The IRS has just released guidance that relieves employers from having to impute income for the health care coverage of most “overage” children (children 19 or older) effective March 30, 2010, and makes it clear that health care coverage of children is never subject to FICA or FUTA tax.

Employers currently providing health care coverage to overage children, whether by choice or in order to comply with state mandates, should examine the tax treatment of such payments. Employers should stop imputing income to employees and stop withholding FICA, FUTA and income tax on the value of such coverage.

Historically, health plans typically did not cover dependents after the age of 19, unless the dependents were enrolled in school on a full-time basis or they were disabled. To extend coverage to this group of uninsured young adults, the legislatures in more than 30 states enacted legislation to require insured health plans to offer health care coverage to young adults up to a specific age regardless of their school or disability status. For example, Washington state requires coverage of dependents to age 25.

In addition, the recently passed federal health care reform legislation will require health plans, both insured and self-insured, to cover children until such child turns age 26, regardless of whether the child is married. The federal health care reform mandate is effective for plan years beginning on or after Sept. 23, 2010.

The immediate issue for 2010 does not concern the federal mandate, but rather involves the tax treatment for such extended coverage to dependents under the statutes previously enacted by the various states.

Previously, in order for such coverage to be tax free, the dependent had to be a “qualifying child” (a child who lives with the taxpayer and is either under age 19—or if older, disabled—or a full-time student under the age of 24) for whom the taxpayer provides over one-half of his or her support, or a “qualifying relative” (a relative, including a child, who bears a close relationship to the taxpayer and for whom the taxpayer provides more than one-half of his or her support).

If these definitions were not met, the state-mandated coverage would result in imputed income to the employee in the amount of the value of the dependent coverage provided. As a result, employers subject to state mandates have been imputing income to employees for health care coverage to dependents between the ages of 19 and 27, if such dependents were not a “qualifying child” or a “qualifying relative.”

However, due to recent changes to Sections 105, 106 and 125 of the Internal Revenue Code, brought about by health care reform legislation, employers can stop imputing income to employees on the value of coverage provided to overaged children (son, daughter, stepson, stepdaughter, legally adopted child or foster child placed with parent by judgment or decree).

The IRS provided guidance on the tax treatment of dependent health care coverage in recently issued Notice 2010-38. Effective March 30, 2010, due to health care reform, revisions have been made to Sections 105, 106 and 125 of the Code. The effects of these changes are:

  • Health care coverage to a child who has not attained age 27 by the end of a calendar year can now be provided tax free, regardless of his or her status as a “qualifying child” or “qualifying relative.” Thus, employees will no longer be taxed, after March 30, on the value of the coverage provided to their children aged 26 or younger.
  • Cafeteria plans may be revised, by an amendment adopted prior to year-end, to permit a change in status election for children who are newly eligible for extended coverage. Health flexible spending accounts will also be able to reimburse participants for the expenses of children under age 27, regardless of tax dependent status.
  • The IRS clarified that the value of dependent coverage is not wages for purposes of FICA, FUTA or incoming tax withholding.

Employers should note that this change does not affect the tax treatment of state-mandated coverage to other individuals who are not children, such as domestic partners, or dependents who have attained the age of 27.