IRS Issues First Guidance on Coverage of Adult
Children Under PPACA
On April 27, 2010, the Internal Revenue Service (IRS) issued Notice 2010-38 to provide guidance on the tax treatment of health coverage for certain adult children under 27 who are covered under a parent's employer health plan. The notice provides that, effective March 30, 2010, employers no longer have to impute income to employees for health coverage of such children, even though they are not tax dependents under the Internal Revenue Code. The notice also expands coverage under health flexible spending arrangements. The change stems from new dependent coverage rules mandated by the Patient Protection and Affordable Care Act (PPACA) that will go into effect for most group health plans in 2011. However, the associated tax relief is available immediately, and impacts all employers currently providing coverage to nondependent children.
Extension of Dependent
Coverage
PPACA requires that, effective for plan years beginning on or after September 23, 2010 (January 1, 2011, for calendar year plans), all group health plans that offer dependent coverage must extend such coverage to an employee's adult child until the child turns 26 (until 2014 certain grandfathered plans only have to offer this extended coverage to adult children who are not otherwise eligible for other employer-sponsored coverage). Many adult children are not tax dependents of their parents. Before March 30, 2010, an employer that provided health coverage to an employee's child who was not the employee's tax dependent had to include the value of the non-dependent's coverage in the employee's wages as taxable income. Employer provided health coverage extended to an employee's child could be excluded from that employee's income only if the child was an actual tax dependent of the employee. Therefore, the new requirement under PPACA would have required employers to include in employees' income the value of the coverage for the non-dependent adult child (commonly referred to as "imputed income").
Imputed Income Relief
for 2010
To address these tax concerns, the Health Care and Education Reconciliation Act (Reconciliation Act) amended Internal Revenue Code (Code) Section 105(b), effective March 30, 2010, to provide that expenses incurred for the medical care of an employee's child who is under 27 at the end of the taxable year are not taxable to the employee. For these purposes, a "child" is the son, daughter, stepchild, adopted child (or child placed for adoption) or eligible foster child of the taxpayer.
Code Section 106 provides that the value of employer-provided health coverage for the employee, his or her spouse, and his or her tax dependents (generally, the cost, or premium, for the coverage) is not taxable to the employee. In Notice 2010-38, the IRS and the Department of Treasury state their intent to amend the regulations under Code Section 106, effective March 30, 2010, to parallel the change made to Code Section 105(b) so that the value of employer-provided health coverage for an employee's child who is under 27 at the end of the taxable year is also not taxable to the employee. Until the regulations are amended, employers may rely on the notice to exclude the value of such coverage from an employee's income.
Taken together, Code Sections 105 and 106 will now permit employers to provide coverage to an employee's child through the end of the year in which the child turns 26 without needing to impute income to the employee for the value of the coverage or the medical expenses paid by such coverage, regardless of whether the child is the employee's tax dependent. Notice 2010-38 also makes clear that medical reimbursements and coverage for these children are not considered wages for the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, and the Railroad Retirement Tax Act, nor are they subject to income tax withholding. PPACA and the Reconciliation Act provide similar preferential tax treatment to adult children who receive coverage under a voluntary employees' beneficiary association, a 401(h) account (an account under certain pension plans that pay for medical expenses), or through a self-employed parent. Note that this extension of tax-favorable coverage will not apply to other non-dependent children, such as a grandchild or the child of a domestic partner, unless the child otherwise qualifies as a tax dependent of the employee.
Impact of Change on
Cafeteria Plans, Flexible Spending Arrangements and Health Reimbursement
Arrangements
Many employers permit employees to pay for their health coverage through a cafeteria plan and also maintain health flexible spending arrangements (FSAs) or health reimbursement arrangements (HRAs). Employees make pre-tax salary reduction contributions through the cafeteria plan on a payroll basis to fund their portion of the premiums and/or to fund a health FSA. The new changes to Code Sections 105(b) and 106 will apply to cafeteria plans so that an employee's premium payment for an adult child's coverage may now be made on a pre-tax basis through a cafeteria plan. In addition, employees with health FSAs or HRAs may now submit medical claims incurred by non-dependent adult children who are under 27 at the end of the taxable year for reimbursement under the health FSA or HRA (provided that any medical expenses relating to non-dependent children are incurred on or after March 30, 2010).
In addition to these changes, the IRS and Treasury intend to make two more important changes to the cafeteria plan rules, effective March 30, 2010, to allow employees to change their elections to cover non-dependent children under a cafeteria plan on a pre-tax basis.
First, the IRS and Treasury plan to amend the regulations under Code Section 125, which govern the circumstances under which an employee may change his or her health plan coverage election in a cafeteria plan (referred to as "change in status events" in the regulations). Absent an express exception in the regulations, an employee generally cannot change his or her health coverage election in the middle of a plan year. The IRS and Treasury intend to amend the regulations, effective March 30, 2010, to allow a mid-year change in status event allowing the addition of a non-dependent child under 27.
Example: An employer currently offers health coverage to its employees, their spouses and their tax dependents. Effective June 1, 2010, the employer decides to amend its health plan to cover adult children of employees through the end of the year in which such children turn 26. An employee participates in the employer's health plan and currently has single plus spouse coverage because his child is 21 and not a full-time student, and is therefore not eligible for coverage under the plan's current terms. In June, the employee wants to make a mid-year change to elect family coverage through the employer's cafeteria plan in order to pay for family coverage through salary reduction on a pre-tax basis. Notice 2010-38 provides that the regulations under Code Section 125 will be amended retroactively to March 30, 2010, to include this as an approved change in status event. Therefore, the employee can make the desired election change.
Please note that we do not believe that this modification to the change in status events would allow an employee to add an adult child simply to benefit from the new preferential tax treatment provided under the Reconciliation Act and Notice 2010-38 if the employer's plan already allowed for adult child coverage. A change in status event requires a change in eligibility status and we do not believe that the change in tax status would meet that standard.
Second, the IRS and Treasury plan to provide relief from the general rule that a cafeteria plan amendment must be prospective only. The relief would allow employers to permit employees to immediately make pre-tax salary reduction contributions under the cafeteria plan for children under 27, even if the cafeteria plan does not currently allow for pre-tax contributions to cover such individuals. To take advantage of the relief, employers must retroactively amend their cafeteria plans to cover such individuals no later than December 31, 2010. This allows all employers who currently cover non-dependent children on an after-tax basis to begin covering such children pre-tax through their cafeteria plan, provided the cafeteria plan is formally amended by the end of the year. In addition, employers may also immediately allow employees to submit reimbursements to health FSAs for these children as long as the employer's cafeteria plan is amended to reflect this change by the end of 2010.
Administration Urging Early Compliance With PPACA
President Obama's administration is urging leading insurance companies to begin covering young adults in 2010, although most group health plans will not be required to do so until 2011. The administration notes that early implementation of the requirement under the PPACA will not increase the tax burden on employers and it will avoid gaps in coverage for children who will graduate or age out of their parents' plan this year, saving the administrative cost of disenrolling such individuals only to re-enroll them next year. A significant number of large insurance companies have agreed to maintain coverage for young adults enrolled on their parents' plans who would otherwise have lost eligibility during 2010. Read the list of insurers that have agreed to early implementation on the White House Fact Sheet.
For more information regarding the new dependent coverage rules under the PPACA and Reconciliation Act, or for any other questions regarding how health care reform impacts group health plans, please contact Christopher Sears, Tara Sciscoe, Katrina Clingerman, Shalina Schaefer or your Ice Miller employee benefits attorney.