October 19, 2004
New Treasury Department Developments in Change of Definition of "Dependent";
Conference Call Friday, October 22 at 2 p.m. ET
Shortly after the Working Families Tax Relief Act of 2004 (H.R. 1308) (sometimes referred to as the "tax extenders" bill) was signed into law by President Bush on October 4, the Council first reported several issues raised by changes in the definition of a "dependent" under Section 152 of the Internal Revenue Code. The Council has had detailed discussions with congressional staff on how the changes made by the legislation will affect employee benefits starting January 1, 2005. In addition, after further discussions with Treasury Department staff, we have been told that the Treasury Department intends to issue regulations "expeditiously" to address concerns about the definition of dependents for the purposes of health benefits. The agency will address issues related to 401(k) hardship distributions in regulations expected before the end of the year.
The changes to the definition of a dependent affect several areas of employee benefits and involve many technical issues. We are aware that other organizations have also reported on the effect of the new legislation on some — but not all — areas of benefits policy. We have also received several calls that other organizations and some benefits advisors believe there is no problem with the new definition of "dependent" because Treasury has indicated it will address the issue. However, as we have identified for the Treasury and congressional staff, the new definition of dependent affects several different areas of benefits policy, no simply health benefits as some have focused on exclusively. We are continuing to work closely with the Treasury Department and congressional staff to try to resolve each of these matters.
To sort out these issues, on October 19 Council President James Klein sent a letter to the Treasury Department summarizing our analysis of the changes made by the tax extenders bill and recommending follow-up action by the Department.
Here is our latest understanding of how different employee benefits will be affected by the new definition of dependents and which issues will and will not be address by further Treasury guidance:
Background: The tax extenders bill contains changes to Section 152 and other sections of the Internal Revenue Code designed to unify the definition of dependent for various statutory purposes. For the first time, Qualifying Child dependents as defined in Section 152 will be subject to a maximum age limitation — the child must not have attained age 19 as of the close of the calendar year, or age 24 if a full-time student. A non-child dependent, known as a Qualifying Relative, will be subject to a gross income limitation of $3,100 for 2004 (indexed in future years for inflation). Individuals who make more than that amount cannot be a Qualifying Relative dependent. Therefore, as amended, the general rule for the definition of a dependent is that an individual must either be a child under the age of 19 or under the age of 24 if a full-time student, or must make less than $3,100 in 2004.
Technical and conforming amendments in the tax extenders legislation applied the dependent age and gross income limitations to some, but not all, benefits-related Code sections. The effect of the changes in the definition of dependents for various sections of the tax code relating to employee benefits policy and expected next steps are as follows:
Health Plans: Internal Revenue Code Sections 105 and 106 govern the tax status of health benefits provided to employees, including those provided by flexible spending arrangements (FSAs) and health reimbursement arrangements (HRAs). Code Section 105 allows benefits received under health plans to be tax free for plan participants. Section 106 allows employers to make contributions to premiums on a plan participant's behalf on a tax-free basis to the individual. The Working Families Tax Relief Act applies the new age limitation provisions for dependents, but not the gross income limitation provisions, to Code Section 105. However, a different definition of "dependent" would apply to Code Section 106, which is governed by longstanding Treasury regulations. The effect of the different definitions for dependents would mean that, starting on January 1, 2005, individuals would only qualify as dependents if they satisfied either the age limitation test for a Qualifying Child or the gross income limitation for a Qualifying Relative. However, Treasury Department staff informed us they will revise their longstanding regulations "expeditiously" to conform the definition of dependent under Code Section 106 to the definition established by the Working Families Tax Relief Act for Code Section 105. With this conforming change, individuals will be able to qualify as a dependent under a health plan either by meeting the age limitation requirements of a Qualifying Child or the standards for a Qualifying Relative, without regard to the individual's gross income.
Health Savings Accounts: The regulatory correction to Code Section 106 that Treasury plans to issue for health plans (eliminating the application of the gross income limitation for a Qualifying Relative) will apply to high deductible health plans (HDHPs) offered in conjunction with health savings accounts (HSAs). However, the definition of dependents under Code Section 152 (which includes the gross income limitation) applies to distributions from the front-end accounts established under HSAs when used by family members for medical expenses. We will continue to explore with Treasury Department and congressional staff whether a change can be made by regulation or legislation to conform the definition of dependents for both the high deductible coverage and the savings account components of HSAs.
Dependent Care Spending Arrangements: Adult dependents as defined in Code Section 152 will be subject to a gross income limitation ($3,100 for 2004). Individuals who make more than that amount cannot be dependents under Dependent Care Spending Arrangements (DSCAs). This may create problems for those who use DCSAs to provide day care services for adult dependents, such as their parents. In addition, Code Section 21(b) previously provided that a dependent adult had to spend at least eight hours per day in the taxpayer's home. This section has been amended so that now the dependent must live with the taxpayer for at least half of the tax year. This may create a problem for 2005 as open enrollment is either underway or complete for many companies. We are told that Congress did intend to apply the gross income limitation and the change in Code Section 21(b) to DSCAs, so we do not expect regulations by Treasury to affect these new requirements. However, we are working with Treasury staff to determine if any transition relief may be needed where it might not be possible for plan participants to make a timely rescission or amendment to their elections to contribute to a DSCA for an adult dependent after the change in tax law.
401(k) Plans: Hardship distributions permitted under Section 401(k) plans are governed by regulations issued under that section that include several references to expenses for dependents as defined in Code Section 152. Without a conforming change in the regulations, this would cause problems, for example, for plans that want to allow hardship distributions for the medical expenses of the same-sex partner of an employee or a 25-year-old full-time student child that earned more than $3,100. In our conversations with Treasury staff, they have said they plan to address these concerns when they issue final 401(k) regulations, which are expected before the end of 2004.
Non-Qualified Deferred Compensation Plans: Problems similar to those for 401(k) hardship distributions will occur in non-qualified deferred compensation plans that permit distributions for an unforeseeable emergency under the statutory requirements recently added as Section 409A of the Internal Revenue Code by the international tax bill (H.R. 4520/ S. 1637) which incorporates the definition of dependents under Section 152 by reference. It is possible that 409A was not contemplated when making technical and conforming amendments to the tax extenders bill because the international tax bill was enacted following enactment of the tax extenders bill. Our letter to the Treasury Department also addresses this issue and we will continue to explore whether a correction can be made either by regulation or legislation.
To learn more: We will hold a Benefits Briefing conference call (click here to RSVP and for call-in information) on this issue on Friday, October 22 at 2:00 Eastern Time. For additional information about plans affected by this change in definition of dependent, please contact Susan Relland, Council health policy legal counsel (health plan issues) or Jan Jacobson, Council director of retirement policy (retirement plan issues) at (202)289-6700.
The American Benefits Council is the national trade association for companies concerned about federal legislation and regulations affecting all aspects of the employee benefits system. The Council's members represent the entire spectrum of the private employee benefits community and either sponsor directly or administer retirement and health plans covering more than 100 million Americans.