September 11, 2007

Dependent Child Conundrum

In the very recent past, and particularly in 2007, many State Legislatures have found it to be in their collective wisdom to amend State insurance laws as they relate to the definition of dependent child. In large part, the definition of dependent child, for health insurance purposes only, has been expanded. It appears that States are attempting to narrow the gap of their uninsured population. Young people, particularly those recently out of school, are a significant portion of the uninsured population. The theory goes that allowing these children to stay on their parents’ plan for longer period of time will reduce the uninsured population.

The conundrum comes into play in that these State definitions do not match the Federal definition of dependent. The Federal definition is important for tax purposes. What can happen is a health plan could define dependent child more broadly than the Federal tax code. As such, a child could remain on his/her parents’ plan, but once the child no longer meets the Federal tax definition of dependent, the cost of this coverage creates a taxable event for the employee.

The federal tax definition of a dependent1 is one who meets the definition of either 1) a qualifying child, or 2) a qualifying relative:

Who is a Qualifying Child?

Beginning January 1, 2005, a qualifying child must meet the following criteria:

  • The individual is the taxpayer’s child or stepchild (whether by blood or adoption), foster child, sibling or stepsibling, or a descendant of one of these.
  • The individual resides for over 50% of the taxable year with the taxpayer.
  • The individual is either:

  • Under the age of 19 by the end of the calendar year;

  • A full-time student who has not attained age 24 by the close of the calendar year; or,

  • Permanently disabled, without regard to age.

  • The individual did not provide more than 50% of his/her own support for the year.

Who is a Qualifying Relative?

Beginning January 1, 2005, a qualifying relative for purposes of IRC §152 must meet the following criteria:

  • The individual is a relative of the taxpayer, as defined in IRC §152(d); or other than a spouse, someone who has the same principal place of abode and is a member of the taxpayer’s household.
  • The taxpayer provides more than 50% of the individual’s total support for the year.
  • The individual:

  • Is not a qualifying child of another taxpayer.

  • Does not have gross income in excess of the exemption amount ($3,400 for 2007; $3,300 for 2006).

  • Cannot be married and filing a joint return.

Exemption from Restrictions

In determining whether an individual qualifies as a dependent, either as a qualifying child or a qualifying relative, for purposes of a health plan under IRC §§105 or 106, a health savings account under IRC §223, a dependent care assistance plan under IRC §129, a 401(k) plan or a 403(b) plan, the restrictions listed in 3(a) through 3(c) under Who is a Qualifying Relative, above, do not apply.

The State insurance mandates are mandates on the insurance contract; they are not mandates on the employer. However, any employer sponsoring an insured plan subject to that State’s insurance laws, would be subject to that State’s insurance definition; or, a more generous definition as adopted by the insurer. In any event, the employer would be obligated to follow the definition of dependent contained in the insurance contract. Some multi-jurisdictional insurers may choose to find a definition that satisfies many State’s definitions, rather than having different definitions in every state.

Employers sponsoring purely self-funded health plans can take a sigh of relief as they are not impacted by these insurance law changes. Self-funded plans can continue to define dependent consistent with the Federal tax code.

The problem for an employer arises in determining whether there is a tax consequence for the employee. How can the employer possibly know whether a particular individual qualifies as a dependent, as defined in the Federal tax code?

This issue first surfaced on a large scale basis when employers began to offer domestic partner benefits. Generally, the fair market value of the health benefits provided to a domestic partner is includible in the employee’s income. Some employers have taken the position that all domestic partner benefits will be includible in the employee’s income, and if the employee believes the domestic partner qualifies as a dependent, the onus is on the employee to seek a refund from the IRS.

This process may not work well for dependent children, since the vast majority of dependent children will meet the Federal tax definition of dependent. One option for employers might be use of an affidavit or certification (click here for a sample affidavit), placing the onus on the employee to tell the employer about which dependents qualify for tax-favored benefits, and making it clear that it is ultimately the employee’s responsibility to ensure that he/she is properly taxed.

This issue arises not only for the employer’s cost of providing coverage, but also for the employee-share of the coverage if the employee’s share is paid through a cafeteria plan. Recently issued cafeteria plan regulations provide that an employee can pay for non-dependent coverage on a salary reduction basis, as long as the fair market value of the coverage is includible in the employee’s income.

Alternatively, if the employer’s payroll system can bifurcate the premium payment, the employee could pay his share in part with salary reduction dollars, and part with after-tax dollars. It is probably an understatement to say that this eventuality will cause HR departments and payroll systems some degree of angst.

Nevertheless, it is important to be aware of these issues, and be prepared to deal with the ever-changing world of benefit taxation. As new ideas emerge about how to deal with the situation, we will share them with you. In the meantime, we encourage you to consult with your tax advisor if you are affected.

1   Special rules apply in the case of divorce.


The information contained in this Benefit Beat is not intended to be legal, accounting, or other professional advice, nor are these comments directed to specific situations.

As required by U.S. Treasury rules, we inform you that, unless expressly stated otherwise, any U.S. federal tax advice contained in this Benefit Beat is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed by the Internal Revenue Service.


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