Important: On August 5, 2008, we issued the below Client Alert which highlights an important clarification contained in the final regulations regarding application of a special rule that created an unusual situation in which the custodial parent would release the right to claim the child as a dependent, but (despite the release) could continue to treat the child as a dependent for purposes of group health plan coverage and HSA distributions.
The IRS upon further reflection, determined this unusual outcome was unnecessary and on Monday, August 18, 2008, the IRS released Revenue Procedure 2008-48, which reverses the clarification contained in the final regulations. We since then have issued a new Client Alert outlining these changes. Please read the additional information found here.
IRS Releases Final Regulations Impacting Definition of Dependent
August 5, 2008
Important: The rules contained in these final regulations impact group health plans (including major medical, dental, health flexible spending accounts, and health reimbursement arrangements) and dependent care flexible spending accounts (a/k/a dependent care expense reimbursement plans or dependent care assistance plans).
The IRS recently released final regulations addressing the rules applicable to the determination of a child’s dependent status if the child’s parents are:
- divorced,
- are legally separated under a decree of separate maintenance,
- are separated under a written separation agreement, or
- live apart at all times during the last six (6) months of the calendar year.
The regulations (available http://edocket.access.gpo.gov/2008/pdf/E8-15044.pdf) were issued under Section 152 of the Internal Revenue Code (the “Code”). Section 152 of the Code is relevant in determining whether: (1) providing medical, dental, or vision coverage to a child is taxable to the employee, (2) expenses incurred by the child may be reimbursed under a health flexible spending account (“FSA”) or a health reimbursement arrangement (“HRA”), (3) expenses incurred by the child may be reimbursed on a tax-free basis from a health savings account (“HSA”), and (4) the child is a “qualifying individual” for purposes of a dependent care FSA.
General Rule – Custodial Parent. Under Section 152 of the Code, a child is a “qualifying child” of a parent only if, among other things, the child resides with the parent for more than ½ of the year. If a child otherwise satisfies the requirements of a “qualifying child” with respect to both parents, but the parents do not file a joint federal income tax return, the child is the qualifying child of only one parent. The parent that can treat the child as a “qualifying child” is the parent with whom the child resided for the longest period of time or, if the child resides with both parents for the same amount of time, the parent with the highest adjusted gross income. As a result of the application of this general rule, in divorce or separation situations, typically only the custodial parent can treat a child as a dependent for purposes of the Code.
Note: Special rules apply if the child is not the “qualifying child” of either parent and the parents seek to treat the child as a “qualifying relative.”
Special Rule – Non-Custodial Parent. A non-custodial parent may claim a child as a qualifying child if the requirements of Code Section 152(e) are satisfied. Generally, those requirements are satisfied if:
- the parents (both parents together) of the child provide more than ½ of the child support for the calendar year,
- the child is in the custody of one or both parents for more than ½ of the calendar year
- the parents are divorced, legally separated under a decree of separate maintenance, separated under a written separation agreement, or live apart at all times during the last six (6) months of the calendar year; and
- the custodial parent releases the right to claim the child as a dependent.
The regulations contain information regarding the application of the special rule, including rules regarding determining which parent is the custodial parent, and releasing the right to claim the child as a dependent. The regulations include twenty (20) examples applying the rules.
Application to Group Health Plans and HSAs – Very Important Clarification. The Code sections governing:
- who may receive tax-favored coverage under a group health plan,
- for whom expenses may be reimbursed under a health FSA or HRA, and
- for whom expenses may be reimbursed on a tax-free basis under an HSA,
provide that if the special rule described above applies, both parents may treat the child as a dependent. However, the regulations contain one significant clarification of the application of the special rule to group health plans and HSAs. The regulations clarify that a child will be considered a dependent of both parents only if the custodial parent releases the right to claim the child as a dependent.
Note: Previously, it was unclear whether a release was necessary for both parents to treat the child as a dependent for these purposes. It is now clear that a release is necessary.
Application to Dependent Care FSAs. In most cases, to be a “qualifying individual” under a dependent care FSA, an individual must be a qualifying child under Section 152. Although the special rule in Section 152(e) described above applies in determining who is a qualifying child under Section 152, the dependent care FSA rules indicate, for purposes of determining whether a child is a qualifying individual, if the requirements of the special rule regarding children of divorced or separated parents are satisfied, then the child is the qualifying child (and thereby the qualifying individual) of the custodial parent.
Caution: This is different from how the special rule applies in other contexts (e.g., group health plans and HSAs). As a result, in some cases, a child will not be a “qualifying individual” of a non-custodial parent for purposes of the dependent care FSA, but will be considered a dependent of that parent for purpose of the group health plans and HSAs.
Action Items. In light of the final regulations, we recommend the following actions be taken:
- Review and, if necessary, revise any forms or descriptive materials being used for the purpose of identifying whether children covered under your medical, dental, or vision plans are tax dependents.
Note: We have made some minor revisions to our standard Certification of Dependent Status form, which is available on our website.
- Review and revise group health plan (e.g., medical, dental, and vision plans), health FSA, and HRA documentation to accurately describe which individuals are dependents for tax purposes, as clarified in the final regulations.
- Review and revise dependent care FSA documentation to accurately describe which individuals are “qualifying individuals” for purposes of dependent care FSAs.
- If a high deductible health plan is offered with an HSA, review any descriptive materials distributed to employees about HSA distributions to ensure they accurately describe which individuals are dependents for whom tax-free distributions may be taken, as clarified in the final regulations.
Please let us know if you have any questions regarding the final regulations or need our assistance with any of the action items.
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The information contained in this ALERT is intended for general information purposes only and does not constitute legal advice relative to a specific situation.