but the state definition did not automatically absorb the change made at the federal level? For example, in Minnesota, the definitions of income for federal and state purposes were the same until Health Care Reform changed the federal definition. From January 1 through March 29, federal and state income tax determinations are based upon the same taxable income amount. As of March 30, 2010, the federal definition changed. From March 30, 2010 through December 31, 2010, Minnesota state income taxes are calculated using a different taxable income amount than that used for calculating federal income tax.
Unlike the federal income tax calculation, state income taxes will be based upon the same definition that existed prior to March 30, 2010; the state income tax definition did not change. For many employers, this means year-end adjustments, most likely manual.
Impacts of Adjusting Taxable State Income
For states in which, as of March 30, 2010, the definitions of income no longer matched the federal definition, year-end adjustments may require imputation of income to the employee — for state income tax purposes only. Once imputed, the underlying amount of income upon which state income tax withholdings were based changes. The amount actually withheld from wages by the employer for purposes of state income taxes may be short. This has potential ramifications for the employer and the employee.
The employer typically has the obligation to make state income tax withholdings from wages. Failure to correctly withhold can result in penalties (and interest) being assessed to the employer. Employers need to (1) identify whether they have a state withholding issue, and, if so, (2) contact the appropriate state agency for guidance. For example, the Minnesota Department of Revenue posted a bulletin on its website4 indicating it is permissible for employers to continue to withhold using the federal definition. The bulletin makes it very clear that the employee will be responsible for any additional amounts owed for state income tax purposes. While this addresses the immediate systems issues faced by many Minnesota employers due to the mid-year change in the federal definition and the disconnect with the state definition, it creates a potential employee communication nightmare.
The employee owes the State any shortage between the withholdings made by the employer over the course of the tax year and the actual amount of state income taxes due. It makes good sense to communicate that this will be happening in advance to permit employees time to plan (e.g., set aside additional funds to pay the state tax or increase the state withholding amount5).
Imputation of Income
Making a year-end adjustment through imputation of income may not be as simple as it sounds. In general, income is imputed reflecting the fair market value of the coverage to the recipient; the child that receives the benefit. Employers have received little direction or assistance from their insurance companies or third party administrators of self-insured major medical plans regarding the value of the coverage for imputation purposes. And, the IRS has traditionally not issued guidance on how to calculate the fair market value.
Health FSAs and HRAs
Differences between state and federal tax definitions of taxable income are even more problematic when it comes to health FSAs and HRA plans. Many health FSAs and HRAs may have plan language that automatically changed when the federal definition changed. Other plans may have chosen to expand their definition of reimbursable expenses to take advantage of the change in the federal definition.
As with the employment based major medical coverage described above, the value that needs to be determined and imputed is the “fair market value” of the coverage. Determining fair market value for these types of plans is more difficult than for the employment based major medical coverage. The information upon which to make the determination is less defined (e.g., there is no readily available premium upon which to rely). In general, for employees with children in the gap (i.e., whose coverage is excluded for federal purposes but included for state purposes), there needs to be a fair market value determined and an imputation of income to the employee; even if there are no actual reimbursements attributable to that child actually made. It is the value of the coverage, not the amount of reimbursements that is imputed as taxable income to the employee.6
Our Challenge
As “interested parties” in the health care industry, it is our job to understand and then meaningfully and timely communicate this type of tax information.
1 Minn. Stat. § 2901.01(19), (29), (30), (31) (2010).
2 See http://www.revenue.wi.gov/taxpro/news/100727.html.
3 North Dakota Statutes directly tie to the federal definition of taxable income, providing in part that “[t]axable income” in the case of individuals, estates, trusts, and corporations means the taxable income as computed for an individual, estate, trust, or corporation for federal income tax purposes under the United States Internal Revenue Code of 1954, as amended . . .” N.D. Cent. Code, § 57-38-01(12)(2010).
4 See http://taxes.state.mn.us/withholding/pages/other_supporting_content_whats_new_employers_10.aspx#P10_433
5 See Form W-4MN, Minnesota Employee Withholding Allowances/Exemption Certificate; http://taxes.state.mn.us/withholding/pages/forms.aspx .
6 But See Wisconsin’s decision to use actual reimbursements as the “fair market value”; http://www.revenue.wi.gov/taxpro/news/100727.html.