IRS Clarifies Adult Child Dependent Coverage and Federal Healthcare Tax Credit for Small Employers

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1 IRS Clarifies Adult Child Dependent Coverage and Federal Healthcare Tax Credit for Small Employers For additional information, please contact your Account Manager or Tony Sorrentino at or May 2010 The Internal Revenue Service has recently provided more detailed guidelines on these two topics, which have caused considerable confusion for employers attempting to plan for immediate changes brought about by the Patient Protection and Affordable Care Act, and the subsequent Health Care and Education Reconciliation Act of 2010 (collectively, the Act). Adult Child Dependent Coverage and IRS Notice The IRS issued Notice (the "Notice") on April 27, 2010, regarding the expanded healthcare tax exclusion for children through age 26 ("Adult Child"), as added by the Act. As you know, the Act expanded the definition of "dependent" for purposes of tax free health coverage under Code Sections 105 (accident and health coverage), 401(h) (healthcare accounts in pension plans), 501(c)(9) (VEBAs) and 162 (self employed deduction) to include Adult Children. This expansion, which was effective March 30, 2010, will have an immediate impact on plans that define eligibility based on reference to healthcare dependents found in Section 105(b) of the Code, including many health flexible spending arrangements (FSAs) and health reimbursement arrangements (HRAs). This expansion overlaps with (but differs slightly from) the health insurance coverage mandate under the Act that requires "group health plans" to provide coverage of children to age 26 (this insurance reform is effective for plan years beginning on or after September 23, 2010). The Notice clarifies the following with respect to the expansion of the tax exclusion to Adult Children: The exclusion under 105 (self-funded plans) applies only for reimbursements for medical care of individuals who are not age 27 or older at any time during the employee's taxable year (which you may assume is a calendar year). Employers may rely on the employee's representation as to the child's birth date. For purposes of this expansion, Adult Child is defined by reference to Section 152(f) of the Code (i.e., son/daughter, step son/daughter, adopted child or eligible foster child), without regard to whether the child is otherwise a tax dependent. Although Congress did not specifically amend IRC Section 106 (relating to the cost of fully insured accident and health insurance), the IRS notes that there is no indication that Congress intended to provide a broader exclusion in 105 than it does in 106. Therefore, the IRS intends to amend the 106 regulations retroactively to March 30, 2010 to parallel the exclusion set forth in 105 by the Act. This material is intended for informational purposes only and should not be construed as legal advice and is not intended to replace the advice of a qualified attorney, tax advisor or plan provider. This information has been taken from sources which we believe to be reliable, but there is no guarantee as to its accuracy. The information provided herein is intended solely for SilverStone Group clients. You may not display, reproduce, copy, modify, license, sell or disseminate in any manner any information included in this special bulletin.

2 The expansion does not appear to impact HSAs under Section 223 (you may recall that Congress had to separately adopt a mirrored provision for HSAs the last time Section 105(b) was amended. The Notice confirms the rules that coverage for spouses or dependents of Adult Children is not excluded under 105 or 106 solely because the Adult Child's coverage is excluded. The current election change regulations in allow certain election changes on account of and corresponding to events affecting dependents, as defined by Code Section 152 (the definition of dependent for purposes of personal exemptions). The Act did not change the definition of "dependent" under Code Section 152; therefore, an Adult Child may not otherwise qualify as a dependent under 152, even though healthcare coverage for such Adult Child may be provided tax free. Nevertheless, the IRS intends to retroactively amend the regulations back to March 30, 2010 to include change in status events affecting Adult Children under age 27 who are not otherwise Code Section 152 dependents, including becoming newly eligible for coverage or eligible for coverage beyond the date on which the child otherwise would have lost coverage (note--health FSAs and HRAs that previously defined an eligible dependent solely by reference to Code Section 105(b) arguably require no amendments). Despite the general rule that cafeteria plans may only be amended prospectively, the IRS will permit retroactive amendments with regard to pre-tax salary reductions under an accident and health plan for Adult Children. The amendment must be made by December 31, 2010 and must be retroactively effective to the first date in 2010 (but no earlier than March 30, 2010) when employees were permitted to make pre-tax salary reductions to cover Adult Children. Taxpayers may rely on this notice until such time as regulations are amended. In addition, the agencies (Treasury, Labor, and HHS) issued regulations on May 10, 2010, regarding the Act s new requirement on group health plans that offer coverage of dependent children to extend coverage to children up to age 26. This rule applies to health coverage (including grandfathered plans) other than HIPAA excepted benefits. A link to the regulations on the EBSA website, as well as a link to FAQs issued by the DOL are provided below. The following is a brief overview of the regulations: "Terms of eligibility": Plans may only define dependent child by reference to the relationship between the child and the participant- at least until the child is age 26. Factors that may no longer be used are: (i) student status (ii) residency (iii) financial dependency (iv) employment (v) eligibility for other coverage (except that grandfathered plans may, until the first plan year beginning on or after January 1, 2014, restrict eligibility to children who are NOT eligible to enroll in an employer sponsored health plan, other than an employer sponsored plan of the parent). The following are a few key issues related to this rule; The regulations make no distinction between minor and adult children. Therefore, the same rules apply regardless of age until age 26. The plan's terms may not vary with respect to such child based on age. Thus, additional surcharges may not be added based solely on the age of the child. For example, if the plan's coverage levels are employee and family and the employee already has family, then adding an adult child may not result in an additional premium. However, premium surcharges are permitted, even for an adult child, if based solely on the number of individuals covered. Many companies are considering converting current "single/family" coverage categories to "employee plus 1, employee plus 2, plus 3" etc. to limit potential adverse selection. 2

3 Coverage may end on the day before the child's 26th birthday. However, plans that wish to extend coverage beyond that date - e.g., through the end of the plan year in which the child turns age 26 - may do so on a tax free basis (in accordance with PPACA and Notice ) to the extent coverage does not extend into a year in which the child will turn age 27. Unlike the expansion of the definition of tax dependent under Code Section 105(b), which defines "child" by reference to Code Section 152(f)(1), the regulations do not define "child." For grandfathered plans, it isn't clear whether eligibility for other "employer sponsored health plans" means eligibility as an employee or otherwise. The fact that the regulations indicated that grandfathered plans could deny coverage to a child who is eligible for an employer sponsored health plan (other than a group health plan of the parents) suggests that eligibility for an employer sponsored plan as a "dependent" under a plan other than the parent's plan (e.g., a spouse) could permit a plan to decline to offer coverage. Impact of plan change on grandfathered status: The agencies believe that guidance expected to be released in the near future regarding grandfathered health plans will clarify that changes made to comply with this law and/or voluntary compliance with the law (e.g., implementing the rule earlier than otherwise required) will NOT affect grandfathered health plan status. Transitional rule: Children who previously lost coverage under the Plan due to loss of dependent status or who were never enrolled because they were not eligible, must be provided a special enrollment opportunity to the extent now eligible under the new rules. The enrollment period must be at least 30 days in duration and begin no later than the first day of the plan year beginning on or after September 23, Plans may use their existing annual enrollment periods to satisfy this requirement. The following are a few other key elements of this rule: Coverage must be effective on the first day of the plan year beginning on or after September 23, 2010, even if the enrollment is requested after that date (e.g., the plan's special enrollment period extends beyond the first day of the plan year). Notice of the enrollment period may be provided to the employee. It is treated like a "special enrollment." Thus, employees eligible, but not enrolled, must be permitted to enroll as well and all benefit package options made available to similarly situated individuals must be offered. Note: Although not specifically addressed in the regulations, the above mentioned rules do not appear to apply to excepted benefits as defined by HIPAA. Thus, non-integral dental and vision plans, and other excepted benefit coverages, such as most Health FSAs, do not have to comply with this rule. The regulation, available at A fact sheet, available at FAQs, available at 3

4 Federal Healthcare Tax credit for Small Employers and IRS Notice The Internal Revenue Service issued guidance on May 17, 2010 to clarify that small businesses receiving state healthcare tax credits can still qualify for the full federal healthcare tax credit under the new health law. Small employers can also receive the healthcare tax credit not only for regular health insurance, but also for add-on dental and vision coverage. Notice provides detailed guidelines, illustrated by more than a dozen examples, to help small employers determine whether they qualify for the credit and to estimate the amount of the credit. Responding to a number of taxpayer questions about the interaction of the credit with state-level healthcare tax credits and subsidies, the IRS guidance provides that the new tax credit will not be reduced by a state healthcare tax credit or subsidy, except in limited circumstances to prevent abuse of the credit. In particular, an employer that receives such a state tax credit or subsidy will also receive the full federal credit based on its entire contribution, so long as the federal credit does not exceed the employer s net contribution. Approximately 20 states offer these benefits. The guidance clarifies that small businesses can receive the credit not only for traditional health insurance coverage, but also for add-on dental, vision and other limited-scope coverage. The employer must meet the requirements for limited-scope coverage that are similar to those that apply for single coverage. The employer must offer to pay at least 50% of the premium. In general, the federal healthcare tax credit is available to small employers that pay at least half the cost of single coverage for their employees in The credit is specifically targeted to help small businesses and tax-exempt organizations that primarily employ moderate and lower-income workers. For tax years 2010 to 2013, the maximum credit is 35% of premiums paid by eligible small-business employers and 25% of premiums paid by eligible employers that are tax-exempt organizations. The maximum credit goes to smaller employers - those with 10 or fewer full-time equivalent employees - paying annual average wages of $25,000 or less. The credit is completely phased out for employers that have 25 FTEs or more, or that pay average wages of $50,000 per year or more. Because the eligibility rules are based in part on the number of FTEs, not the number of employees, businesses that use part-time help may qualify, even if they employ more than 25 individuals. Eligible small businesses can claim the credit as part of the general business credit, starting with the 2010 income tax return they file in For tax-exempt organizations, the IRS will provide further information on how to claim the credit. Because the tax credit s matching rate is highest for employers with 10 or fewer FTEs, the number of hours worked is an important factor in calculating the credit. The new guidance allows employers to choose among three different methods of determining hours to minimize their bookkeeping duties while receiving the maximum tax credit for which they are eligible. Employers can look at actual hours of service, or can use simple rules of convenience to estimate hours based on total days or weeks of service. Because the tax credit is effective for 2010 but was not enacted until March 23, some small businesses that are providing health insurance in 2010 may not meet all the requirements for a qualifying health insurance offer. 4

5 To ensure that these businesses benefit from the credit, the Obama administration is providing special transition relief for tax year The transition rules simplify the requirements for what constitutes a qualifying health insurance offer, while maintaining the core requirement that an employer make a significant contribution to the employee s coverage For more information on the Federal Healthcare Tax Credit for Small Employers, please see our April Bulletin entitled REALLY Immediate Healthcare Reform: Small Business Healthcare Tax Credit Already Effective. 5