Notice 2010-38 Clarifies Tax Treatment of Employer-Provided Health Coverage For Adult Children

Overview

The IRS has just released Notice 2010-38, providing guidance on the tax treatment of employer-provided health coverage for adult children under age 27 under the new health reform law (“Health Reform Act”).¹

Code section 105(b) as amended by the Health Reform Act provides that employer-provided medical care for an employee’s “child” who does not attain age 27 by year’s end is excludable from gross income (“nontaxable”). Nontaxable treatment is available even if the child is not the employee’s “dependent” under Code section 152 (very generally, a child who is either under age 19 or under age 24 and a full time student, and who meets support and residency tests).

Plugging a hole in the statute, the Notice clarifies that health coverage under an employer plan is excludable under Code section 106, and reimbursements for health care from a Health Savings Account (HSA) are excludable “under the same rules” as apply for purposes of Code section 106 and 105(b), if provided for a non-Code section 152 dependent child under age 27.

The provisions are effective March 30, 2010.

Who is a “child” for this purpose?

A child is defined for this purpose under Code section 152(f)(1) as a son, daughter, stepson, or stepdaughter, legally adopted child (or child that has been lawfully placed for adoption), or a legally placed foster child. Thus, for example, a “child” does not include a grandchild, or the spouse of a child.

Is the employer required to verify the child’s age?

Generally, no. The Notice states that the employer may rely on the employee’s representation. Based on our experience with IRS audit practice, however, it is likely that if the employer has the child’s birthday on record, the employer may not rely on contrary employee representations.

Is an employer plan required to cover any non-dependent adult children in 2010?

No. Coverage of adult children is not required in 2010 for a calendar year plan. Effective January 1, 2011, for a calendar year plan,² any plan providing “dependent coverage” for children must generally continue to make such coverage available to children under age 26. The scope of the new coverage mandate is extremely unclear, and it is hoped that HHS guidance will address its many issues soon.

Can my cafeteria plan allow Flexible Spending Account (FSA) reimbursements for adult children under age 27 beginning mid-year in 2010?

Yes, but an amendment is probably needed. Some employees may wish to increase their pre-tax FSA contributions to cover medical expenses incurred in 2010 for non-dependent children under age 27. If an employer wants to accommodate these employees, a plan amendment will likely be needed. Why? Because, typically, FSAs and other medical plans are drafted to include only children who are Code-section 152 dependents of the participant. Since the new tax exclusion applies even for non-Code section 152 dependent children under age 27, the typical plan will require amendment.

Retroactive amendment permitted. Generally, cafeteria plan amendments may not be retroactively effective.³ The Notice provides relief for the no-retroactivity rule. Participants’ pre-tax contributions under a cafeteria plan — including pre-tax salary reduction elections for FSA coverage — will be permitted for non-dependent children under age 27, even if the plan’s terms do not cover these children, provided that the cafeteria plan is amended by December 31, 2010, effective retroactively to the first date in 2010 when pre-tax salary reduction elections were permitted for coverage for these children. The amendment’s effective date, however, may not be before March 30, 2010.

Technical Note. There is an odd gap in the Notice’s protection for retroactive plan amendments. The IRS has historically taken the position that the Code section 105 exclusion for medical care does not apply to retroactive coverage changes. The apparent thinking is that retroactive coverage violates the “insurance” concept underlying Code section 105. The Notice provides no exception to this longstanding rule. But an exception can be inferred from the Notice’s express exception to the no-retroactivity rule under Code section 125, which here would be meaningless absent the same rule under Code section 105.

If I allow FSA reimbursements for non-dependent children under age 27 mid-year in 2010, can I also allow mid-year FSA election changes?

Yes. IRS regulations allow mid-year FSA elections changes only in narrowly described circumstances — which do not include the situation described here.⁴ The Notice, however, provides that Participants may revoke their old FSA elections mid-year and make new elections to cover non-dependent children under age 27.⁵

VEBAs and 401(h) Accounts: Do they keep their tax exempt status if they provide medical care coverage for non-dependent children under age 27?

Yes. Code section 501(c)(9) was amended by the Health Reform Act to provide that, for purposes of providing for the payment of sickness and accident benefits to VEBA members and their “dependents”, the term dependent includes a child under age 27. Code section 401(h) is similarly amended.

Does the same exclusion apply for FICA, FUTA and income tax withholding purposes?

Yes. Even before enactment of the Health Reform Act, coverage of an employee’s “dependent” was excludable from FICA and FUTA wages, and exempt from income tax withholding, where “dependent” was defined to include the employee’s “child” without regard to any age limit, residency, support or other test. Accordingly, coverage of an employee’s non-Code section 152 dependent child is excludable from FICA and FUTA wages, and exempt from income tax withholding.