Guest Article

(From the January 28, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Massachusetts: Helpful Guidance Issued On The Personal Income Tax Treatment Of Employer-Provided Health Coverage For Children Who Are Not Dependents

Effective January 1, 2008, Massachusetts requires insured health benefit plans that provide dependent coverage to make the coverage available until age 26 (or, if earlier, until two years after the individual ceases to be a dependent under Internal Revenue Code § 106). As a result, the benefits provided to an employee in certain circumstances -- in particular, where health insurance is provided to a nondependent child -- will be imputed and taxed to the employee. In a Technical Information Release, the Massachusetts Department of Revenue outlined the personal income tax treatment of providing coverage to a nondependent, and delineated the differences between the state and Federal tax treatment. Massachusetts Department of Revenue, Technical Information Release 07-16 (December 21, 2007).

Federal Income Tax Treatment of Employer-Provided Health Coverage

IRC § 61(a)(1) states that, unless otherwise exempted, gross income includes fringe benefits. Employer-provided health insurance coverage is a fringe benefit -- however, IRC § 106 exempts such coverage from the employee's gross income if it is for the employee, spouse, or dependents. For purposes of IRC § 106, to be such a dependent an individual must be either a "qualifying child' or a "qualifying relative." In general, a

As a result, an employee may exclude from Federal gross income the value of employerprovided health insurance coverage for a child who is either a "qualifying child" or a "qualifying relative." Children who do not satisfy age requirements for a "qualifying child" will often meet the requirements of a "qualifying relative." A child who is too old to be a "qualifying child" would nonetheless be a "qualifying relative" if the employee provides over half of the child's support for the year.

Further, any child who is of divorced parents and who meets the definition of a IRC § 106 dependent with regard to one parent is considered a IRC § 106 dependent of both parents.

Despite this broad definition, there are circumstances where employer-provided health benefits will be provided to a child who is not a IRC § 106 dependent (e.g., where the child is too old to be a "qualifying child" and fails to be a "qualifying relative" because the child provides at least half of his or her support). For Federal income tax purposes, an employee who receives health coverage for a child who is not a IRC § 106 dependent will be taxed on the fair market value of the child's coverage. If the employee pays for any portion of the coverage on an after-tax basis (e.g., pays a portion of the premium with after-tax dollars), the fair market value imputed as income to the employee will be reduced to take into account the portion purchased by the employee. /3/ /4/

Massachusetts Income Tax Treatment

Employer-paid health insurance coverage for a child who is a IRC § 106 dependent is excluded from the employee's Federal gross income and Massachusetts gross income. Employer-paid coverage for a child who is not a IRC § 106 dependent is included in the employee's Federal gross income. However, this coverage is nonetheless excluded from Massachusetts gross income to the extent it is required by Massachusetts law. The exclusion from state income applies to coverage which is required for insured plans, as well as to coverage under self-funded plans that voluntarily elect to adopt the requirements for insured plans.

Examples: Imputed Income from Employer-Provided Health Coverage

The Technical Information Release provides the following examples.

Example 1. A 25 year old child earns $10,000 per year, receives over half of her support from her mother, and is included in the mother's employer-provided health insurance coverage.

Example 2. A 25-year old child of divorced parents is a full-time student who lives with his mother. Both parents support the child. The father is a Massachusetts resident, and the child is covered by the father's employer-provided health insurance. The divorce agreement provides that the mother may claim the Federal dependency exemption for the child.

Example 3. A 25-year old child who earns $30,000, who does not live with his parent, and whose parent does not provide over one-half of his support, is included in the parent's employer-provided health insurance coverage as a result of the expanded coverage required by the new Massachusetts law.

The parent is not entitled to take a Federal or Massachusetts income tax dependency exemption for the child. The child is not a "qualifying child" because his age exceeds the maximum age. Also, the child is not a "qualifying relative" because he does not receive over half of his support from the parent, and his earnings exceed the income limitation for the dependency exemption (i.e., $3,400 in 2007).

/1/ The child must be the employee's child, stepchild, sibling or stepsibling. A descendant of any of the above also qualifies (e.g., the employee's grandchild).

/2/ A third requirement that the relative's gross income must be less than the Federal exemption amount (i.e., $3,400 for 2007) was eliminated by IRS Notice 2004-79 and does not apply in determining whether the relative is a IRC § 106 dependent. The income limitation continues to apply, however, for purposes of determining whether the relative is a dependent for Federal income tax purposes.

/3/ Treasury Regulation §1.61-21(b)(2) provides that the fair market value of a fringe benefit is the amount that an individual would pay for the benefit in an arm's length transaction. TIR 07-16 makes clear that the valuation is a question of Federal law and the employer must determine the value consistent with Federal law. For its own purposes, it appears that the Commonwealth utilizes the COBRA premium (less the 2% fee) in determining the fair market value of health coverage it provides to same-sex spouses of state employees. See MMARS Policy: Payroll, Commonwealth of Massachusetts, Office of the Comptroller (July 1, 2004).

/4/ The fair market value is included in employee's Federal gross income for the year, as reflected in the Form W-2, and is subject to taxation and withholding.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any 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, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2008, Deloitte.