Many employers provide some sort of benefits for employees’ dependents. These can take many forms. Some are benefits that do not require expenditure of much, or any, money and which are not taxed. Other benefits for dependents, however, may entail more significant expenditures and have to be provided under specific rules in order to not constitute income on which an employee will be taxed.
Dependent care flexible spending accounts (FSAs) and coverage of dependents through health FSAs are among the most common kinds of coverage employers provide employees’ dependents.
These kinds of coverage may seem straightforward. For instance, an employer simply makes it possible for employees to participate in these kinds of FSAs and makes sure employees follow the rules.
But as any employer and plan administrator knows, situations easily can arise that create complications. Questions often concern whether a particular expense is covered, whether a situation is among those for which the IRS allows a participant to make a change of election during the plan year before open enrollment, who exactly can be covered and more.
Following are two examples of questions that can arise and how an employer can address them.
Q. Suppose a dependent care FSA participant has a child who will not behave and the facility that provides the dependent care will no longer allow the child to attend. Can the participant change their election? Does this qualify as a change in status that would allow them to do that?
A. Every time a participant changes dependent care providers he or she can change the dependent care FSA election. A participant in such a situation can make a mid-year change in their dependent care FSA election. It probably can be considered a significant curtailment of coverage with a loss of coverage (as cited in Treasury Regulation (Treas. Reg.) §1.125-4(f)(3)).
The Treas. Reg. §1.125-4(f) election changes do apply to dependent care FSAs (but not health FSAs). In this situation, coverage has been curtailed and lost. It does not matter who was at fault for causing the change.
This situation is akin to Example 5 in the Treasury regulations, which reads as follows:
(i) Employee A is married to Employee B and they have one child, C. Employee A’s employer, M, maintains a calendar year cafeteria plan that allows employees to elect coverage under a dependent care FSA. Child C attends X’s on site child care center at an annual cost of $3,000. Before the beginning of the year, A elects salary reduction contributions of $3,000 during the year to fund coverage under the dependent care FSA for up to $3,000 of reimbursements for the year. Employee A now wants to revoke A’s election of coverage under the dependent care FSA, because A has found a new child care provider.
(ii) The availability of dependent care services from the new child care provider (whether the new provider is a household employee or family member of A or B or a person who is independent of A and B) is a significant change in coverage similar to a benefit package option becoming available. Because the FSA is a dependent care FSA rather than a health FSA, the coverage rules of this section apply and M’s cafeteria plan may permit A to elect to revoke A’s previous election of coverage under the dependent care FSA, and make a corresponding new election to reflect the cost of the new child care provider.
Q. Is a dependent who is married also eligible for coverage under the parents’ FSA? Has this changed since the enactment of the health care reform law?
A. The expansion of coverage for dependent children under the Patient Protection and Affordable Care Act applies regardless of the child’s marital status. A married adult child of an employee whose
employer-provided plan covers that child through age 26 can still be covered even though that child is married. The marital status of the adult child has no relevance regarding whether that adult child still can be covered under the employer’s plan.
In addition, under IRS Notice 2010-38, the spouse of an employee’s adult child can also be covered under the employee’s employer-provided health coverage. However, the tax treatment of the coverage for the employee’s child and the spouse of the employee’s child is different. The employer-provided coverage for the employer’s child is excludable from the employee’s gross income, but the coverage for the adult child’s spouse is includible in the income of the employee. Therefore, the employee will not be taxed on the coverage provided to the employee’s adult child who is age 26 or under — but the employee will be taxed on the coverage provided to the spouse of the employee’s child.
Example. G is married to H, and neither is a dependent of E. G and H have decided not to participate in the health coverage offered by G’s employer, and Employer Y provides health coverage to G and H. G is a child of E within the meaning of dependent (26 U.S.C. §152). Accordingly, and because G will not attain age 27 during the 2010 taxable year, the health coverage and reimbursements for G under Employer Y’s plan are excludible from E’s gross income under tax Code Sections 106 and 105(b) for the period on and after March 30, 2010 through the end of the 2010 taxable year. The fair market value of the coverage for H is includible in E’s gross income for the 2010 taxable year.
The exclusion for employer-provided coverage applies to reimbursements for expenses the employee already paid and to direct employer payments to medical care providers to discharge an obligation of the employee, spouse or dependent.
Note that although a child can still be covered through age 26, the parent whose employer-provided coverage still covers those adult children cannot claim that adult child as a dependent for income tax purposes.