updated 5/1/2011 by SHRM Online staff
The Patient Protection and Affordable Care Act (PPACA) amended the federal Internal Revenue Code to exclude from an employee’s income for federal tax purposes the value of health coverage provided to an “adult child” through the end of the year in which the adult child turns age 26. However, the value of this coverage might be includible in the employee’s income for state tax purposes if the state’s tax code does not coordinate with the change in federal tax treatment.
State tax treatment is a “moving target” as many legislatures in nonconforming states are considering whether to change state tax laws to conform to federal tax treatment.
The PPACA, as amended by the Health Care and Education Reconciliation Act, requires group health plans and insurance issuers that cover an employee’s biological, adopted, step or foster children to extend coverage to these children until they attain age 26.
Plans and issuers must make coverage available regardless of the adult child’s marital or student status or whether the child resides with, or is supported by, the employee. (Prior to 2014, a grandfathered group health plan does not have to offer coverage to an adult child who is eligible for health coverage from his or her employer.)
This provision was effective for plan and policy years beginning on or after Sept. 23, 2010. However, some plans and issuers adopted some version of adult child coverage earlier voluntarily or pursuant to existing state laws.
To coordinate the federal tax laws with the mandatory coverage of adult children, PPACA amended the Internal Revenue Code to exclude from federal income tax the value of health coverage and benefits provided to adult children. The federal tax exclusion that took effect on March 30, 2010, is available until the end of the calendar year in which the adult child attains age 26.
Observation: PPACA extends the special federal tax treatment to the end of the calendar year in which the adult child turns age 26 (even though the mandatory coverage requirement only applies until the adult child attains age 26) in order to prevent an employee from facing a federal tax issue if the plan provides coverage beyond the birthdate.
It is not unusual for plans to continue coverage until the end of the month in which the birthday occurs or, in some cases, until the end of the calendar year.
Prior to PPACA, the federal tax code limited the income exclusion for health coverage to dependents, defined as a “qualifying child” or a “qualifying relative,” as set out below:
• An individual is a “qualifying child” if he or she satisfies the following requirements:
✔The individual lives with the employee for more than one half of the tax year.
✔The individual is the employee’s son, daughter, stepchild, sibling, stepsibling or a descendent of any such individual.
✔As of the end of the calendar year, the individual is under the age of 19, under the age of 24 and a full-time student, or permanently disabled.
✔The individual does not provide over one half of his or her own support.
✔The individual has not filed a joint tax return for the year with his or her spouse.
• An individual is a “qualifying relative” if he or she satisfies the following requirements:
✔The individual bears a specified relationship (including that of a child, a sibling or a descendent of a child or sibling) to the employee.
✔The employee provides more than one-half of the individual’s support.
✔The individual is not a qualifying child of the taxpayer or any other person for that calendar year.
Prior to PPACA, the value of health coverage provided to children who did not fall within these definitions (i.e., was a “nonqualifying dependent”), such as a 25-year-old individual who did not receive more than one half of his or her support from the employee, would be includable in the employee’s income. PPACA removed the need for biological, adopted, step or foster children to meet one of the dependent tests.
Observation: PPACA did not eliminate the dependent tests as an alternative means of income exclusion, and these rules are still applicable, for example, in determining whether the employee can exclude the value of coverage for the child of a domestic partner.
State Taxation Issues
In many states, the starting point for calculating an individual’s state income tax liability is the individual’s federal adjusted gross income (AGI) as determined under the applicable provisions and definitions of the federal tax code. In those states that have tax codes that “conform” automatically to the most current version of the federal code, the individual’s AGI generally will be the same for federal and state tax purposes.
However, in those states that refer to a version of the federal tax code that was in effect on a date prior to March 30, 2010, (the effective date of the new federal tax exclusion), that do not refer to the federal tax code and/or that have their own rules, the AGI of an employee covering an adult child could be higher for state tax purposes than for federal tax purposes. Income will not be higher under state tax law if the adult child qualifies for the income tax exclusion under the federal tax code referred to by the state as a dependent or if the state has some special provision under its tax code.
Many states have legislation pending that could affect 2010 (and thus 2010 W-2s) and/or 2011 (and thus 2011 withholding). In these states, the state tax treatment is a moving target. Employers should continue to check with their tax advisors or payroll administrators for the latest information.
States that have addressed the state tax treatment directly, in whole or in part, to date are California, Iowa, Kentucky, Minnesota, Oregon, Virginia and Wisconsin. In some of these states, however, the information provided contains a caution that the state legislature may revise the treatment retroactively.
[Update: On April 7, 2011, California Gov. Jerry Brown signed into law AB36, which brings California state law into conformity with the federal health care reform law, retroactive to March 30, 2010. California employers who started covering nondependent children under age 27 in 2010 and included the value of such coverage in their employees' state but not federal wages should issue corrected W-2s for 2010 and remove the value of young-adult benefits from employees' state wages. If the employer does not issue a corrected W-2, employees can use FTB Form 3525 as a substitute.]
Iowa follows the federal tax code as in effect on Jan. 1, 2008, but its state tax code provides for an adjustment to an employee’s income to exclude the value of health coverage provided to a child who does not qualify as a taxpayer’s tax dependent under the federal code. The Iowa Department of Revenue has issued guidance stating that, as a result of Iowa’s adjustment, the tax treatment of coverage of “nonqualified dependents” will be the same for federal and state income tax purposes.
The Kentucky Department of Revenue issued guidance informing employers that the state follows the federal tax code in effect as of Dec. 31, 2006, and that employers must treat the amounts paid to provide health coverage to children who are not dependents (i.e., not “qualifying children” or “qualifying relatives”) under that federal code as being paid with post-tax dollars for state income tax purposes. [Update: In March 2011, Kentucky Gov. Steven Beshear signed into law H.B. 255, which enables employers to extend health care coverage to employees’ adult children without employees being subject to state taxes on the coverage.]
The Minnesota Department of Revenue issued guidance stating that although under current state law the fair market value of nondependent child health coverage would constitute wages to the employee, the department would not require employers to withhold taxes with respect to these benefits until the state legislature addresses the issue.
Observation: In January 2011, a bill providing for retroactive amendment of the state law to conform to federal law was introduced.
[Update: In Minnesota, federal tax laws were amended effective March 30, 2010, to exclude from gross income health insurance coverage (including reimbursements under flexible spending accounts) provided to children under age 27. Such coverage was excluded from income under Minnesota tax law for the 2010 tax year. If the employer had already issued a 2010 W-2 reporting the value of health insurance coverage provided to adult children for Minnesota state tax purposes, no corrected W-2 would be required. However, until further legislation is enacted, the value of the health insurance coverage must be reported for 2011 and future tax years.]
Oregon follows the federal tax code as in effect on Jan. 1, 2009. The Oregon Department of Revenue takes the position that the provision of health coverage to a child who is not a dependent (i.e., not a “qualifying child’ or “qualifying relative”) under the Jan. 1, 2009, federal code will result in taxable “imputed” income to the employee for state tax purposes.
The department states that the amount of imputed income is the fair market value of the coverage, and it suggests that one way to determine this is to use the plan’s COBRA rate minus the administrative fee. The department release includes a caution that only the legislature can change the treatment.
On Feb. 16, 2011, Virginia’s governor signed HB 1874, which amends the Virginia tax code to follow the federal code and other federal tax laws as they existed on Dec. 31, 2010. (The prior reference was to Jan. 22, 2010.)
Observation: Employers should check with their tax advisors as to whether this change affects 2010 state tax treatment. On its surface, it appears to affect only 2011 and later years.
Wisconsin follows the federal tax code as in effect on Dec. 31, 2008. The Wisconsin Department of Revenue has issued guidance stating that if an adult child does not qualify for the exclusion as a dependent, the fair market value of the adult child's health insurance coverage and the reimbursements from a medical flexible spending account are income and taxable wages to the employee. The department notice includes a caveat that any change in treatment requires legislation.
Other Nonconforming States
Nonconforming states that have not yet taken a formal position on the taxation issue included Arizona, Arkansas, Georgia, Hawaii, Idaho, Indiana, Maine, Massachusetts, Mississippi, New Jersey, South Carolina and West Virginia.
Observation: There are a number of states—conforming and nonconforming—that require coverage of adult children to ages beyond the date the child attains age 26. For example, New York requires coverage until the “child” attains age 30, and New Jersey requires coverage until the “child” attains age 31. This mandatory health coverage is likely to generate federal and perhaps state tax on the employee (unless the “child” is otherwise a dependent).
[Update: In Arkansas, legislators approved and sent to Gov. Mike Beebe a bill that would eliminate the adult child coverage state tax. The measure got caught in a tax cut "logjam" when the House-Senate-governor reached an impasse on tax cuts.]
Employers in nonconforming states face great uncertainty—even in states that have provided preliminary guidance. With many legislatures considering whether to change their law and the lack of clarity in many cases as to what income to impute as the fair market value of coverage for “nonqualifying dependents,” employers face challenges in determining the amount to withhold and the amount to report as wages.
While it is likely that in most states the fair market value of the provided coverage would have to be reported as additional wages to the employee, some states might require only that the incremental cost of covering the adult child be reported. Employers should consult with their payroll administrators and state tax advisors as to whether the state tax treatment has changed and whether there is additional state guidance on imputed income and withholding.
In addition, employers should keep in mind that some of the previously ineligible children who have been added to health coverage as a result of health care reform will satisfy the definition of “qualifying relative” if they are receiving more than one half of their support from the employee. Employees that can provide evidence that their adult children are “qualifying relatives” will not have taxable income for federal and perhaps state purposes.
The above is reposted with permission from Buck Consultants' FYI newsletter. It is intended to provide general information. It does not offer legal advice or purport to treat all the issues surrounding any one topic.
© 2011 Buck Consulants LLC. All rights reserved.
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