Dependent benefits tax issue clarified

Employees should not be taxed on amounts their employers pay for health and accident insurance coverage for an employee's "dependents" as that term is defined under current law, according to an Internal Revenue Service (IRS) notice issued Nov. 17.

The notice advises that the changes to the definition of dependent in Internal Revenue Code Section 152 made by the Working Families Tax Relief Act of 2004 (WFTRA) do not affect employer-provided medical plans.

The IRS notice repairs one apparently unintended adverse effect on taxpayers that was created by the WFTRA dependent definition. However, other problems remain for HR professionals who deal with benefits issues. WFTRA took effect Jan. 1.

In some respects, the WFTRA definition is narrower than the old definition: it covers a smaller class of people as dependents.

The most concern involves domestic partners and children over age 24 who have income above the new definition's limit of $3,100 per year. As such they would not be "qualifying relatives" under the new dependent definition as approved by Congress in WFTRA.

The IRS said in its Nov. 17 notice that it intends to revise the rules for the exclusion from an employee's gross income of employer-provided coverage under an accident or health plan. The revised regulations will be effective for taxable years beginning after Dec. 31, 2004.

Until the new regulations come out, the IRS says, taxpayers may rely on the intent of the notice: "an employee may exclude from gross income the value of employer-provided coverage for an individual who meets the definition of a qualifying relative except that the individual's gross income equals or exceeds the exemption amount."

The new WFTRA definition raised a ruckus in the employee benefits community because code section 152 applies to the definition of dependent under many types of employee benefit plans. The recent IRS guidance applies only to WFTRA's effect on employer-provided accident and health plans.

Here's how the IRS was able to fix the problem in that area:

Code section 106(a) says that an employee's gross income does not include employer-provided coverage under an accident or health plan.

In regulations, the IRS extended that tax-favored treatment to employer contributions for spouse and dependent coverage, adopting the section 152 definition of dependent. If the WFTRA definition applied, "the value of employer-provided coverage for an individual who is not a qualifying child and who does not meet the gross income limitation for a qualifying relative would have to be included in the employee's gross income," the IRS explained in Notice 2004-79. But the IRS concluded that Congress had not intended the new definition to apply to employer-provided coverage.

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--MARGARET M. CLARK, J.D., SPHR

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