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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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