The recently-enacted Patient Protection and Affordable Care Act ("PPACA") requires group health plans and health insurance issuers that provide coverage for dependent children to make such coverage available to adult children through age 25.
On April 27, 2010, the Internal Revenue Service ("IRS") issued Notice 2010-38, its initial guidance on taxation of expanded coverage for adult children. The Notice provides that coverage of adult children who will not have attained age 27 by the end of the calendar year will be subject to the same favorable income tax rules that that apply to coverage of dependent children even if the adult child is not a dependent for tax purposes. In addition, the IRS clarified that it will allow employees to make mid-year cafeteria plan elections to elect coverage for adult children and pay for such coverage on a pre-tax basis.
This alert summarizes how Notice 2010-38 will affect employers and their group health plans.
PPACA PROVISIONS ON EXTENDED COVERAGE FOR ADULT CHILDREN
The PPACA made important changes in the law affecting medical coverage for an employee's adult children. First, effective for plan years beginning on or after September 23, 2010, the PPACA amended the Public Health Services Act ("PHSA") (and corresponding provisions of the Internal Revenue Code (the "Code") and the Employee Retirement Income Security Act) to require group health plans and health insurance issuers that provide dependent coverage to make such coverage available for an adult child until age 26 (i.e., through age 25). This requirement does not apply to group health plans in existence on March 23, 2010 ("grandfathered health plans") for plan years beginning before January 1, 2014 if the adult child is eligible to enroll in another eligible employer-provided group health plan. (For a discussion of "grandfathered health plans," please view our prior client alert entitled "Health Care Reform Legislation: Provisions Affecting Employer-Sponsored Group Health Plans.") The PPACA does not require a group health plan to cover a child of an adult child receiving extended coverage under this provision.
The PPACA separately modified Code Section 105(b) to provide that an employee will not be taxed on reimbursements received under a group health plan with respect to an adult child who will not have attained age 27 by the end of the employee's tax year (generally the calendar year). Thus, the PPACA does not require a group health plan to extend group health coverage to the adult child of an employee on or after the child's 26th birthday but if the plan extends coverage beyond the child's 26th birthday, the favorable tax treatment under Code Section 105(b) will continue until the end of the tax year in which the child attains age 26.
Without this change to Code Section 105(b), reimbursements under a group health plan that are attributable to such an adult child would have been taxable to the employee unless the child is the employee's "dependent" within the meaning of Code Section 152. Although the changes to the PHSA do not require group health plans to extend coverage to adult children until January 1, 2011, the change to Code Section 105(b) appears to be effective immediately upon enactment. This will allow employers to extend coverage to employees' adult children earlier than is otherwise required by the PPACA without subjecting the employees to taxation on reimbursements for medical expenses incurred by such adult children.
The differences between the tax provisions and the PHSA provisions in the PPACA raised many important questions, including the effective date of the changes to Code Section 105(b) and the tax implications that extending coverage to a non-dependent adult child will have under other sections of the Code (such as Code Sections 106 and 125) governing taxation of employer-provided benefits.
IRS NOTICE 2010-38
On April 27, 2010, the IRS issued Notice 2010-38 ("Notice"), its initial guidance on the application of the new tax provisions regarding the extension of group health coverage for adult children.
Clarification of Application of Revised Code Section 105(b)
The Notice clarified that the change to Code Section 105(b) enacted in the PPACA was effective on March 30, 2010 and applies to reimbursable expenses incurred by an employee's child during the employee's taxable year if the child is age 26 or younger as of the end of the employee's taxable year. The Notice allows employers to assume that the employee's taxable year is the calendar year. Thus, for example, an employee's child born on April 10, 1985 will attain age 26 on April 10, 2011. The employee's group health plan must allow the employee to continue coverage for the child from January 1, 2011 (if the plan year is the calendar year) until April 10, 2011 when the child attains age 26. If the plan allows coverage to be extended past that date, favorable tax treatment will continue to be available through the end of 2011. The favorable tax treatment will not apply at any time during 2012, however, because the child will attain age 27 during the 2012 calendar year.
An employee's child need not be a "dependent" under Code Section 152(a) for this favorable tax treatment to apply. Thus, if an employee's child will be age 26 or younger at the end of the year, the age limit, residency, support, and other tests described in Code Section 152 for "dependent" status will not apply with respect to such child for purposes of determining the excludability under Code Section 105(b) of reimbursements for expenses incurred by such child during that year.
Intention to Expand Tax Benefits to Code Section 106
In the Notice, the IRS indicated its intent to amend regulations under Code Section 106, retroactively to March 30, 2010, to provide that if an employee's child will be age 26 or younger at the end of the calendar year, employer-provided group health coverage for such child during that calendar year will also be excluded from the employee's gross income. In contrast to Code Section 105, which addresses the taxation of reimbursements under employer accident and health plans, Code Section 106 addresses the taxation of the cost of coverage under an employer's accident and health plans. The IRS noted that Code Sections 105 and 106 paralleled each other prior to the PPACA and it saw no indication in the PPACA that Congress intended to provide a broader exclusion under Code Section 105 than under Code Section 106. Thus, on and after March 30, 2010, both the cost of coverage under an employer's group health plan for an employee's non-dependent adult child who is age 26 or younger at the end of the calendar year and any amounts reimbursed (directly or indirectly) under the plan for covered expenses of such adult child incurred in any calendar year in which the child is age 26 or younger at the end of such year may be excluded from the employee's gross income.
Mid-Year Election Changes Under Cafeteria Plans
Generally, a cafeteria plan may permit employees to make mid-year election changes only in certain limited circumstances, such as a change in status event. Although a change in status event includes a change in the number of an employee's dependents, "dependents" for this purpose includes only the employee's federal tax dependents under Code Section 152.
In the Notice, however, the IRS says it intends to amend its cafeteria plan regulations, effective retroactively to March 30, 2010, to allow mid-year elections relating to change in eligibility affecting non-dependent children who are age 26 or younger as of the last day of the calendar year, including children becoming newly eligible for coverage or eligible for coverage beyond the date on which the child otherwise would have lost coverage. Thus, it appears that employees may be permitted to make mid-year election changes to add coverage for an adult dependent child who had previously aged out of the employer's plan. Presumably, the regulations will also allow an employee to make a mid-year election change to begin making salary reduction contributions for existing adult child coverage on a pre-tax basis where such contributions were previously required to be made on an after-tax basis, if such coverage was permitted at all.
Proposed cafeteria plan regulations previously issued by the IRS (in 2007) generally require cafeteria plan amendments to be effective prospectively only. The Notice offers relief from this rule, however, with respect to the addition of adult child coverage to a cafeteria plan. Specifically, the IRS states that employers may permit employees to immediately make pre-tax salary reduction contributions for health benefits under a cafeteria plan (including under a health flexible spending account (a "health FSA")) for children who are age 26 or younger as of the last day of the calendar year, even if the cafeteria plan has not yet been amended to add such individuals, as long as the plan is amended no later than December 31, 2010. The amendment must be effective retroactively to the first date in 2010 when employees were permitted to make pre-tax salary reduction contributions to cover adult children who are 26 or younger as of the last day of the calendar year (but in no event before March 30, 2010).
WHAT SHOULD EMPLOYERS DO NOW?
- If an employer's group health plan currently covers adult children, the employer should consider whether it wishes to offer employees the opportunity to make an election to begin paying for such coverage on a pre-tax basis under its cafeteria plan. This is not required. There is nothing in the Notice, however, to indicate that an employer may automatically convert the employee's salary reduction contributions from after-tax to pre-tax. Thus, an employer wishing to offer this opportunity to its employees will need to implement a special election period for its employees under normal cafeteria rules (e.g., elections, including negative elections, must be irrevocable for the remainder of the year).
- Group health plans that do not currently cover adult children are not required to provide such coverage until the first plan year beginning on or after September 23, 2010. An employer may, however, voluntarily expand coverage under its group health plan to adult children earlier. Also, a grandfathered health plan may continue to exclude (until the first plan year beginning on or after January 1, 2014) any adult child who is eligible to enroll in another eligible employer-provided health plan. Employees taking advantage of the expansion of coverage to their adult children will be required to make cafeteria plan elections in order to have their contributions made on a pre-tax basis.
- All employers will need to amend their cafeteria plans on or before December 31, 2010. Those employers who do not expand coverage this year will be required to do so next year and, as noted, cafeteria plan regulations generally require that an amendment be adopted prior to its effective date. For calendar year plans, this would require an amendment by December 31, 2010, as the Notice did not provide relief for cafeteria plan amendments for years after 2010.
- Employers should consider whether to modify their health FSAs and health reimbursement arrangements to allow reimbursement for medical expenses of adult children.
- All employers should review their group health plans and cafeteria plans to ensure that existing language does not inadvertently expand coverage beyond that intended by the employer.
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