(From the November 29, 2004 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)
IRS Issues Guidance on Interaction of New Dependent Definition and Section 106
The IRS is planning to update its regulations to clarify the definition of "dependent" for purposes of IRC section 106, which permits employers to provide group health benefits to employees and their families on a tax-favored basis. Notice 2004-79. The Working Families' Tax Relief Act (WFTRA) of 2004 (P.L. 108-311) amends the federal tax code's generally applicable definition of a "dependent" to impose an age limit on dependent children and an earnings limit on adult children and others that may be claimed as dependents. The updated regulations, which will have the same effective date as the WFTRA amendment, will specify the earnings limit (and other special rules) does not apply for purposes of IRC section 106. Taxpayers can rely on Notice 2004-79 until the IRS issues the revised regulations.
Significantly, Notice 2004-27 does not address problems the new definition of "dependent" has created for HSAs and Dependent Care Assistance Programs, including Dependent Care Flexible Spending Arrangements. Congress will have to address those issues by legislation, which probably will not happen until next year at the earliest.
Current law generally defines a taxpayer's "dependent" as someone who satisfies both a support test and a relationship test. The support test is satisfied if the taxpayer provides more than half of the individual's support for the year. The relationship test is satisfied if the individual is the taxpayer's parent, child, sibling, etc., or if the individual shares the taxpayer's principal place of abode and is a member of the taxpayer's household.
Effective for tax years beginning after December 31, 2004, the WFTRA amends IRC section 152 to generally define a taxpayer's "dependent" as someone who is either the taxpayer's "qualifying child" or "qualifying relative," and who satisfies certain other requirements. A taxpayer's "qualifying child" is someone who--
A taxpayer's "qualifying relative" is someone whose gross income is less than the "exemption amount" ($3,200 in 2005), and who--
The amended definition also precludes a taxpayer from claiming anyone as a dependent if that person is married and files a joint income tax return. Also, anyone claimed as a dependent by another taxpayer will not be able to claim others as dependents, even if the relevant requirements are otherwise satisfied.
Differences Between Current and Amended Definitions
Obviously, there are significant substantive differences between the current and amended definitions. For example, the current definition does not require a taxpayer's child to be a certain age to qualify as a dependent, and does not impose an earnings limit on adult children and nonchildren whom taxpayers may seek to claim as dependents.
Under the current definition, a taxpayer probably can claim as a dependent a 25-year old child still living at home, even if the child has a part-time job. But this will not be possible under the new definition if the child earns $3,200 or more. This earnings limit also will make it difficult to claim other adults as dependents, including domestic partners.
Effect of New Definition on Group Health Plans
As noted, the new definition also raises issues relating to the tax treatment of employer-provided health benefits. In general, employer-provided health coverage is not taxable to the employee. IRC section 106(a). This is true even if the employer provides health coverage to the employee's spouse and dependents (as defined in IRC section 152). Treas. Reg. Sec. 1.106-1. Also, payments made by a group health plan to reimburse medical expenses incurred by the employee, his or her spouse and dependents (as defined in IRC section 152), are not taxable. IRC section 105(b).
The WFTRA makes a conforming amendment to IRC section 105 to clarify that, for purposes of that section, the new dependent definition will be applied without reference to the earnings limit and without reference to the special exclusions for individuals who are married or claimed as dependents on other taxpayers' returns. The WFTRA does not make a similar change to IRC section 106, because the term "dependent" appears only in the regulations under IRC section 106, and not in the statute. However, according to Notice 2004-79, the IRS plans to update the regulations under IRC section 106 to clarify the term "dependent" for purposes of that section will be defined the same way as for purposes of IRC section 105.
Thus, in spite of the changes to IRC section 152, the meaning of the term "dependent" for purposes of IRC sections 105 and 106 will change very little.
Updated Regulations Will Not Apply to HSAs, Dependent Care Assistance Programs
Unfortunately, the IRS's revised regulations will not correct all benefits-related problems resulting from the new dependent definition. Unless Congress enacts changes to IRC section 223, the earnings limit will apply to the dependent definition used for purposes of the HSA rules. Senate Finance Committee Chairman Charles Grassley (R-IA) and Ranking Democrat Max Baucus (D-MT) introduced legislation on November 19 that would accomplish that. However, it probably will be next year before Congress acts on any such legislation.
The legislation proposed by Senators Grassley and Baucus also would prevent the earnings limit from being applicable to the dependent definition used by rules relating to Dependent Care Assistance Programs, including Dependent Care Flexible Spending Arrangements
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