December 1, 2004
Changes to the Definition of “Dependent” Affect Medical Plans and Dependent Care Assistance Programs
Through the Working Families Tax Relief Act of 2004 (“WFTRA”), Congress has changed the definition of “dependent” for certain purposes. Of primary concern to employers, changes to Code Sections 151 and 152 may affect who is eligible under employer-sponsored health plans, including health care reimbursement accounts through a flex plan. Additional changes were made to definitions applicable to dependent care assistance programs under Section 129. The changes are effective January 1, 2005.
HEALTH PLANS
Change to the definition of “dependent.” WFTRA essentially combines Code Sections 151 and 152, which establish who is a dependent for purposes of claiming a dependency exemption. Code § 152 now recognizes two types of dependents: a qualifying child and a qualifying relative.
Generally, a qualifying child is:
(a) child (son, daughter, stepson, or stepdaughter), brother, sister, stepbrother, or stepsister, or a descendant of any such person; (b) who has the same principal place of abode as the taxpayer for at least one-half of the relevant year; (c) who has not attained age 19 (or age 24 if a full time student) during the relevant year or is permanently and totally disabled; and (d) who does not provide over half of his/her own support during the relevant year.
A qualifying relative includes a:
(a) child (or a descendant of a child) brother, sister, stepbrother, or stepsister, parent (or a parent’s ancestor), stepparent, brother or sister’s son or daughter, parent’s brother or sister, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law or, if not such a relative, an individual who has the same principal place of abode as the taxpayer and is a member of the taxpayer’s household; (b) whose gross income for the relevant year is less than the Section 151(d) exemption amount ($3,200 for 2005); (c) who generally has received more than one-half of his/her support from the taxpayer during the relevant year; and (d) who is not a qualifying child.
Several Exceptions Apply. An individual who is the dependent of another is treated as having no dependents. And, if an individual files a joint return with his/her spouse, that individual cannot be another person’s dependent.
Key comparison. There are four notable differences between the old and new definitions.
Old rule. Previously, Section 152 provided that an individual is a dependent if he/she: (a) receives over one-half of his/her support for the relevant year from the taxpayer, and (b) is of a particular relation to the taxpayer or has the same principal place of abode as the taxpayer and is a member of the taxpayer’s household.
Under the new definition, (1) there is no requirement that the taxpayer provide more than half of a child’s support to be a dependent; (2) a child must reside with a taxpayer in order to be a dependent; (3) if a child is too old to be a qualifying child, he/she will be a dependent (i.e., qualifying relative) only if the gross income requirement is met; and (4) non-children can be dependents only if the gross income requirement is met (i.e., meets the definition of qualifying relative).
Changes to Code Sections 105 and 106. In light of the changes to the definition of dependent, Congress and the IRS have also made changes to Code Sections 105 and 106; the sections of the Code that allow employers to provide health benefits to their employees on a tax-free basis.
Important. Congress did not intend to change the definition of dependent for purposes of determining who could receive health benefits on a tax-free basis.
Consequently, Congress also changed the definition of dependent under Section 105 to essentially undo the changes to Section 152 for purposes of Section 105. Specifically, for purposes of Section 105, “dependent” means a dependent under Section 152 without regard to the gross income limitation and the exceptions for married individuals and dependents of dependents. The IRS has indicated regulations will be issued under Section 106 to make the same changes under that section of the Code.
As a result of the changes to Sections 105 and 106, with one exception explained below, employers may continue to provide benefits to the same dependents of employees as they have in the past and those benefits will not be taxed to the employee.
Exception: An individual that was a dependent under the old Section 152 but who does not reside with the employee will no longer be a dependent and the value of the benefits provided to that employee will be imputed income for the employee. The changes to Sections 105 and 106 do not address this issue.
Check your document language. Depending on the terms of the plan documents governing benefits, those who are eligible for benefits under the plan may have changed. Many plan documents, especially medical reimbursement plans and health reimbursement arrangements, define “dependent” for purposes of identifying whose expenses are eligible for reimbursement, by reference to Section 152. Because of the change to Section 152, the individuals who meet that definition are now different.
For example, if a son of an employee earns more than $3,200 in 2005, he will no longer be a dependent under Section 152 and any plan that uses the Section 152 definition. However, because of the changes to Sections 105 and 106, that son would still be eligible for health benefits on a tax-free basis if the plan were amended.
“To Do” Items. As a result of the changes to Section 152, sponsors of health plans should review their plan documents to determine how “dependent” is defined for purposes of the plans. If the definition incorporates the definition under Section 152, determine whether you want to use the new Section 152 definition or the expanded definition allowed under Sections 105 and 106. If you chose the latter, your plan documentation will need to be amended. Changes to the plan’s descriptive materials may also be necessary. If the plan definition does not incorporate the definition under Section 152, you need to compare the plan’s definition to the new definition under Sections 105 and 106 to make sure either (1) the plan does not provide benefits to an individual not considered a dependent under those sections, or (2) the benefit is taxable to the employee.
DEPENDENT CARE ASSISTANCE PROGRAMS
WFTRA also changed the definition of qualifying individual for purposes of Section 129 of the Code. Accordingly, expenses that may be reimbursed under dependent care assistance programs (“DCAP”) (a/k/a dependent care reimbursement plans) have changed. The new definition of qualifying individual is:
(a) a qualifying child (as defined above) who has not attained the age of 13; (b) a dependent (a qualifying child or qualifying relative) who is physically or mentally incapable of self-care and who has the same principal place of abode as the taxpayer for more than one-half of the relevant year; or (c) a spouse who is physically or mentally incapable of self-care and who has the same principal place of abode as the taxpayer for more than one-half of the relevant year.
Currently, this new definition includes the gross income limitation imposed on qualifying relatives. Thus, certain persons who were qualifying individuals previously will no long satisfy the definition. Legislation has been introduced seeking to remove the gross income limitation for this purpose, as it was for purposes of Section 105. But, until that legislation passes, the gross income limitation applies.
WFTRA also removed the requirement that the taxpayer maintain a household (i.e., provide more than one-half of the cost of maintaining the household) in order to be eligible for DCAP benefits.
“To Do” Items. As a result of these changes, sponsors of DCAPs should review and revise plan documents and descriptive materials.
This memorandum is a resource for informational purposes only and is not intended to serve as legal advice. HitesmanLaw, P.A. assumes no liability for the interpretation and/or use of the information contained in this memorandum.