Effective January 1, 2005, the Working Families Tax Relief Act of 2004 amends the Code Section 152 definition of "dependent" to provide a uniform definition of “qualifying child” for various provisions under the Internal Revenue Code. While the law was not intended to affect the operation of employee benefit plans, the unintended consequences of this change may cause headaches for employers who sponsor certain types of employee benefit plans.
The New Definition of Dependent
New Code Section 152 now defines a dependent as a "qualifying child" or a "qualifying relative." To satisfy the definition of a "qualifying child," a child must meet the following requirements:
- bear a specified relationship to the taxpayer;
- have the same principal place of abode as the taxpayer for more than one-half of the taxable year;
- satisfy age requirements (i.e., must not have attained age 19 (age 24 for a student) before the close of the calendar year in which the taxable year of the taxpayer begins, or must be totally and permanently disabled); and
- not provide more than one-half of his or her own support.
Previously the definition of dependent did not include a residence or age requirement for qualifying children.
If an individual does not satisfy the definition of a "qualifying child," the individual may still be treated as a "qualifying relative." To satisfy the definition of a "qualifying relative," the individual must meet the following requirement:
bear a specified relationship to the taxpayer or be an individual (other than a spouse) who has the same principal place of abode as the taxpayer and is a member of the taxpayer's household;
have gross income for the taxable year less than the "exemption amount" ($3,200 for 2005);
receive over one-half of his or her support from the taxpayer; and
not be a qualifying child of the taxpayer or any other taxpayer.
The new definition of qualifying relative essentially precludes any individual who has income in excess of the exemption amount from being treated as a dependent for tax purposes.
The law includes a conforming change clarifying that, for purposes of Code Section 105(b), an individual need not have income less than the exemption amount ($3,200 for 2005) to satisfy the definition of "qualifying relative." Under Code Section 105(b), an employee can be reimbursed tax-free for medical care provided under an employer-sponsored health plan. Unfortunately, the law does not make similar conforming changes to Code Section 106 (which provides an exclusion from income for the value of health coverage provided to an employee and the employee’s spouse and dependents as defined in Code Section 152). In the absence of this conforming change, an employer would be required to impute income to an employee for the value of employer-provided health coverage for a dependent who does not satisfy the definition of a "qualifying relative" (e.g., a 24-year old child whose 2005 income exceeds $3,200).
Notice 2004-79 and Legislative Action
The IRS issued Notice 2004-79 to address this problem. The notice provides that an employee may exclude from gross income the value of employer-provided health coverage for an individual who meets the definition of a qualifying relative even though the individual's gross income exceeds the exemption amount ($3,200 for 2005). The regulations will be revised effective for taxable years beginning on and after January 1, 2005, and taxpayers may rely on the notice pending the issuance of the revised regulations.
Unfortunately, there has been no legislative or regulatory fix for other provisions that reference the Code Section 152 definition of dependent. These include Code Section 129, governing the tax treatment of reimbursements for dependent care expenses under a dependent care assistance program; Code Section 223, governing the tax treatment of health savings account withdrawals for a dependent’s qualified medical expenses; and Code Sections 401(k) and 457, governing the tax treatment of hardship and unforeseeable emergency withdrawals for a dependent’s qualified medical or education expenses.
As a result, the tax-favored treatment of these benefits may no longer be available for certain individuals including dependent children who do not live with the employee for more than one half of the year (although special rules apply to children of divorced parents) and adult disabled dependents who have income in 2005 in excess of $3,200. To remedy this situation, Senators Grassley and Baucus have introduced the Tax Technical Corrections Act of 2004 (S. 3019), which would permit an individual to qualify as a dependent for purposes of the code provisions governing health savings accounts, the dependent care credit and dependent care assistance programs, without regard to the limit on gross income. While it is unlikely the bill will pass during the current session of Congress, the lawmakers have stated their intent to reintroduce the bill in the 109th U.S. Congress.
Next Steps for Employers
Based on the relief granted under Code Sections 105 and 106, most employers will probably be able to retain the current definition of dependent in their group health plans without having to impute income to employees. However, employers will still need to review other employee benefit plans and programs to determine the potential impact of the new definition. In addition, various documents (including plan documents, SPDs, insurance contracts, enrollment materials and administrative procedures) should be reviewed and revised as necessary to reflect the changes to the definition of dependent.
With respect to dependent care assistance programs, employees may have elected during the 2004 open enrollment period to contribute to a dependent care spending account in order to submit expenses for reimbursement on behalf of an individual who will no longer qualify as a dependent. In order to avoid forfeiture of such amounts, various employee benefit groups have urged the IRS to provide a one-year transition period or to permit affected individuals to revoke their dependent care spending account elections for the 2005 plan year without violating the cafeteria plan change in status rules. The IRS has indicated informally that a change in election should be permitted under these circumstances.
In the absence of any further guidance or clarification, it may be prudent to communicate the new definition of dependent to participants in dependent care spending account plans and permit those employees who planned to submit expenses for non-qualifying individuals to revoke and/or revise their elections so as to avoid any forfeitures. In addition, employers should review their hardship withdrawal procedures under 401(k) and 457 plans to determine whether any changes are required.