Employee Benefits-IRS Provides Guidance On Tax Treatment Of Health Care Benefits Provided To Children Under Age 27

The recent health care reform legislation, found in the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010, signed into law by the President on March 23 and 30, 2010, respectively (for convenience, the “Act”), provides a tax exclusion for health care coverage provided to an employee’s child who is under age 27. In Notice 2010-38, the Internal Revenue Service (the “IRS”) provides guidance on this new tax exclusion. Here is what the Notice says:

Section 105(b) of the Internal Revenue Code (the “Code”) generally excludes from an employee’s gross income employer-provided reimbursements for medical care expenses of the employee, the employee’s spouse or the employee’s dependents. The Act amends section 105(b), effective as of March 30, 2010, so that this exclusion from gross income is extended to employer-provided reimbursements for the medical care expenses of the employee’s child who has not attained age 27 as of the end of employee’s taxable year in which the reimbursement is made. The exclusion is available without regard to whether the child is a “dependent”, within the meaning of section 152 of the Code. For this purpose, “child” is defined under section 152(f)(1).

Section 106 of the Code excludes the cost of coverage under an employer-provided accident or health plan from an employee’s gross income. Although the Act does not amend section 106, the IRS intends to amend the regulations under section 106, retroactively to March 30, 2010, to provide that the cost of coverage for an employee’s child under age 27 is excluded from gross income.

Section 125 of the Code allows employees to elect between cash and certain qualified benefits, including accident or health plan coverage (described in section 106) and health flexible spending arrangements (health FSAs) (described in section 105(b)). A “qualified benefit” is generally any benefit which (with the application of section 125) is not includible in the employee’s gross income. Accordingly, on and after March 30, 2010, a benefit will not fail to be a “qualified benefit” under a cafeteria plan (including a health FSA), merely because it provides coverage or reimbursements that are excludible under sections 106 and 105(b) for a child who has not attained age 27 as of the end of the employee’s taxable year.

A cafeteria plan may permit an employee to revoke an election during a period of coverage, and to make a new election, only in limited circumstances, such as a change in status event. The IRS intends to amend the cafeteria plan regulations, effective retroactively to March 30, 2010, to include change in status events affecting children under age 27, including becoming newly eligible for coverage or eligible for coverage beyond the date on which the child otherwise would have lost coverage. The Notice contains a transitional rule for amending cafeteria plans to reflect the new rules.

In general, a health reimbursement arrangement (an “HRA”) is an arrangement which is paid for solely by an employer (and not through a section 125 cafeteria plan), and which reimburses an employee for medical care expenses up to a maximum dollar amount for a coverage period. The same rules that apply to an employee’s child under age 27 for purposes of sections 106 and 105(b), as described above, apply to an HRA.

Coverage and reimbursements under an employer-provided accident and health plan for employees and their dependents are generally excluded from wages for Federal Insurance Contributions Act (“FICA”) and Federal Unemployment Tax Act (“FUTA”). For this purpose, any child of the employee (as defined under section 152(f)(1)) is a dependent. Thus, coverage and reimbursements under a plan for an employee’s child under age 27 are not wages for FICA or FUTA purposes. Such coverage and reimbursements are also exempt from income tax withholding.

The Notice also provides guidance on payments made by VEBAs, 401(h) accounts in pension plans and self-employed individuals.