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Guest Article


(From the January 17, 2006 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Dependent Definition Clarified for HSAs, Dependent Care FSAs

Congress included some important technical corrections in the Gulf Opportunity Zone Act of 2005 (P.L. 109-135) to update the definition of "dependent" for purposes of employer-sponsored Dependent Care Assistance Programs -- including Dependent Care Flexible Spending Arrangements (FSAs) -- and Health Savings Accounts (HSAs).

The Issue

The IRC 152 definition of dependent is primarily used to determine if a taxpayer can claim someone as a dependent on his or her federal individual income tax return. But many other sections of the IRC, including sections relating to employee benefits, incorporate the IRC 152 definition by cross-reference.

Prior to 2005, IRC 152 generally defined a taxpayer's "dependent" as someone who satisfied both a support test and a relationship test. The support test was satisfied if a taxpayer provided more than one-half of the relevant individual's support for the year. The relationship test was satisfied if the relevant individual was the taxpayer's parent, child, sibling, etc., or if the individual shared the taxpayer's principal place of abode and was a member of the taxpayer's household.

Congress significantly changed the IRC 152 definition of dependent when it enacted the Working Families' Tax Relief Act (WFTRA) of 2004 (P.L. 108-311), effective for tax years beginning after December 31, 2004. Under the new definition, a taxpayer's dependent is someone who is either the taxpayer's "qualifying child" or "qualifying relative." A taxpayer's "qualifying child" is someone who --

  1. is related to the taxpayer;
  2. is below age 19, or below age 24 and still in school, as of the close of the calendar year;
  3. lives with the taxpayer for more than half the year; and
  4. does not provide more than half of his or her own support for the calendar year.

A taxpayer's "qualifying relative" is someone whose gross income is less than the "exemption amount" ($3,300 in 2006), and who --

  1. bears any of several specified relationships to the taxpayer (e.g., parent, child, sibling, niece or nephew, aunt or uncle, or non-spouse who shares the taxpayer's principal place of abode and is a member of the taxpayer's household);
  2. receives more than half of his or her support from the taxpayer; and
  3. is not a qualifying child of the taxpayer or any other taxpayer.

The new 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 may not claim others as dependents, even if the relevant requirements are otherwise satisfied.

Effect of New Dependent Definition on HSAs and Dependent Care FSAs

There are significant substantive differences between the pre-2005 and post-2004 definitions of dependent. For example, the pre-2005 definition does not impose an earnings limit on adult children and other adults taxpayers may want to claim as dependents.

Fortunately, Congress decided the earnings limit and certain other features of the post-2005 definition should not apply in all instances in which the IRC 152 definition of dependent is used. For example, the WFTRA amended IRC 105 (relating to payments by group health plans to reimburse medical expenses incurred by employees, their spouses and dependents) to clarify that, for purposes of that section, the new dependent definition is applied without reference to the earnings limit and the special exclusions for individuals who are married or claimed as dependents on other taxpayers' returns. (The WFTRA did not make a similar change to IRC 106, which provides a gross income exclusion for employer-provided health coverage, because the term "dependent" appears only in the regulations under that section and not in the statute. However, the IRS plans to update the IRC 106 regulations to clarify the dependent definition is the same for purposes of that section and section 105.

Unfortunately, the hastily crafted WFTRA did not make similar changes to all employee benefits-related provisions that incorporate the IRC 152 definition. Specifically, the gross income exclusion for Dependent Care Assistance Programs, including Dependent Care FSAs, is available with respect to benefits provided for "qualifying individuals." In addition to dependent children below the age of 13, this term includes a dependent "who is physically or mentally incapable of caring for himself or herself and who has the same principal place of abode as the taxpayer for more than one-half of" the year. IRC 21(b)(1)(B). Under the post-2004 definition of dependent this latter group (which might include the taxpayer's parents, siblings, or adult children, among others) must satisfy the earnings test to be qualifying individuals.

Likewise, distributions from a taxpayer's HSA to pay qualified medical expenses incurred by the taxpayer's dependents are not taxable. IRC 223(d)(2)(A). But under the post-2004 definition, the qualifying child and qualifying relative rules apply for this purpose.

The Solution

The Gulf Opportunity Zone Act of 2005 makes technical corrections to IRC 21 and 223 to clarify that, for purposes of those sections, the new dependent definition is applied without reference to the earnings limit and the special exclusions for individuals who are married or claimed as dependents on other taxpayers' returns. As a practical matter, this means the same criteria for determining dependent status under the pre-2005 definition will continue to apply under the post-2004 definition for these purposes. These technical corrections are effective retroactive to taxable years beginning after December 31, 2004.

DeloitteThe information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2006, Deloitte.

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