Employee Benefits Advisory Bulletin
Congress Tinkers with Definition of “Dependent”;
IRS Fixes Technical Glitch
By Jeff
Belfiglio and Stuart
Harris
[Dec. 2004]
Signed into law in October, the Working Families
Tax Relief Act of 2004 (the “Act”) changes how the Tax
Code defines a “dependent.” The change is important
because many employee benefit plans define dependent by
simply referring to the Tax Code. In addition, the tax benefits
available under employer-provided health and welfare plans are available
only to employees, their spouses and dependents. As a result,
some individuals who previously qualified for tax advantages available
to dependents may no longer qualify; correspondingly, some individuals
who previously failed to qualify as dependents, may now
satisfy the definition under the new law. The change becomes effective
Jan. 1, 2005. Prior to that date employers should check their plans
and assess whether the new definition affects them.
The second item addressed in this Advisory
is the issuance of IRS Notice
2004-79, which corrects a technical glitch raised by the new
definition of dependent. The IRS Notice will allow some domestic
partners and other non-children to continue to qualify as dependents
for purposes of tax-free health plan coverage.
The new definition of “dependent”
Effective for tax years beginning Jan. 1, 2005,
Section 152 of the Tax Code defines a dependent as someone
who is either a “qualifying child” or a “qualifying
relative.” A taxpayer’s qualifying child
for any taxable year is someone:
- Who is the taxpayer’s child, sibling or step-sibling,
or a descendant of any such relative;
- Who has the same principal place of abode as the taxpayer for
more than one-half of the taxable year;
- Who is younger than 19 as of the close of the year, or is a
student younger than 24 as of the close of the year (no age limit
for someone who is disabled); and
- Who has provided one-half or less of his or her own support
for the year.
A taxpayer’s “qualifying relative” for
a taxable year is someone:
- Who is the taxpayer’s child (or descendant of a child),
sibling or step-sibling, parent (or ancestor of either parent),
step-mother or step-father, niece, nephew, uncle, aunt, son-in-law,
daughter-in-law, father-in-law, mother-in-law, brother-in-law,
sister-in-law or any other individual who has the same principal
place of abode as the taxpayer for the year and was a member of
the taxpayer’s household;
- Who receives from the taxpayer more than one-half of his or
her individual support for the year;
- Who is not a qualifying child of the taxpayer (or
any other taxpayer) for the year; and
- Who has gross income for the year that is less than the dependent
exemption amount listed in Tax Code § 151(d) ($3,200 in 2005).
Examples of how the new definition makes a difference
The changed definition encompasses some individuals who would not
previously qualify as a dependent, but in other respects
is narrower, excluding some individuals who historically have qualified.
For example, the prior definition contained no age limit for children,
whereas the new definition of qualifying child does. However,
a child who fails to fit the qualifying child category
may still qualify as a dependent by satisfying the definition
of a qualifying relative. Note that while the qualifying
relative definition does not have an age restriction, there
is a gross income limit not previously found in the definition of
dependent, but that income limit does not apply for purposes
of treating a qualifying relative as a dependent
for health insurance purposes. The reason is that a corresponding
change to Code § 105(b) (which makes health insurance coverage
for employees, their spouses and dependents tax-free) says
the income limit does not count when considering whether someone
qualifies as a qualifying relative (and hence a dependent)
for purposes of Code § 105(b).
As an example of a situation in which the new definition provides
broader coverage, assume a child lives at home but receives one-third
of his support from his parents, one-third from an uncle, and the
final third from his own efforts. Under the old definition of dependent,
a child needed to receive more than half of his or her support from
the parents to be treated as their dependent. The new law
makes a subtle change and instead requires that the child not provide
more than half of his or her own support for the year. Under the
hypothetical scenario, the child would not qualify as a dependent
under the old definition, but would qualify as a dependent
(through the definition of a qualifying child) under the
new definition.
IRS fixes technical glitch concerning tax status of health
coverage
As described above, in connection with the new definitions of dependent,
Congress specifically deleted from Code § 105(b) the requirement
that qualified relatives be subject to an annual income
test. Again, Code § 105(b) states that actual payments from
a group health plan to employees, spouses and dependents
are tax free. Correspondingly, Code § 106 provides that an
employer’s contributions to a plan, on behalf of employees,
spouses, and dependents, do not trigger tax consequences
to the employee. Under current regulations, this means that individual
who would otherwise qualify under the qualifying relative
definition because the employee provides more than half of their
support, but who earn more than the minimum threshold ($3,200 for
2005), for example a domestic partner, would not qualify for tax-free
employer-paid health care or pre-tax coverage tax under a cafeteria
plan. [Note: This odd feature of the new law was discussed at recent
DWT Employee Benefit Seminars.] Fortunately, the IRS has quickly
remedied this legislative defect. In Notice 2004-79, the IRS advised
that it would revise the regulations under Code § 106 so that
they incorporate the more liberal definition of dependent under
Code § 105(b), rather than the plain definition under Code
§ 152, as changed the Act. The Notice assures employers and
employees that they may continue to exclude employer-paid or pre-tax
coverage for individuals who would be qualifying relatives,
but for the fact that they earn more than the exemption amount.
What should employers do?
In short, the Act’s new definition dependent creates
some subtle distinctions that should not cause issues for most employers.
Nevertheless, all employers should check their plans to make sure
they continue to cover the intended group, and that covered dependents
who previously qualified for special tax treatment still merit the
same treatment.
Click
here to view Notice 2004-79.
For more information, contact any of the following or your
usual DWT business contact:
Jason
T. Froggatt, Seattle, (206) 628-7629, JasonFroggatt@dwt.com
This
Employee Benefits Advisory is a publication of the Employer Services
Department of Davis Wright Tremaine LLP. Our purpose in publishing
this Advisory is to inform our clients and friends of recent developments
in employment law. It is not intended, nor should it be used, as
a substitute for specific legal advice as legal counsel may only
be given in response to inquiries regarding particular situations.
Copyright
© 2004, Davis Wright Tremaine LLP.
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