The Working Families Tax Relief Act of 2004 (“the Act”) was signed into law on October 4, 2004. The Act provides a uniform definition of “child” that changes taxation of dependent coverage under health and accident plans effective January 1, 2005. This article provides a summary of some of the major changes impacting employee benefit plans. The Internal Revenue Service has indicated that it will issue related guidance before the end of this year.
Internal Revenue Code Section 152 Dependents for Employer Provided Health and Accident Coverage
The Current Rules
Under the current rules, to qualify as a Dependent under Internal Revenue Code section 152 (“Section 152 Dependent”), a person must be a United States citizen or national or a resident of the United States (or any country contiguous to the United States), must receive over half of his or her support from the participant and must either be a relative of the participant or live with the participant for the entire year.
The New Rules
Effective on and after January 1, 2005, to qualify as a Section 152 Dependent, a person must be a U.S. citizen or national or a resident of the United States or a resident of a country continuous to the United States (or be a child adopted by and living with such a person), and must either be a participant’s “qualifying child” or “qualifying relative.” For purposes of determining who is a “qualifying child” or “qualifying relative,” “child” includes a participant’s natural child, step child, adopted child, a child placed with the participant for legal adoption, or a child placed with the participant as a foster child by an authorized placement agency or by judgment, decree, or other order of a court of competent jurisdiction. Special rules apply for children of divorced or separated parents and when there are multiple support orders.
A participant’s “qualifying child” includes a participant’s children, brothers, sisters, stepbrothers, stepsisters, and their descendants who do not provide over one-half of their own support for the calendar year (not taking into account scholarship payments) and who share a principal place of abode with the participant for over half of the calendar year if they are:
- under age 19 as of the close of the calendar year (under age 24 for full time students of approved educational organizations); or
- permanently and totally disabled.
If a child is potentially a “qualifying child” of more than one taxpayer, the child will be the “qualifying child” of: (1) a parent over a non-parent; and (2) the parent with whom the child resides for the longest period during the year (over the other parent). If both taxpayers are nonparents, or parents who reside with the child for equal duration during the year, the child will be the “qualifying child” of the taxpayer with the highest gross income.
A participant’s “qualifying relative” is a person who is not a “qualifying child” of the participant or another taxpayer and who receives over half of his or her support for the calendar year from the participant and is:
- a relative as defined by Code sections 152 (d) (2)(A)–(H) (generally a relative will include a parent, grandparent, stepparent, child, grandchild, sibling, stepsibling, aunt or uncle, niece or nephew, or a participant’s spouse’s parents, siblings, or children); or
- a person who shares a principal place of abode with the participant and is a member of a participant’s household for the entire calendar year.
If the participant contributes over 10% of a person’s support and no other individual provides more than half of the person’s support, the participant may be treated as providing over half the person’s support if each other individual who contributed over 10% of the person’s support files a written declaration that he or she will not claim the person as a dependent.
The new “qualifying relative” definition is very similar to the current Code section 152 rules. A major difference is that a person cannot be a “qualifying relative” if they are a “qualifying child” of another taxpayer.
Section 152 Dependents for General Tax Purposes
Code section 152 contains additional rules that apply for general tax purposes, such as the dependency exemption, but do not apply to health and accident plans. First, to be a “qualifying relative” a person’s gross income must be less than the exemption amount, which was $3,100 for 2004. Second, a person cannot be a Section 152 Dependent if the person is married and files a joint return with their spouse. Third, a person who is a Section 152 Dependent cannot have his or her own Section 152 Dependent(s).
Section 152 Dependents for Purposes of other Employee Benefit Rules
The changes to Code section 152 also impact a number of other employee benefits. The following summarizes some of the changes that impact employee benefits.
- The 10% penalty tax on early withdrawals does not apply to IRA distributions made to unemployed persons that do not exceed the health insurance premiums paid for the person’s Section 152 Dependents as defined for health plans. It also does not apply to amounts used to pay for “higher education expenses” of a taxpayer, the taxpayer’s spouse, or the taxpayer’s “child” defined using the definition in Code section 152.
- For purposes of cafeteria plan nondiscrimination testing, the definition of Section 152 Dependents as defined for health plans is used.
- For purposes of determining whether distributions from an Archer Medical Savings Account are includible in gross income, “qualified medical expenses” mean amounts paid for medical care for the account holder, the account holder’s spouse, or the account holder’s Section 152 Dependents as defined for health plans.
- Qualified employee discounts and no-additional-cost services are excludible benefits if they are provided to the employee, the employee’s spouse, or the employee’s “child” defined using the definition in Code section 152, if the child is the employee’s Section 152 Dependent or if the child is an orphan under age 25.
- Payment for qualified long-term care service provided to an individual does not qualify as a payment for medical care if the service is provided by the individual’s unlicensed relative (as defined by Code sections 152 (d)(2)(A)–(H)).
- A qualified tuition program account can be rolled over, or the designated beneficiary can be changed without tax consequences if the new beneficiary is the old beneficiary’s relative (as defined by Code sections 152 (d)(2)(A)–(H)).
- Current guidance and the proposed 401(k) regulations permit participants to take hardship withdrawals for medical and qualified higher education expenses of Section 152 Dependents. Under the new rules, this will require that the dependent make less than the exemption amount.
- A qualified domestic relations order can only provide benefits to alternate payees, which are limited to Section 152 Dependents. Under the new rules, this will require that the dependent make less than the exemption amount.
The Working Families Tax Relief Act of 2004 Changes to Dependent Care Flexible Spending Accounts
The definition of “qualifying individual” for purposes of the child and dependent care credit was also changed by the Working Families Tax Relief Act of 2004. This definition applies to determine which expenses may be reimbursed through a dependent care flexible spending account because reimbursement is allowed only for expenses incurred by a “qualifying individual.” Under current law, a “qualifying individual” means the dependent of the taxpayer under age 13 or the spouse or dependent of a taxpayer who is physically or mentally incapable of caring for himself or herself if the individual was included in a household maintained by the taxpayer. Under the new law, a “qualifying individual” means:
- a “qualifying child” of the taxpayer under age 13; or
- a spouse who is physically or mentally incapable of caring for himself or herself, if the individual has the same principal place of abode as the taxpayer for over half of the tax year; or
- a Section 152 Dependent (which includes the requirement that the dependent’s income be less than the exemption amount) of the taxpayer who is physically or mentally incapable of caring for himself or herself, if the individual has the same principal place of abode as the taxpayer for over half of the tax year. If the individual is not a relative of the taxpayer as defined by Code sections 152(d)(2)(A)–(H), the individual must share a principal place of abode as the taxpayer for the entire taxable year.
This means that the need to maintain a household is relaxed to sharing the same principal place of abode for over half of the year. Additionally, children can qualify only if they are “qualifying children” of the participant or are not “qualifying children” of anyone else.