June 2, 2010 – Minnesota Taxation of Health Care Coverage Provided to Certain Children
Note: The recently passed “health care reform legislation”1 impacts employers and their group health plans in many ways. This Alert focuses on one aspect of the legislation relevant to employers – the federal tax treatment of the “adult child.” Future Alerts will address other aspects of the legislation.
1 The Patient Protection and Affordable Care Act , Public Law No. 111-149, and the Health Care and Education Reconciliation Act of 2010, Public Law No. 111-162, collectively referred to by the IRS on Notice 2010-38 as the Affordable Care Act
The health care reform legislation expands the group of individuals to whom employer-provided group health coverage may be provided without resulting in taxable income to the employee. Effective March 30, 2010, group health plan coverage provided to the employee’s “adult child” is now excluded from the employee’s income as the result of an amendment to Section 105(b) of the Internal Revenue Code of 1986, as amended (the “Code”). This change impacts employer group health plans NOW.
Note: There are two distinct parts of the health care reform legislation dealing with “adult children.” One provision addresses the federal tax consequences of providing coverage to adult children. The other provision addresses providing the group health plan coverage itself to adult children. This Alert only addresses the federal tax consequences of providing coverage to adult children.
Group Health Plan Coverage: Before Health Care Reform Legislation
When group health plan coverage was provided to anyone other than the employee and the employee’s spouse and tax dependents (as defined for purposes of group health plans in Section 105(b)), the fair market value of that individual’s coverage was taxable income to the employee. [It either needed to be imputed to the employee or the employee needed to pay the fair market value with after-tax dollars.]
Observation: For many payroll personnel this was an administrative nightmare and for benefits personnel this was a communication and information tracking nightmare.
Group Health Plan Coverage: After Health Care Reform Legislation
The context of providing group health coverage to a non-tax dependent child has drastically changed. And, that change is already effective for most of the 2010 tax year.
Definition of “Adult Child.” According to amended Section 105(b), an “adult child” includes the employee’s natural, step, adopted, or foster child who will not attain age 27 during the calendar year. In other words, an employee’s child is an “adult child” for purpose of group health plan taxation until the end of the calendar year in which the child attains age 26.
There are no other requirements for purposes of determining the federal tax consequences of providing coverage to an adult child. For example, the adult child need not be financially dependent on the employee for support nor live with the employee. Also, the adult child can be married and have other coverage available through another employer. Provided the individual is the employee’s child and meets the age requirement, beginning April 1, 2010, the fair market value of the group health coverage provided is not included in the employee’s taxable income.
Expansion. The series of questions for purposes of federal tax treatment now consists of whether the person receiving group health coverage through the employee (including former employee) is (1) that employee’s spouse, (2) that employee’s tax dependent (as defined for purposes of group health plan in Section 105(b)), or (3) that employee’s “ adult child.” If the person satisfies any of the three categories, the coverage does not result in taxable income to the employee.
Impact on Cafeteria Plans: Before the Health Care Reform Legislation
In the past, if coverage was provided to a non-tax dependent child, employers generally had two mechanisms to address the tax consequence. Under the proposed cafeteria plan regulations, employers could allow employees to pay for the non-tax dependent child’s coverage through the cafeteria plan (i.e., on a pre-tax, salary reduction basis), provided the employer then imputed income to the employee equal to the fair market value of the non-tax dependent child’s coverage. Many cafeteria plans were amended to specifically allow this to take place.
The alternative was to require the employee pay an amount equal to the fair market value of the non-tax dependent child’s coverage on an after-tax basis (e.g., through after-tax payroll deduction). In some cases, this additional payment was substantial. For example if the employee had family coverage (employee, spouse, tax dependent child and non-tax dependent child), the employee would have to pay the cost of the family coverage plus the fair market value of the coverage provided to the non-tax dependent child. The non-tax dependent child could not be part of the “family” premium.
Impact on Cafeteria Plans: After IRS Notice 2010-38
IRS Guidance: The IRS has already released guidance regarding the federal tax consequences of an “adult child” in Notice 2010-38. It is available at http://www.irs.gov/pub/irs-drop/n-10-38.pdf.
The IRS, through Notice 2010-38, recognizes the impact of the law changing the status of the child during a cafeteria plan year. Where all premiums for group health coverage are being paid through a cafeteria plan, followed by imputation of income reflecting the fair market value of the non-tax dependent child’s coverage, the mid-year change to Section 105(b) means (1) the pre-tax payment of the entire cost of coverage continues through the end of the plan year, and (2) the imputation of income stops (i.e., the value of the coverage is no longer subject to federal income and employment (e.g., FICA) taxes). There is no change in cafeteria plan election necessary.
However, if the employee was paying the fair market value of the cost of the non-tax dependent child’s coverage on an after-tax basis, payment does not need to be made on an after-tax basis as of April 1, 2010. Instead, it could be made available on a pre-tax basis. But until the IRS issued Notice 2010-38, the employee had no recognized basis upon which to change the cafeteria plan election. [Remember cafeteria plan elections are irrevocable unless a specific exception applies.] Notice 2010-38 states the cafeteria plan exceptions to the irrevocable election rule will be amended to allow election changes based upon a status change of an adult child due to the change in the law. A status change will include the employee’s acquisition of an adult child as a result of the amendment to Section 105(b). In other words, if the adult child was not previously a tax dependent under Section 105(b), the amendment to Section 105(b) will allow the employee to now make an election change to pay for that adult child’s coverage on a pre-tax basis. Notice 2010-38 specifically states that taxpayers can rely on Notice 2010-38 now.
Caution: When election changes under a cafeteria plan are permitted, with very limited exceptions, the election changes must be made on a prospective basis. Although it authorizes election changes with respect to adult children, Notice 2010-38 does not authorize retroactive election changes. To the extent after-tax premiums have already been paid for coverage for April and May, it is unclear whether an employer can reprocess those payments and allow them to be paid on a pre-tax basis (i.e., allow a retroactive election change back to April 1st).
Plan Amendments Needed. To accomplish the changes under a cafeteria plan discussed above, the cafeteria plan requires amendment. Provisions in the plan requiring the imputation of income for adult children who are not tax dependents should be removed. If the plan does not allow premium payments for non-tax dependent children, and the employer wishes to allow employees to pay for an adult child’s coverage on a pre-tax basis, the definition of “dependent” applicable for premium payments must be changed to include adult children. In addition, the provision addressing election changes should be amended to specifically allow changes with respect to adult children. Notice 2010-38 allows such amendments to be adopted by the end of 2010 and to be effective retroactively back to the date the changes were implemented (but not earlier than March 30, 2010).
Impact on Health FSAs and HRAs
The amendment to Code Section 105(b) also impacts health flexible spending accounts (FSAs) provided through a cafeteria plan and health reimbursement arrangements (HRAs). Section 105(b) identifies the individuals for whom reimbursements may be made under such plans. Accordingly, beginning March 30, 2010, health FSAs and HRAs may reimburse expenses incurred by an adult child in addition to expenses incurred by the employee and the employee’s spouse and tax dependents. Whether taking advantage of the expanded definition requires plan amendment, depends upon the current language of the plan.
Automatically Expanded: Some health FSAs and HRAs define dependent as an individual identified in Section 105(b). In that case, expenses incurred by adult children on or after March 30, 2010, automatically became eligible for reimbursement under the plan.
If the plan language does not automatically incorporate the change to Section 105(b), and the employer wants to allow reimbursements for adult children, the plan should be amended to allow reimbursements for this new category of dependents. Such amendment should be prospective in nature; not retroactive.
Notice 2010-38 allows the written amendment to the health FSA to be effective retroactively if adopted by the end of 2010. Accordingly, the amendment may be implemented operationally at any time beginning after March 30, 2010. Notice 2010-38 did not provide any similar transition relief for HRAs. Amendments to an HRA are generally effective only on a prospective basis. Therefore, a written amendment to the plan should be adopted before the change is implemented.
No Impact on HSAs
HSAs are not governed by Section 105(b). Consequently, the expansion under Section 105(b) to include adult child does not apply to HSAs. Distributions can still take place for the expenses of an adult child but the distribution would not be tax free. Tax free HSA distributions remain only available for the spouse and tax dependents.
Minnesota Tax Law
As of the writing of this Alert, Minnesota law has not been amended to incorporate the change to Section 105(b) of the Code. In general, for purposes of Minnesota income taxes, income is based upon income determined under the Code. However, for this purpose, Minnesota law currently incorporates the Code as it existed on March 31, 2009 (i.e., the Code prior to the amendment to Section 105(b)).
Unless and until the Minnesota legislature amends Minnesota law to incorporate the current version of the Code, providing coverage to adult children who are not also tax dependents will result in taxable income for purposes of Minnesota income tax.
Action Items
In light of the amendment to Section 105(b) and its mid-tax year effective date, employers sponsoring group health plans (including health FSAs and HRAs) and cafeteria plans should consider the following actions:
- If income is currently being imputed to the employee because an “adult child” is covered under the health plan, cease imputing income immediately. Reverse the income imputed for any coverage provided after March 30, 2010.
- If an employee is paying for an adult child’s coverage with after-tax dollars, consider allowing the employee to make an election change under the cafeteria plan to begin paying the entire premium on a pre-tax basis. This requires a cafeteria plan amendment. If the cafeteria plan is amended to allow an election change, consider whether to implement the change prospectively or retroactively.
- Review definitions of “dependent” in health FSAs and/or HRAs to see if adult children are automatically covered as a result of the amendment to Section 105(b). If so, communicate the impact of the law change to participants or amend the plan to exclude coverage for adult children. If not, consider amending the cafeteria plan now to permit pre-tax payment for coverage of adult children.
Please contact us if you have any questions regarding the requirements, or if you need our assistance with any of the foregoing action items.