Boardman Law Firm

New Insurance Coverage Laws Have Tax Implications for Cafeteria Plans and Employees in Wisconsin

By Andrew DeClercq  

NOTE: The recent federal health care reform legislation changed the law after the initial publication of this article. As of the President's signing of the Patient Protection and Affordable Care Act on March 30, 2010, the value of health care coverage for adult children who are covered as dependents under a parent's employer-sponsored health plan will be excluded from the parent's income. This exclusion applies to coverage provided for any child who will not reach age 27 by the end of the tax year. This means that after March 30, 2010, employers will no longer have to impute income to an employee who has elected coverage for a child who will be younger than age 27 at the end of the tax year. Please follow this link to read an update with additional details regarding this new law: UPDATE

The 2009–2011 Wisconsin biennial budget bill contains provisions that (1) extend the required age that certain health insurance plans are required to offer dependant coverage for the children of participants, and (2) extend certain protections to domestic partners. In addition, Dane County currently has an ordinance in place that requires certain businesses that contract with the County to provide equal benefits to domestic partners. While these laws may expand eligibility for health insurance, they do not affect the federal tax rules. Consequently, there are those who will find that, while they now are entitled to health insurance benefits, they will be taxed on the value of those benefits. After the Summary, this article first gives an overview of the health insurance tax exemption then discusses the tax implications of each of these laws as they apply to cafeteria plans.

Summary

Dependant Age Extension: Effective January 1, 2010, the dependent age extension provisions of the budget bill require certain insurers to offer dependant coverage for the child of a participant until the child turns 27 (and for longer in some cases involving children who are called to active military duty). This mandate will require insurers to provide coverage to the children of participants even though those children do not meet the definition of “dependent” under the Internal Revenue Code (the “Code”). In such cases, the value of the coverage will be taxable to the employee. If the employee participates in a cafeteria plan allowing pre-tax payment of insurance premiums, the employee will not be permitted to use pre-tax earnings to pay for the taxable coverage. Because of this, cafeteria plans will have to take certain steps to ensure that pre-tax earnings do not improperly pay for benefits that are provided to a child who does not qualify as a “dependent” under the Code. Failure to do so could lead to tax consequences for the participant and the plan.

Domestic Partnership Benefits: Effective August 3, 2009, the domestic partnership provisions of the budget bill extended certain rights to domestic partners. Although these provisions do not require public employers to extend health care benefits to the domestic partners of their employees, many employers do so voluntarily. In addition, some employers may be required to provide domestic partner benefits. For example, the Dane County Domestic Partner Equal Benefits Requirement, which is currently in place, mandates that employers provide equal benefits for domestic partners if the employer has a contract with the County for $5,000 or more. If an employer does provide domestic partner benefits—whether by choice or by mandate—there may be certain situations in which the value of the benefits is taxable to the employee and pre-tax earnings may not be used to pay for such benefits. Thus, employers who provide such benefits should monitor the funding of those benefits to avoid unwanted tax consequences.

Tax Code Exemption for Health Insurance

In general, employers may provide health insurance to their employees and employees’ spouses and dependents on a tax-free basis. This is due to a specific exemption in the Code. (Without this exemption, the value of the benefits would be treated as taxable compensation.) As part of this exemption, the Code defines “spouse” and “dependents.”

1. Spouses

Generally, an employee’s spouse qualifies under the Code if he or she is considered a spouse under state law. However, under federal law, a same-sex spouse does not qualify as a spouse under the Code, regardless of whether the same-sex spouse is considered a spouse under state law. Nevertheless, a same-sex spouse may qualify as a dependent under the Code if he or she meets the criteria discussed below.

2. Dependents

Generally, to qualify as a dependent under the Code, the employee’s dependent must be either a “qualifying child” or a “qualifying relative” as defined in section 105(b) of the Code. The definition of “dependent” under section 105(b) is slightly more expansive than the definition of “dependent” for income-tax purposes (for which the definition in section 152 of the Code is used).

In addition to meeting the criteria of section 105(b), a qualifying dependant must be a United States citizen or national or a resident of the United States or a country contiguous to the United States (i.e., Canada or Mexico). This rule regarding nationality does not apply to a child adopted by a United States citizen or national if the child has the same principle residence and is a member of the household of the citizen or national.

1. Qualifying Child

A “qualifying child” must be related to the participant in a one of the ways specified in the Code and must also satisfy five additional factors outlined in the Code. Specifically, a “qualifying child” must be related to the participant in one of the following ways:

• as a child (son, daughter, stepson, stepdaughter, eligible foster child, or adopted child) of the participant;
• as a descendant of a child of the participant;
• as a brother, sister, stepbrother, or stepsister of the taxpayer; or
• as a descendant of a brother, sister, stepbrother, or stepsister of the taxpayer.

In addition, a “qualifying child” must meet all of the following five criteria (assuming the participant is on a calendar-year tax schedule):

1. He or she must have the same principal residence as the participant for more than one half of the tax year.
2. He or she must be younger than the participant.
3. He or she must be under the age of 19 at the close of year tax year or he or she must be a student who is younger than 24 at the close of the tax year.
4. He or she must not have provided over one-half of his or her own support during the tax year.
5. He or she must not have filed a joint return with his or her spouse for the tax year.



If a participant’s child does not meet relationship requirement as well as these five criteria, the child is not a “qualifying child.” Consequently, unless the child is a “qualifying relative” (as discussed below), the child will not qualify for the health insurance tax exemption and any insurance provided for the child will be taxable.

2. Qualifying Relative

Similarly to a qualifying child, a “qualifying relative” must be related to the participant in one of the ways specified in the Code and must also satisfy two additional factors. Specifically, a “qualifying relative” must be related to the participant in one of the following ways:

• as a child (son, daughter, stepson, stepdaughter, eligible foster child, or adopted child) of the participant;
• as a descendant of a child of the participant;
• as a brother, sister, stepbrother, or stepsister of the participant;
• as a stepfather or stepmother of the participant;
• as a son or daughter of a brother or sister of the participant;
• as a brother or sister of the father or mother of the participant;
• as a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law of the participant; or
• as an individual (other than a spouse of the participant) who for the tax year has the same principal residence as the participant and who is a member of the participant’s household.

In addition, a “qualifying relative” must meet both of the following criteria (assuming the participant is on a calendar-year tax schedule):

1. The participant must provide over one-half of the relative’s support for the tax year.
2. He or she must not be a “qualifying child” of the participant or any other taxpayer.

If a person (such as a participant’s child or domestic partner) does not meet the relationship requirement as well as these two requirements, then the person is not a qualifying relative. Consequently, unless the person meets another exemption (such as a “qualifying child,” discussed above), the person will not qualify for the health insurance tax exemption and any insurance provided for the person will be taxable.

DEPENDANT AGE EXTENSION

1. Health Coverage Costs for Some Children Will Be Taxable

The dependent age extension provisions apply to disability insurance policies as defined by Wisconsin Statutes Section 632.895(1)(a), including individual health and group health benefit plans, and to certain governmental self-insured plans. It requires that these plans cover as dependents any child of an applicant or insured who satisfies all of the following three criteria:

1. The child is over 17 but less than 27 years of age.
2. The child is not married.
3. The child is not eligible for coverage under a group health benefit plan that is offered by the child’s employer and for which the amount of the child’s premium contribution is no greater than the premium amount for his or her coverage as a dependent under the parent’s plan.

In addition, certain children in the military who do not meet criteria one (i.e., they are age 27 or older) but who satisfy criteria two and three, will still be eligible for coverage if all of the following three conditions are met:

1. The child is a full-time student, regardless of age.
2. The child was called to federal active duty in the national guard or in a reserve component of the U.S. armed forces while the child was attending, on a full-time basis, an institution of higher education.
3. The child was under the age of 27 years when called to federal active duty.

Thus, the dependant age extension provisions will result in situations in which an employee’s child may be covered under the employee’s health insurance plan as a dependant even though the child is not a “dependent” under the Code. For example, a 26 year-old self-supporting child who is not eligible for a group health benefit plan through the child’s employer would not qualify as either a “qualifying child” or a “qualifying relative” under the Code, as a result of the child’s self-support. Such a child would, however, meet the criteria of the Wisconsin dependant age extension. Consequently, the child’s parent could elect to cover the child as a dependent under the parent’s individual or group health benefit plan, but the parent would have to be taxed for the fair market value of the coverage.

2. Cafeteria Plan Issues

In general, a cafeteria plan may allow a participant to elect to provide benefits for the participant’s spouse and dependents (e.g., children), as defined under the Code. For a spouse or dependent that meets the applicable definition, these benefits can be paid for using the participant’s pre-tax earnings. However, if the spouse or dependent does not satisfy the applicable definition, then the participant’s pre-tax earnings may not be used to pay for their benefits. This is true even if those benefits are paid for through a cafeteria plan. Therefore, a cafeteria plan that allows its participants to elect to pay for benefits for spouses and dependents who do not meet the definition of “spouse” or “dependent” under the Code must ensure that the participant’s pre-tax earnings are not used to pay for those benefits.

In that situation, cafeteria plans have two options for compliance. One option is to pay for the benefits of non-qualifying children using the employee’s after-tax earnings. Alternatively, the plan may pay for the non-qualifying child’s benefits through a pre-tax salary reduction so long at it treats the employee as receiving cash compensation equal to the full value of the benefit at the time the benefit is received and then purchasing the benefit with after-tax earnings. Under this option, the employer would have to impute the value of the benefit to the employee for income-reporting purposes and withhold all necessary taxes for that imputed income.

Besides determining how to pay for benefits provided to a non-qualifying child, the plan must also determine how to value those benefits. The IRS requires the plan to value the benefits at their fair market value, which is generally defined as the amount the beneficiary would have to pay for coverage in an arm’s length transaction. The IRS has not explicitly adopted a single method for this calculation, but it has indicated at least two appropriate methods. The first method is using the plan’s individual COBRA premiums (minus any administrative costs). A second method, which typically results in a lower determination of fair market value, is to use the difference between the cost of an employee-only plan and an employee-plus-one plan. Note that this calculation is not the same as the marginal cost of adding an additional beneficiary to the employee’s current plan. Although the IRS has not explicitly rejected such an approach, it has indicated that it may be problematic. In some situations the addition of a beneficiary will not increase the cost of the employee’s premium (e.g., the addition of a child to a family plan). The IRS has indicated informally that in such a situation income must still be imputed to the employee.

DOMESTIC PARTNER PROTECTIONS

The 2009 Wisconsin biennial budge bill introduced certain legal protections for individuals in Wisconsin who are in a domestic partnership. Under the new law, an individual may be entitled to these protections as either a registered or unregistered domestic partner, if the individual meets all the applicable statutory criteria. As discussed, the domestic partnership protections that are included in the law do not require private employers to offer health care benefits to the domestic partners of their employees. But many employers voluntarily provide such benefits, and other employers may be required to do so under local provisions, such as the Dane County Domestic Partner Equal Benefits Requirement. In either case, if a plan provides coverage to domestic partners who do not qualify as a “spouse” or “dependent” under the Code, the same tax issues discussed above will apply; for example, the value of the insurance provided will be taxable income to the employee, and a cafeteria plan may not be used to pay for the coverage with pre-tax earnings.

CONCLUSION

Employers and employees need to be aware of the tax issues that arise when insurance coverage is expanded to those beyond the definition of “spouse” or “dependent” in the tax Code. Cafeteria plans should monitor the benefits that they provide to ensure that pre-tax earnings are not being used to fund benefits for individuals who do not qualify as a “spouse” or “dependent” under the Code. In situations in which a participant has elected to provide benefits though a cafeteria plan for a beneficiary who is not a qualified “spouse” or “dependent,” the plan must ensure that it is properly designed to allow for such benefits to be paid for through the plan. This includes ensuring that those benefits are not being paid for with pre-tax earnings. These precautions are particularly salient in light of the Wisconsin dependent care age extension provisions of the most recent budget bill, as well as for any cafeteria plan that provides benefits to domestic partners.

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This legal update is not legal advice. Individuals should seek advice based on their particular circumstances from their own counsel.