November 19, 2010
To determine how to treat the value of health coverage for the dependents of employees—and whether to include the value of that coverage in the employee's gross income—employers and taxpayers need to consider whether the dependent qualifies as a dependent under Section 152 of the Internal Revenue Code. This is true under both federal and California law. Except for the treatment of certain domestic partner relationships, California and federal law generally follow the same rules on the tax treatment of dependent coverage.
There is now another exception, however: federal and California law do not follow the same rules with respect to the tax treatment of adult dependents. The federal health care reform law not only requires health plans to cover adult dependents up to age 26, the law was also changed to provide that such coverage is not included in the employee's gross income, even if the adult dependent does not satisfy the definition of a dependent under Section 152 of the Internal Revenue Code. However, California did not pass a bill conforming California's tax law to federal tax law.
Because California law differs from federal tax law on this point, the tax treatment of dependent coverage will differ for federal and state purposes. Employers, for California state tax purposes, must include the value of the coverage provided to adult dependents in the employee's gross income (unless the child qualifies as a "tax dependent" under Section 152 of the Internal Revenue Code), but not for federal tax purposes as mentioned above. This will most commonly impact covered dependent children who are between ages 24‐26 as well as those who do not qualify as students. (Please see Section 152 of the Internal Revenue Code for the full definition of "tax dependent".)
Employers should consult their payroll/tax advisors for advice on how to implement both federal and state tax law in light of these new rules, as well as on how to value the coverage for purposes of including it in the employee's gross income.
The health care reform law requires health insurers and self‐funded group health plans to provide dependent coverage to the age of 26 if the plan provides dependent coverage. This provision is effective for plan years beginning on or after September 23, 2010.
As part of this provision, the health care reform law amended some, but not all, of the Internal Revenue Code sections dealing with tax treatment of health insurance coverage. To further align the code with the health care reform law, the IRS issued Notice 2010‐38 on April 27, 2010. Changes announced in the notice were retroactively effective March 30, 2010.
The notice clarified that:
Employer‐paid coverage (directly or via cafeteria plan) for an adult child is excludable from income for any tax year ending before the year in which the child attains age 27.
This tax exclusion for adult children is also available under flexible spending accounts and health reimbursement arrangements.
However, the health care reform law did not amend the definition of dependent for health savings account (HSA) expenses. Therefore, for employees who have a high‐deductible health plan (HDHP) and an HSA: Employees do not have to pay taxes on their adult dependent's HDHP coverage.
However, HSA disbursements for a dependent are tax‐free only if the dependent meets the definition of a "tax dependent" under Section 152 of the Internal Revenue Code (which is narrower than the definition of dependent set forth in the health care reform law). This will most commonly impact covered dependent children who are between ages 24‐26 as well as those who do not qualify as students. (Please see Section 152 of the Internal Revenue Code for the full definition of "tax dependent".)
Disbursements for a dependent who doesn't meet the Section 152 of the Internal Revenue Code definition of "tax dependent" may be considered nonqualified expenses, which are subject to taxes and penalties. In 2011, the penalty on nonqualified expenses is increasing from 10% to 20% of the disbursed amount. (The rules are different for distributions after the age of 65 and distributions made after the participant's death or disability.)
For more details about eligible expenses and dependents for HSAs, refer to IRS Publication 969, Keep in mind that this document changes regularly and you should check with your tax adviser if you have questions.
For More Information
For more information about this ACA Pathways or about any other health care reform-related provisions, please contact your Burnham Benefits consultant or Burnham Benefits at:
This ACA Pathways is not intended to be exhaustive nor should any discussion or opinions be construed as legal advice. Readers should contact legal counsel for legal advice.
The information contained in this ACA Pathways includes emerging health care news from a limited perspective and does not encompass all views. The information was selected from a wide range of sources selected on the basis of their potential impact on employers and/or their employee benefit plans. For more information, please contact Burnham Benefits.