IRS Issues Guidance on Tax Treatment of Health Care Coverage for Adult Children Under Age 27

On April 27, the Internal Revenue Service issued Notice 2010-38, which addresses various questions relating to the tax treatment of health care coverage provided to nondependent adult children under the Patient Protection Act.1 The Notice primarily focuses on the tax treatment of coverage and the application of cafeteria plan rules if an employer voluntarily extends coverage to nondependent adult children in 2010. The Notice also discusses how these tax law changes affect the tax treatment of coverage that is already being provided to nondependent adult children under existing plans.

The key provisions of this Notice are:

• Coverage for adult children who do not turn age 27 until after 2010 is tax-free beginning on March 30, 2010.
• If employers choose to cover adult children in 2010, they may amend their cafeteria plans in 2010 to permit employees:
• to pay with pretax dollars for coverage relating to their adult children; and
• to change (or make) health care flexible spending account (FSA) elections in 2010 as if their adult child(ren)’s becoming eligible were a change in family status under the cafeteria plan rules.

Background
 
The Patient Protection Act addresses coverage of adult children in two ways. First, the Act requires that plans that provide for dependent coverage continue to cover children of covered employees until those children turn age 26. This requirement applies beginning with plan years that begin on or after September 23, 2010 (i.e., January 1, 2011 for calendar-year plans). Generally, plans in existence on March 23, 2010 are “grandfathered” and not required to offer coverage to adult children who are eligible for medical coverage at their current employer. Many insurance companies have announced that they will implement this expanded coverage earlier than required for these insurance plans.
 
Second, the Act provides that health care coverage of children is tax-free to the covered employee until the calendar year in which a nondependent adult child turns age 27. For example, if a nondependent adult child will turn 27 in 2012, a plan may continue to cover that child through the end of 2011 on a tax-free basis. If coverage continues into 2012, the fair market value of the coverage for all of 2012 will be taxable income to the covered employee in 2012.
 
2010 Coverage
 
The Notice confirms that the statutory change relating to the tax treatment of health care coverage for nondependent adult children was effective immediately, and thus coverage for such an adult child is tax-free on and after March 30, 2010, so long as the adult child will not turn age 27 until a future year.
 
If a plan was covering a nondependent adult child prior to March 30, 2010, and the employer was imputing the fair market value of the coverage to the covered employee, the employer may stop imputing income for coverage on and after March 30 (again, until the year the adult child will turn age 27).
 
The Notice makes it clear that the Patient Protection Act requirements about offering coverage to adult children do not affect the taxation of that coverage. As noted above, grandfathered plans are not required under the Patient Protection Act to offer coverage to nondependent adult children who are eligible for coverage under their employer’s medical plan. Nevertheless, an example in the Notice makes it clear that if a plan were to offer coverage to an adult child who is eligible for (but declines) coverage at his/her employer, that coverage is still tax-free through the end of the year in which the child turns age 26.
 
Cafeteria Plans
 
Cafeteria plan rules under Section 125 of the Internal Revenue Code provide that participants may change coverage paid for with pretax dollars only at the beginning of the plan year or, if permitted under the plan, upon the occurrence of an eligible change in status (e.g., marriage, divorce, birth, etc.) during the plan year.
 
Under the Notice, if an employer chooses to extend coverage to nondependent adult children for the balance of 2010, the IRS will permit the employer to amend its cafeteria plan in 2010 to treat the new eligibility of a nondependent adult child as an eligible change in status under the cafeteria plan rules. Thus, the covered employee will be able to elect to cover the adult child and pay with pretax dollars for any additional employee premiums relating to covering that adult child. The Notice requires any employer that extends coverage in 2010 to amend its cafeteria plan by December 31, 2010 to permit this change in coverage. The amendment must specify the date on which adult children were permitted to be covered under the plan (which can be retroactive to as early as March 30).
 
Similarly, a cafeteria plan that contains a health care FSA may be amended to permit the employee to make (or change) health care FSA elections for the remainder of 2010 on account of, and consistent with, an adult child’s becoming eligible for coverage under the plan. Again, such an amendment must be adopted by December 31, 2010 and can be retroactive to the specified date on which the change became effective.

If you have any questions regarding this IRS Notice, please contact Philip L. Mowery (312-609-7642), Paul F. Russell (312-609-7740) or any other employee benefits attorney with whom you have worked.

FEDERAL TAX NOTICE: Treasury Regulations require us to inform you that any federal tax advice contained herein is not intended or written to be used, and cannot be used, by any person or entity for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

 1 References to the "Patient Protection Act" or "Act" are references to both the Patient Protection and Affordable Care Act that was signed into law on March 23, 2010 and the Health Care and Education Reconciliation Act of 2010 that was signed into law on March 30, 2010.