Janet LeTourneau

Can employers now set up cafeteria plans in Puerto Rico? Because of Puerto Rico House Bill (HB 453), which became law in January, 2017, one might think they are well on their way. In fact, the “Labor Transformation and Flexibility Act” (HB 453) included language to amend Section 1032.06 of the Puerto Rico Internal Revenue Code of 2011 which regulates cafeteria plans in Puerto Rico. The bill amended the term “qualified benefits” to now include the flexible benefits authorized by Section 125 of the U.S. Tax Code. However, upon a closer look, this isn’t the case. 

Puerto Rico has its own income tax code and, as amended in 2004, added employer-sponsored flexible benefit plans. Puerto Rico Treasury Circular letter number 04-07 states that qualified benefits are contributions of an employer to group life insurance, employee health or accident group plans, and dependent care assistance plans, plus group life insurance under $50,000 of coverage. However, the term “flexible benefit plan” does not include a plan that provides for deferred compensation.

Employee benefit contributions made with pretax contributions, as well as paid vacation days purchased by the employee, will be treated as cash under the Puerto Rico tax code. That means FICA will be paid on those contributions. Even with the passage of HB 453, in order to treat Puerto Rico cafeteria plans as a U.S. cafeteria plan, amendments to the U.S. Code are needed. The FICA tax exemption on employee contributions to a U.S. Code Section 125 cafeteria plan do not necessarily apply to a Puerto Rico Code cafeteria plan.

Clarification is still needed to ensure that employee contributions can be exempt from FICA. In addition, Puerto Rico will need to resurrect the qualification process for plans. The qualification process requires employers to submit their cafeteria plan to a government office, with a specific filing fee, to have it qualified prior to establishing the plan for employees. So far, there’s no direction on where employers would submit such plans, how much the filing fee is and what the process is for qualification. As a result, in practice, there aren’t yet cafeteria plans in Puerto Rico.

No information contained herein is intended to be legal, accounting or other professional advice. We assume no liability whatsoever in connection with your use or reliance upon this information. This information does not address specific situations. If you have questions about your specific situation, we recommend that you obtain independent professional advice.

As benefits administration becomes more and more complicated, compliance is on everyone’s to-do list. In the compliance world of never-ending change, the following is a refresher course for employers on just two compliance requirements for Internal Revenue Code section 125 cafeteria plans that haven’t changed – nondiscrimination testing and Form 5500 filing obligations.

What are the Nondiscrimination Tests?
The overall “25% Concentration test” compares all the pre-tax benefits elected by key employees with all the pre-tax benefits elected by non-key employees. Not more than 25 percent of the total benefits elected by all employees may be attributed to key employees.

Here’s an example. All elections to the cafeteria plan add up to $35,000. Of those total elections, key employee elections equal $5,000. Key employee elections are about 14 percent of the total elections to the plan ($5,000/$35,000). In this example, the FSA plan passes the 25 percent Concentration test.

The “55% Average Benefits test” involves just the dependent care portion of the cafeteria plan. The average dollar amount of benefits elected by non-highly compensated employees must be at least 55 percent of the average dollar amount of benefits elected by highly compensated employees.

In this example, let’s assume that highly compensated employees’ elections are $10,000 to the dependent care portion of the plan and there are five highly compensated employees in the company. Non-highly compensated employees elect $19,500 to the dependent care portion of the plan and there are 13 non-highly compensated employees. The highly compensated average dollar amount is $2,000 ($10,000/5). The non-highly compensated average dollar amount is $1,500 ($19,500/13). The average dollar amount of benefits elected by non-highly compensated employees is 75 percent of the average dollar amount of benefits elected by highly compensated employees ($1,500/$2,000). In this example, the dependent portion of the FSA plan passes the 55% Average Benefits test.

The “25% Owner test” compares the dependent care benefits elected by more-than-five-percent owners of a company with dependent care benefits elected by non-owners. Not more than 25 percent of the total dependent care benefits elected by everyone in the dependent care benefit may be attributed to more-than-five-percent owners.

An example of this test would consist of a $5,000 election to the dependent care portion of the plan by a more-than-five-percent owner and elections in the amount of $19,500 made by all non-owners. The more-than-five-percent owner’s election is 20 percent of the total benefits elected to the dependent care portion of the plan ($5,000 + $19,500 = $24,500)($5,000/$24,500). In this example, the dependent care portion of the plan passes the 25% Owner test because only 20 percent of the dependent care benefits were elected by the more-than-five-percent owner.

Eligibility, benefits available, and contribution and benefits tests. These tests ensure that employers offer all benefits to an adequate number of employees and benefits do not discriminate in favor of highly compensated or key employees.

In the event the cafeteria plan does not meet all the nondiscrimination requirements, employers may need to change benefit elections and payroll amounts to bring the plan into compliance. And, it is important to test prior to the end of the cafeteria plan year. If testing is completed after the end of the plan year, it’s too late to take corrective action. Instead of reducing key or highly compensated elections in order to pass the nondiscrimination test(s), the affected employees would be taxed on their total election amount.  

Form 5500 Obligation
A frequently overlooked responsibility for cafeteria plan sponsors is Form 5500 filings under certain circumstances. The IRS Notice 2002-24 suspended the filing requirement imposed on cafeteria and fringe benefit plans in 2002. However, don’t be misled! The filing requirement for welfare benefit plans remains unchanged.

What is a welfare benefit plan?
Welfare benefit plans provide benefits such as medical, dental, life insurance, apprenticeship and training, scholarship funds, severance pay, and disability. Healthcare Flexible Spending Accounts (FSAs) contained inside cafeteria plans and Health Reimbursement Arrangements (HRAs) qualify as welfare benefit plans.

Who must file a Form 5500?
Employers that sponsor welfare benefit plans covered by Title I of the Employee Retirement Income Security Act (ERISA), with 100 or more participants at the beginning of the plan year, are required to file a Form 5500 for those plans. However there are a couple of exceptions that apply, depending on the type of employer sponsoring the plan. A general exception applies to:

• A governmental plan; or,
• A church plan under ERISA section 3(33).

The plan may not be exempt from filing if: 

• It is deemed to have plan assets; 
• Plan funds are separated from the employer’s general assets; 
• Plan funds are held in trust; or, 
• Plan funds are forwarded to a Third Party Administrator.

Most non-exempt employer plans will complete all questions on Form 5500. Depending on the funding arrangement or payments from the plan, attaching schedules may be applicable.

However, since 2009, the “Instructions for Form 5500” were modified to make clear that plans with claims paid from the general assets of the employer need not file Schedule C.

When does a welfare benefit need to file a Form 5500?
Forms must be filed by the last day of the seventh calendar month after the end of the plan year. A plan may obtain a one-time extension of time to file. Form 5558 must be sent by the original due date in order to gain a two-and-one-half month extension of time in which to complete and file the Form 5500.

Compliance becomes clearer for employers through knowledge. It’s as easy as suggesting they contact their plan administrators or their own accounting or legal sources for more information and guidance.

No information contained herein is intended to be legal, accounting or other professional advice. We assume no liability whatsoever in connection with your use or reliance upon this information. This information does not address specific situations. If you have questions about your specific situation, we recommend that you obtain independent professional advice.

In a quandary about owners and key employees who can’t fully participate in employer cafeteria plans? Cafeteria plan nondiscrimination tests sometimes prohibit owners and key employees from participating in these plans. 

I’ve been asked over and over how to maximize non-taxable benefits to owners and key and highly compensated employees. The solution may be as simple as a SIMPLE cafeteria plan. This type of cafeteria plan is simple for employers to establish and maintain.

With a SIMPLE cafeteria plan, employers can skip all the applicable nondiscrimination testing requirements associated with today’s cafeteria plans, assuming it:

• Meets certain employer size requirements;
• Passes the SIMPLE plan’s eligibility and participation requirements; and,
• Provides a required contribution.

First I’ll discuss what constitutes an eligible employer and then move on to the eligibility, participation, and contribution requirements. Then, as we go through some examples, you may see how C-Corporations can provide additional non-taxable benefits to owners and key employees. A SIMPLE plan will be a snap for some of your employers. Let’s look at the facts.

Eligible Employer
SIMPLE plans are for “small” employers. This means employers who employed 100 or fewer employees during either of the two preceding years. If employers have not been in existence for two years, they base their calculations on the average number of employees reasonably expected to be employed on business days in the current year. Employers are required to have a working payroll that fits around their potential employees. Some small employers find that with the help of One Click Accountant or a similar accounting service they will need to be aware of the type of employees they will need for their business.

Employers must count employees under common ownership rules, part-time and seasonal employees, and leased employees.

Eligible employers that grow to more than 100 employees after establishing a SIMPLE plan can retain their eligibility to maintain the plan until they employ an average of 200 or more employees on business days during the year. That doesn’t mean they have to abandon their SIMPLE plan in the middle of a plan year. They can finish out the current plan year, but then must revert to a regular cafeteria plan-with nondiscrimination testing-starting with the subsequent plan year.

Although regulations prohibit a sole proprietor, partner in a partnership, member of an LLC (in most cases), or individuals owning more than two percent of an S-Corporation from participating in a cafeteria plan, they may still sponsor a SIMPLE plan. These “owner/employees” still benefit from the savings on payroll taxes and, in some cases, workers’ compensation premiums. Also, these types of entities may have key or highly-compensated employees that can benefit from a SIMPLE plan. Shareholders of regular C-Corporations may participate in the SIMPLE cafeteria plan.

Eligibility and Participation Rule
SIMPLE plans must allow all employees with at least 1,000 hours of service for the preceding year to participate in the plan and each eligible employee must have the right to elect any benefit offered under the plan. 

There are some employees that may be omitted from participating in the plan. Those that are under the age of 21, less than one year of service, covered by a collective bargaining agreement, or nonresident aliens working outside of the United States.

Required Employer Contributions
Required employer contributions can be delivered through the plan by one of two methods.

Non-Elective:
Provide an amount equal to a uniform percentage of not less than two percent of employees’ compensation for the plan year. This amount is made available to all eligible employees, even if they do not make any salary deductions.

Matching:
Contributions may be the lesser of twice the amount of employees’ salary reductions or 6 percent of employees’ compensation for the plan year.

Employer contributions must be available to be used for any qualified benefit offered through the plan, but cash need not be offered for these required employer contributions. The employer contributions cannot be made to highly-compensated or key employees at a greater rate than to the rank and file employees.

Non-Discrimination Tests
What does all this “buy” the employer? In addition to some serious payroll tax savings, there’s no more complicated and confusing nondiscrimination testing associated with offering a cafeteria plan. 

The tests avoided include four tests for the healthcare flexible spending account (FSA) and four tests for the dependent care account; plus the cafeteria plan code section carries another three tests that employers are obliged to complete and pass every plan year. The employer may also have to make adjustments to elections if one or more nondiscrimination test fails.

Two of the tests that are failed more often than any others are the dependent care 55 percent Concentration Test and the overall 25 percent Concentration Test that includes all benefits incorporated into the cafeteria plan. Let’s work through one example to see how the 25 percent Concentration Test works and how the implementation of a SIMPLE cafeteria plan can benefit owners and key employees.

In the example below there are two owners and nine other employees. The owners elect $19,600 and six (NHC) employees elect $26,000 salary reductions to the plan. These amounts include premiums for employer-provided health coverage, dependent care, and healthcare FSA.

This scenario would not pass the 25 percent Concentration Test. $19,600 divided by $45,600 equals 43 percent of total benefits going to key employees. In order to pass, the owners would have to reduce their elections to about $8,700. One owner would lose the $5,000 pretax benefit from the dependent care portion of the plan because the plan would not pass all the dependent care nondiscrimination tests.

By establishing a SIMPLE cafeteria plan, employers need not perform any discrimination tests and the owners could take advantage of substantial employer contributions. 

Table 1 illustrates the contribution options this employer may pursue. In this example the employer could choose between contributing two percent of compensation to the SIMPLE plan for all eligible employees, or contributing an amount equal to six percent of compensation for participating employees. 

In addition, this employer previously paid 50 percent of the group health insurance premiums. Employer contributions to the SIMPLE cafeteria plan will take the place of employer group health insurance premiums in the amount of $27,600.

And don’t forget-if participants don’t spend all their money, it can be forfeited back to the employer to offset administrative expenses. By forfeiting unused contributions, the employer’s net costs could be reduced further.

This employer could make a contribution to the plan of six percent of compensation and provide the two owners with $24,000 and the six non-highly compensated employees $18,000. The employer was previously paying $27,600 for health insurance premiums. Their outlay, considering the premiums they used to pay, would be $14,400, and that is not taking into consideration the FICA savings. For a cost of $14,400, $24,000 goes directly to them.

It’s All in the Numbers
For small or family-owned C-Corporation businesses, a SIMPLE cafeteria plan may be just the ticket to maximize benefits to owners and key employees. For larger companies, it may make sense to establish a SIMPLE plan in order to pass all the nondiscrimination tests and preserve non-taxable benefits to owners and key and highly-compensated employees.

The information contained in this article is not intended to be legal, accounting, or other professional advice. We assume no liability whatsoever in connection with its use, nor are these comments directed to specific situations.

On Wednesday, December 20, 2017, the Tax Cuts and Jobs Act (H.R.1) (the Bill), which overhauls America’s tax code to deliver historic tax relief for workers, families, and job creators, was passed by both the House and Senate.  The Bill was signed into law by President Donald Trump December 22, 2017. This legislation provides the most sweeping changes to the U.S. Tax Code since 1986.

Although the Bill contains numerous changes, this alert will delve into just the changes that affect consumer directed benefit accounts.

1. Transit and parking (commuter) programs: Only the employer’s deductibility of costs for these plans has changed. Industry-standard, pre-tax benefits for transit and parking programs for employees is still both available and tax-free. The only change is that employers can no longer deduct costs for subsidized or paid commuter benefits. The impact to the employer is the cost multiplied by the new lower corporate tax rate minus FICA savings. 

Here’s the impact:

Today, I get paid $5,000 and salary reduced $500 (between transit and parking). Employers get a wage deduction for $4,500 plus a deduction for qualified transportation of $500. They additionally save FICA taxes on the salary reduction amount. The amounts are tax free to the employee. 

As of January 1, I get paid $5,000 and salary reduce $500 (between transit and parking). Employers get a wage deduction for $4,500 but they lose the deduction for qualified transportation of $500. The impact to employers, however, is likely de minimis as they are now paying the new lower corporate tax rate. They still save FICA taxes on the salary reduction amount. The amounts are tax free to the employee. 

2. Qualified bicycle reimbursement program: The qualified bicycle reimbursement program was a tax-free reimbursement of bicycle expenses which was suspended by the Bill through 2025. Therefore, employers continuing to offer bicycle reimbursement programs must begin on January 1, 2018, and until further notice, to reimburse employees for bicycle expenses on a taxable basis. That means employees will now have employer reimbursement of bicycle benefits added to their taxable income. The employer will be liable for the matching FICA on these reimbursements and can write off the wage expenses as with any other taxable compensation.

3. Health Savings Accounts (HSAs): The Bill makes no changes to the tax treatment of Health Savings Accounts.

4. Healthcare flexible spending accounts (FSAs): The Bill makes no changes to the tax treatment of Healthcare FSAs. They continue to be tax-free.

5. Dependent care and adoption assistance programs: The Bill makes no changes to the tax treatment of Dependent Care FSAs or Adoption Assistance Accounts or programs. It also keeps in place the adoption tax credit.

6. Educational assistance programs: The Bill makes no changes to the tax treatment of Employer-provided educational assistance programs.

7. Employer provided healthcare: The Bill makes no changes to the tax treatment of employer-provided healthcare benefits. They continue to be tax-free.

8. Corporate tax rate: Lowers the corporate tax rate to 21 percent beginning January 1, 2018.

9. Chain CPI: The Bill changes the Consumer Price Index (CPI) used for many benefit and tax inflationary adjustments, such as transit and parking monthly limits, Healthcare FSA and Health Savings Account amounts, among others. The new index is referred to as Chain CPI (C-CPI-U) and like the CPI-U, is a measure of the average change over time in prices paid by urban consumers. It is developed and published by the Department of Labor, but differs from the CPI-U in accounting for the ability of individuals to alter their consumption patterns in response to relative price changes. The C-CPI-U accomplishes this by allowing for consumer substitution between item categories in the market basket of consumer goods and services that make up the index, while the CPI-U only allows for modest substitution within item categories.

The information contained in this article is not intended to be legal, accounting, or other professional advice. We assume no liability whatsoever in connection with its use, nor are these comments directed to specific situations.

On October 31, 2017, the Internal Revenue Service (IRS) and the Department of the Treasury issued Notice 2017-67 effective for plan years beginning on or after November 20, 2017. The notice, published in a Q&A format, includes 79 questions, covering several topics, with the applicable answers involving additional requirements for valid small employers offering Qualified Small Employer Health Reimbursement Arrangements (QSEHRAs). See my column in the April 2017 issue on QSEHRAs for background information.

Due to the breadth of Notice 2017-67, this column is the second of two—covering Q&As 35 thru 79.

Internal Revenue Code Section 9831(d) provides the foundation for QSEHRAs, while these Q&As afford additional definitions and guidance on:

• Written notice, minimum essential coverage (MEC), and Proof of MEC requirements;
• Substantiation, reimbursement, and reporting requirements;
• Coordination with the Premium Tax Credit;
• Consequences of failure to satisfy the requirements of a QSEHRA; and,
• Interaction with Health Savings Accounts (HSAs).

Notice Requirements, Minimum Essential Coverage (MEC) Requirement, and Proof of MEC (Q&A 35-43)

• Employers offering a QSEHRA must provide written notice to each eligible employee at least 90 days before the beginning of each plan year or the date on which the individual first becomes eligible to participate in the QSEHRA.
• There are special transition notice rules for 2017 and 2018, and the first written employee notice must be issued no later than February 19, 2018, or 90 days before the first day of the plan year.
• Notices may be provided electronically and must contain the following information: (1) the amount available under the arrangement; (2) a statement that the employee must inform any Marketplace to which he or she applies for an advance premium tax credit of the amount of the benefit available under the arrangement; and (3) a statement that if the employee does not have MEC he or she may be liable for a payment under the employee mandate.
• The sponsoring employer need not directly provide information to a Marketplace concerning their QSEHRA.
• Employees must provide annual proof of MEC prior to an employer reimbursing any expense. The proof can be either a document from a third party, such as the insurer, or an attestation by the employee.
• Notably, the employee must attest to MEC coverage with each new request for reimbursement, even in the same plan year. See Appendix B of this notice for a sample attestation.
• Payments made from a QSEHRA are includible in income for the month in which they are provided if the employee does not maintain MEC for the month in which the charges were incurred or reimbursed. Eligibility is determined on a month-by-month basis throughout the plan year.
• And, the QSEHRA may not routinely reimburse an eligible employee on an after-tax basis—with a couple of exceptions. Those being over-the-counter drugs purchased without a prescription and reimbursement of premiums paid on a pre-tax basis for a spouse’s health plan.

Substantiation, Reimbursement, and Reporting Requirements (Q&A 44-64)

• All claims for reimbursement must be substantiated.
• The notice provides for detailed rules concerning the tax consequences of reimbursement absent substantiation.
• If permitted by the plan, over-the-counter drugs purchased without a prescription may be reimbursed but are taxable to the eligible employee.
• The employer may provide for eligible employees to pay the excess of a health insurance premium, over the amount paid by the QSEHRA, with after-tax payroll deductions as long the employer does not endorse the insurance product. See Q&A 55
• Very significantly, if a QSEHRA operationally  or even mistakenly reimburses an eligible employee’s expense without first receiving substantiation, all payments to all employees under the arrangement —whether or not those payments were substantiated—made on or after the date of mistaken reimbursement become taxable.  The same rule applies for mistaken reimbursements of non-medical expenses. 
• No cash-out of unused permitted benefits may be returned to eligible employees.
• The notice provides detailed rules for how the reimbursement of medical expenses of the employee and the employee’s family are treated for tax purposes.
• QSEHRAs may make reimbursements ratably on a month-by-month basis. However, no deductible or other cost-sharing requirements that must be met can be imposed and medical expenses incurred before the eligible employee is provided QSEHRA coverage may not be reimbursed.
• Self-employed taxpayers will not be allowed a deduction under IRC Section 162(I) when the self-employed taxpayer, for any month, is eligible to participate in any subsidized health plan or QSEHRA maintained by any employer of the taxpayer or the taxpayer’s family members.
• In general, if all of the rules are followed, reimbursements are excluded from taxation.
• Generally, QSEHRA amounts (i.e., permitted benefits) must be reported in Box 12 of an employee’s Form W-2 using code FF.
• The notice provides rules on reporting and calculation of the amounts to be reported. See Q&A 58, 59, 60, 61, 62, 63, and 64.
• The notice clarifies that QSEHRAs should not be reported using a Form 1095-B (used for reporting health coverage offered by an employer).
• The QSEHRA is an applicable self-insured health plan and is subject to the Patient-Center Outcomes Research (PCOR) fee for plans ending before September 30, 2019.

Coordination with the Premium Tax Credit (Q&A 65-71)

• The notice provides detailed rules for how to calculate the amount of Premium Tax Credit for individuals who participate in a QSEHRA. See Q&A 65, 66, 67, 68, 69, 70, and 71.
• Generally, participation in a QSEHRA reduces the amount of Premium Tax Credit for which an individual qualifies. 

Failure to Satisfy the Notice’s Requirements (Q&A 72-78)
If an arrangement fails to meet the requirements of a QSEHRA, it will generally be considered a group health plan subject to all of the requirements of such plans, including the Affordable Care Act requirements, and will be subject to an excise tax of $100 per person per day for any violations of the group health plan requirements. Those violations include the prohibition against annual and lifetime limits. Plus the QSEHRA would not be integrated with a group health plan. In addition to the excise tax, all amounts paid under the arrangement are included in every employee’s gross income and wages.

Interaction with Health Savings Accounts (HSAs)

• An individual in a QSEHRA does not fail to be eligible to contribute to an HSA if the QSEHRA only reimburses expenses that qualify as permitted insurance or disregarded coverage under IRC section 223(c) in addition to premiums for health insurance policies. Note: Employer reimbursement or payment of individually-owned health insurance policy premiums may not be allowed in your state. Please check with the State Insurance Commissioner to determine the eligibility of these expenses in a QSEHRA.
• A switch from a group health plan, during the calendar year, to a program including an individual high-deductible health plan (HDHP) and a QSEHRA may take into account, for purposes of the HDHP’s deductible, the unreimbursed medical expenses incurred by the employee while covered under the group health plan before termination.

The notice provides a comprehensive list of types of MEC, a model attestation for initial proof of MEC, language for a reimbursement form, plus a wealth of details and examples to further assist in answering your questions about QSEHRAs. Please refer to the notice for in-depth guidance.

WageWorks will continue to comment and lobby for even more generous stand-alone HRA guidance in general for both small and large employers.

The information contained in this article is not intended to be legal, accounting, or other professional advice. We assume no liability whatsoever in connection with its use, nor are these comments directed to specific situations.

On October 31, 2017, the Internal Revenue Service (IRS) and the Department of the Treasury issued Notice 2017-67 effective for plan years beginning on or after November 20, 2017. The notice, published in a Q&A format, includes 79 questions covering several topics with the applicable answers involving additional requirements for valid small employers offering Qualified Small Employer Health Reimbursement Arrangements (QSEHRAs). See my column in April 2017 on QSEHRAs for background information.

Due to the breadth of Notice 2017-67 this column is the first of two covering Q&As one through 34.    

Internal Revenue Code Section 9831(d) provides the foundation for QSEHRAs, while these Q&As afford additional definitions and guidance on:

• Eligible employers and employees;
• Same terms requirement for offering a QSEHRA; and,
• Statutory dollar limits.

Eligible Employers and Employees (Q&A 1–11)

• The notice makes clear that an eligible employer may not offer any group health plans, on any day of any month, (including another HRA, a healthcare flexible spending arrangement (FSA), or a plan consisting entirely of excepted benefits such as vision and dental plans) to its employees if it wishes to utilize the QSEHRA.  However, both employers and employees may contribute to health savings accounts (HSAs) through a cafeteria plan and remain eligible for QSEHRAs.
• Relatedly, an employer may not provide employees with continued access to amounts accumulated in an HRA in prior years or carryover amounts from an FSA. However, the employer may suspend access to amounts in the HRA during the period of QSEHRA coverage.
• Eligible employers may, however, offer a group health plan to former employees, including retirees.
• As with the employer mandate, employers that are members of a controlled group under Code section 414(b), (c), (m), or (o) are treated as a single employer for purposes of the QSEHRA requirements. One employer of a controlled group may not offer group health insurance and expect the remaining employers to remain a QSEHRA eligible employer. An eligible employer has fewer than 50 full-time or full-time equivalent employees.
• An eligible employer that employs 50 or more full-time employees during the current year becomes ineligible to sponsor a QSEHRA as of January 1 of the following year.
• The notice distinctly points out that all employees of an eligible employer are eligible employees. If a QSEHRA is offered, all eligible employees must be offered the QSEHRA.
• Employers are permitted, however, to exclude certain employees, including:
  
  • Employees who have not completed 90 days of service with the employer;
  • Employees under the age of 25;
  • Part-time or seasonal employees. Generally part-time employee whose customary weekly employment is less than 35 hours and seasonal employees whose customary annual employment is less than nine months. (IRC section 1.105-11(c)(2)(iii)(C)); and,
  • Employees covered under certain collective bargaining agreements.
• A previously excluded employee who becomes eligible must be provided a QSEHRA no later than the day immediately following the date the employee is no longer excludable under the terms of the plan.
• QSEHRAs may not be offered to non-employee owners, such as a more-than two percent shareholder of an S-Corp.
• Very important, employers may not permit eligible employees to waive participation in a QSEHRA.

Same Terms Requirements (Q&A 12–26)

• A QSEHRA must be provided on the same terms to all eligible employees of the eligible employer, including all employees of employers in a controlled group.
• For purposes of this rule, the maximum amount available under a QSEHRA may vary between employees only based on (i) age or (ii) the “number of individuals covered,” and only in accordance with the variation in the price of a baseline insurance policy in a relevant individual health insurance market. The baseline policy must be the same for all eligible employees, and may be any minimum essential coverage (MEC), as defined in section 5000A(f), policy available for purchase by at least one eligible employee. (See Appendix A at the bottom of this notice for a list of examples of plans and arrangements that are MEC.)
• Individuals may be reimbursed different amounts because they submit different expenses.
• The arrangement may provide for the same single dollar amount or the same percentage of the statutory dollar limits, regardless of whether the employee enrolls in self-only or family coverage.
• A QSEHRA provided to two or more eligible employees of the same eligible employer who are in the same family must provide separate benefits to each employee. Thus, for example, if an employer offers a self-only benefit of $3,960 and a family benefit of $8,040, and three members of the same family work for the employer, the employer must reimburse up to $11,880 ($3,960 x 3) even if all three family members are covered under a single insurance policy.
•  QSEHRAs do not have to allow for a change in permitted benefits, for instance from self-only to family QSEHRA limits if the employee changes coverage during the plan year.
• Limits may be established in increments of $50 to the nearest whole dollar that does not exceed the applicable statutory dollar limit.
• Employees generally may not be offered a choice between different QSEHRAs (e.g., one that only reimburses premiums and one that only reimburses non-premium expenses) without violating the same terms requirement.
• QSEHRAs may be limited to insurance premiums, cost-sharing expenses that are medical expenses, or certain other medical expenses specified by the plan if the arrangement is effectively available to all eligible employees. A plan that only reimburses Medicare and Medicaid premiums would not be effectively available to all eligible employees. Note: Employer reimbursement or payment of individually-owned health insurance policy premiums may not be allowed in your state. Please check with the State Insurance Commissioner to determine the eligibility of these expenses in a QSEHRA.
• Amounts may be carried over from year to year without violating the same terms requirement, subject to certain account limit/coordination rules. (See Statutory Dollar Limits (Q&A 27 -34 for carryover limits.)
• If coverage is offered to those employees who may be excluded based on age, length of employment, part-time or seasonal status, or coverage under a collective bargaining agreement, coverage must be the same as that offered to all eligible employees. 

Statutory Dollar Limits (Q&A 27–34)

• Amounts in a QSEHRA are limited by statute to $4,950 for an individual and $10,000 for a family.  However, they are indexed for inflation after 2016. 
• The 2017 amounts are $4,950 for individuals and $10,050 for families; the 2018 amounts are $5,050 for individuals and $10,250 for families.
• For a calendar year QSEHRA, the indexed statutory dollar limits are not expected to be published before mid-October of the preceding year. However, a 90-day notice must be given to all eligible employees prior to the beginning of the plan year. A calendar year QSEHRA may rely on the prior year’s indexed figures when providing the notice and setting limits for the future calendar year plan.
• A QSEHRA may allow for carryover of unused amounts from previous years. However, taking into account both carryover amounts and newly available amounts may not exceed the applicable statutory dollar limit.
  
  • Example: QSEHRA with a permitted benefit of $3,000 that allows the use of carryover amounts from the prior plan year. In year one, the employee received $500 in reimbursements from the QSEHRA for the year, leaving a carryover amount of $2,500. In year two the applicable statutory dollar limit is $5,000. The employee may receive the permitted benefit of $3,000 from the employer plus $2,000 of the $2,500 carried over from year one.
• Newly eligible employees’ statutory dollar limits are prorated to reflect the actual months they are eligible for the QSEHRA, including a full month if the employee is eligible on any day of that month.
• Eligible employees may receive reimbursements equal to the dollar limit, but later terminate employment midyear and would not be considered covered by the entire plan year. If the reimbursements prior to his termination were not in excess of the annual limit, but were in excess of the prorated amount for the year, the dollar limit received is not taxable.
• But, for expenses incurred before termination, and submitted during a run-out period after termination of employment, the QSEHRA may not reimburse medical expenses in excess of the prorated statutory dollar limit. Extended periods following the plan year end for claims incurred during the plan year to be submitted for reimbursement are permissible.
• Amounts under a QSEHRA offered for a short plan are prorated for the number of months the QSEHRA is provided.
• QSEHRAs provided by different employers to one eligible employee may each reimburse the statutory dollar limit.
• There are special rules for non-calendar year plans, such as prorating dollar limits for each portion of the taxable year or utilizing the limit in place at the beginning of a non-calendar plan year for the entire 12-month plan year.
• A mistaken reimbursement must be paid back with after-tax funds before March 15 of the year following the year in which the excess reimbursement was made, or in the case of an eligible employer whose federal income tax return is under examination for the taxable year during which the excess reimbursement was made, the date the eligible employer receives written notification from the examining agent(s) specifically citing the excess reimbursement as an issue under consideration.

My next column will cover: 

• Written notice, minimum essential coverage (MEC), and Proof of MEC requirements.
• Substantiation, reimbursement, and reporting requirements.
• Coordination with the Premium Tax Credit.
• Consequences of failure to satisfy the requirements of a QSEHRA, and Interaction with Health Savings Accounts (HSAs).

WageWorks will comment and lobby for even more generous stand-alone HRA guidance in general for both small and large employers.

The information contained in this article is not intended to be legal, accounting, or other professional advice. We assume no liability whatsoever in connection with its use, nor are these comments directed to specific situations.

The Internal Revenue Service (IRS) and Social Security Administration have released the cost-of-living (COLA) and inflation adjustments that apply to dollar limitations set forth in certain IRS Code Sections. The Consumer Price Index was 2.0 percent and therefore warranted increases in most indexed figures for 2018.

Social Security and Medicare Wage Base
For 2018, the Social Security wage base is $128,700. The Social Security rate of 6.2 percent is applied to wages up to the maximum taxable amount for the year; the Medicare portion of 1.45 percent applies to all wages.

In addition, individuals are liable for a 0.9 percent “Additional Medicare Tax” on all wages exceeding specific threshold amounts. 

Indexed Compensation Levels
Highly compensated and key employee definitions (shown in the table).

401(k) Plans
"In 2018 the maximum for elective deferrals is $18,500 and the catch-up contribution for those 50 or older is $6,000. That means if you are age 50 or over during the 2018 taxable year, you may generally defer up to $24,500 into your 401(k) plan.

Healthcare FSA
The annual limit for participant salary reductions for the healthcare flexible spending account (FSA) for plan years starting on or after January 1, 2018, may not exceed $2,650. However, this does not preclude employer contributions (as long as they are not convertible to cash) from being added to participants’ healthcare FSAs.

Adoption Credit
For 2018 this tax credit is $13,840. The credit starts to phase out at $207,580 of modified adjusted gross income (AGI) levels, and is completely phased out when modified AGI reaches $247,580.

The exclusion from income provided through an employer or a Section 125 cafeteria plan for adoption assistance also has a $13,840 limit for the 2018 taxable year. And remember—a participant may take the exclusion from income and the tax credit if enough expenses are incurred to support both programs separately.

Health Savings Account (HSA)
Minimum deductible amounts for the qualifying high-deductible health plan (HDHP) rose to $1,350 for self-only coverage and $2,700 for family coverage for 2018. Maximums for the HDHP out-of-pocket expenses also increased to $6,650 for self-only coverage and $13,300 for family coverage for 2018.

Maximum contribution levels to an HSA for 2018 are increased to $3,450 for self-only coverage and $6,900 for family coverage. The catch-up contribution allowed for those 55 and over is set at $1,000 for 2018. Remember, there are two requirements in order to fund an HSA: You must have qualifying HDHP coverage and no other impermissible coverage (such as coverage under another employer’s plan or from a healthcare FSA that is not specifically compatible with an HSA).

Archer Medical Savings Account (MSA)
For high-deductible insurance plans that provide self-only coverage, the annual deductible amount must be at least $2,300 but not more than $3,450 for 2018. Total out-of-pocket expenses under plans that provide self-only coverage cannot exceed $4,600. For plans that provide family coverage in 2018, the annual deductible amount must be at least $4,600 but not more than $6,850, with out-of-pocket expenses that do not exceed $8,400.

Although new MSAs are not allowed, maximum contributions to existing MSAs that are attributable to single-coverage plans is 65 percent of the deductible amount. Maximum contributions for family-coverage plans are limited to 75 percent of the deductible amount. MSA contributions must be coordinated with any HSA contributions for the taxable year and cannot exceed the HSA maximums.

Dependent and/or Child Daycare Expenses
Just a reminder that although the daycare expense limit associated with a cafeteria plan is not indexed, the tax credit available through a participant’s tax filing was raised in 2003. The daycare credit must be filed on Form 2441 and attached to the 1040 tax filing form. Limits for daycare credit expenses are $3,000 of expenses covering one child and $6,000 for families with two or more children. If one of the parents is going to school full time or is incapable of self-care, the non-working spouse would be “deemed” as earning $250 per month for one qualifying child and $500 for two or more qualifying children. This “deemed” earned income is used whether a person is using the employer’s cafeteria plan or taking the daycare credit.

The cafeteria plan daycare contribution limit is $5,000 for a married couple filing a joint return, or for a participant filing a single return, or filing as “Head of Household.” For a married couple filing separate returns, the limit is $2,500 each. The daycare credit is reduced dollar for dollar by contributions to or benefits received from an employer’s cafeteria plan. An employee may participate in their employer’s cafeteria plan and take a portion of the daycare expenses through the credit if they have sufficient expenses in excess of their cafeteria plan annual election, but within the tax credit limits. 

Commuter Accounts
For 2018 the monthly parking limit is $260 and the 2018 monthly limit for transit also increases to $260.

Long Term Care
For a qualified long term care insurance policy, the maximum non-taxable payment remains the same at $360 per day for 2018.

Finally, by participating in a cafeteria plan, the participant will be lowering their income for the Earned Income Tax Credit (EITC). Check out the new limits in IRS Publication 596 “Earned Income Credit” and for more information about this tax credit. 

The information contained in this article is not intended to be legal, accounting, or other professional advice. We assume no liability whatsoever in connection with its use, nor are these comments directed to specific situations.

Dependent care regulations, effective August 14, 2007, regarding the dependent care tax credit are still relevant today. This is a refresher course of basics and clarifications issued by the Internal Revenue Service (IRS).

The dependent care credit is a nonrefundable tax break which is a percentage of eligible daycare expenses incurred in order for the taxpayer (and spouse, if married) to be gainfully employed. For incomes below $15,000, the tax credit is 35 percent of eligible expenses, ratably decreased to 20 percent when the household income exceeds $43,000. 

Now is a good time for employers and employees to review the rules for the dependent care credit, dependent care flexible spending accounts (FSAs), and point out the clarifications contained within the guidance. Incorporated in this article are basic facts surrounding dependent care rules and limits. These regulations are specifically for the tax credit available under IRC Section 21, but shed a lot of light on eligible expenses for dependent care FSAs. 

Qualifying Person
Expenses must be incurred for a qualifying person, such as the taxpayer’s dependent child who has not attained age 13. A qualifying person can also be the taxpayer’s spouse, dependent, or qualifying relative provided they are physically or mentally incapable of self-care and have the same principal residence as the taxpayer for more than half the year.

If the child turns 13 during the year, the full credit may still be taken, but only for expenses incurred prior to them turning age 13. And if services are provided outside of a taxpayer’s home, the dependent must spend at least eight hours per day in the taxpayer’s home.

Earned Income
Expenses qualifying for the credit may not exceed:

1. A single taxpayer’s earned income for the taxable year; or,
2. For a married taxpayer, the taxpayer’s earned income or the spouse’s earned income, whichever is less.

If the spouse is a full-time student or incapable of self-care, they are considered to have “deemed” earned income. The amount of “deemed” earned income is $250 per month if the household contains one dependent and $500 per month for two or more dependents. 

A “full-time” student is an individual who is enrolled at and attends a school or educational institution during each of any five calendar months (need not be consecutive) of the taxable year. The definition of “school” includes technical, trade and mechanical schools, but does not include on-the-job training, or correspondence or internet schooling. The number of credit hours taken must be considered to be a full-time course of study and cannot be taken exclusively at night. 

“Deemed” earned income may be attributable to only one spouse. As a result, under certain circumstances, the credit may not be available to particular households. An example would be if one spouse is incapable of self-care and the other spouse is attending school full time. Taxpayers may, however, be able to include nontaxable combat pay as earned income.

Work-Related Expenses
The taxpayer must be gainfully employed or actively seeking gainful employment in order to take advantage of this tax break. Employment can be inside or outside the house and includes self-employment. Work as a volunteer or for nominal consideration is not considered gainful employment.

Expenses for dependent daycare must be allocated on a daily basis. However, for administrative convenience, short or temporary absences from work may be disregarded. A minor illness or vacation is construed to be temporary for taxpayers who must pay dependent care expenses on a weekly basis. And each case is determined based on all the facts and circumstances. For instance, a four-month absence from work because of illness would not be considered short or temporary.

An example of this rule involves a part-time employee who works three days per week and pays their daycare provider on a weekly basis. Generally, part-time employees must allocate expenses for care between days worked and days not worked. However, if they are required to pay daycare expenses on a periodic basis like weekly or monthly, no allocation is necessary because the payment includes days worked and not worked. 

In the above example, if the daycare provider charges on either a three-days-per-week or five-days-per-week scale, then this participant could not count the other two days because a fee structure is available for paying the daycare provider a three-day fee.

The IRS also reasoned that a day on which the taxpayer works at least one hour is a day of work.

• Nursery school expenses qualify for the dependent care credit, although some or all of the expenses may be educational.
• Food, lodging and clothing are generally not considered for the care of a qualified individual and therefore cannot be used toward the tax credit. However, if these expenses are incidental to and inseparably a part of the care of a qualifying individual, the entire amount of the expense is deemed to be for care.
• Kindergarten expenses are considered educational and not allowed as an expense for the tax credit. But expenses for care provided before and after school may be applied toward eligible expenses.
• Day camp expenses are acceptable for qualified individuals even if the camp specializes in a particular activity like music or soccer.
• Overnight camp is not considered work related. Expenses, even prorated, that are paid for an overnight camp may not be taken into account as eligible expenses for the tax credit.
• Medical expenses may not be regarded as daycare expenses. For example, the expenses incurred by a taxpayer may not be used as both medical and daycare expenses for tax return purposes.
• Transportation to a day camp or to an after-school program not on school premises and furnished by a dependent care provider may be eligible daycare expenses if all other applicable requirements are satisfied.
• Wages paid for household services may be applied toward the tax credit if their main responsibility is for the care and well-being of a qualified person. If the household services are partly for common household services and partly for the care of a qualified individual, the wages should be allocated appropriately for the daycare tax credit.
• Even the employment taxes paid on behalf of a household services person are considered eligible daycare expenses. However, you can’t include payments for the services of a chauffeur, bartender or gardener—these amenities are not considered “household services.”
• Indirect expenses eligible for the daycare credit may include the cost of a care provider’s room and board, application and agency fees, and deposits if the taxpayer is required to pay the expenses in order to obtain the care. However, forfeited deposits and other payments are not considered for the care of a qualifying individual if the care is not actually provided.
• Although boarding school is generally not an eligible daycare expense, an order to report for duty in the Armed Forces may make some boarding school expenses suitable for the tax credit. The expenses must be allocated between care, education, and other services not constituting care.
• Payments to relatives. Payments to either the taxpayer’s spouse or to a parent of the taxpayer’s child who is not the taxpayer’s spouse do not qualify for the credit. Payments to an individual for whom a deduction on the tax return can be taken or their child under the age of 19 at the close of the taxable year also do not constitute eligible expenses.
• The tax credit may only be claimed by the custodial parent. In other words, only one parent may claim the credit. Although the child may reside with the “non-custodial” parent during the summer and eligible daycare expenses are incurred, the non-custodial parent cannot take the credit for that period of time. This is true even if the non-custodial parent claims the dependency exemption for that child, but the child does not share the same principal residence for the greater portion of the calendar year.

Joint Return Requirement and Dollar Limits

Dependent Care FSAs
Current limits for Dependent Care FSAs fall under the jurisdiction of IRC Section 129. A participant may redirect $5,000 for any taxable year if a joint return is filed with a spouse, or for singles that file as “head of household.” A $2,500 limit applies for those who are married and file separate returns. These dollar limits were initiated by adding IRC Section 129 in 1981, have never been increased, and are used regardless of the number of qualifying dependents.

One more thing—the available tax credit is reduced dollar for dollar by the amount of payments received from the dependent care FSA.

Dependent Care Expense Limits for the Tax Credit
The dollar limits for the tax credit are based on the number of dependents in the household. They are $3,000 for one qualifying dependent and $6,000 for two or more qualifying dependents. 

However, expenses do not have to be equally divided between the two or more dependents. These regulations add an interesting clarification that a taxpayer may apply the limitation for two or more qualifying individuals in unequal proportions. For example, eligible expenses would include those incurred in the amount of $4,000 for one dependent and $2,000 for the remaining dependent.

Provider Identification
Taxpayers must fill out Form 2441 or Schedule 2 and attach to their Form 1040 or 1040A in order to take the credit or if they participate in an employer’s dependent care assistance plan, and taxpayers are warned to maintain adequate records to support the expenses claimed.

The daycare provider must be identified on Form 2441 or Schedule 2 at tax filing time. In order to receive the credit, the taxpayer must provide the name, address and taxpayer identification number of the daycare provider. Failure to procure this information may mean the expenses cannot be used either for the tax credit or dependent care FSA expenses.

Spare no expense! The IRS pointed out that daycare services selected by the taxpayer need not be the most inexpensive. However, we’re looking at a maximum of expenses for the credit to be $3,000 or $6,000 —or $5,000 through a cafeteria plan. So let’s face it, how far is that going to go?

Also, check out IRS Publication 503. It is a terrific resource for all the rules surrounding the tax credit and dependent care expenses.

The information contained in this article is not intended to be legal, accounting, or other professional advice. We assume no liability whatsoever in connection with its use, nor are these comments directed to specific situations.

These days mark a flurry of merger and acquisition activity. Typically the parties focus on tangible assets and monetary figures. However, many concerns surround employees and their benefits such as retirement plans, paid time off accruals, health insurance, and flexible spending accounts. Employees don’t want to lose benefits they’ve earned and funded. Often, aside from job retention, employees’ first concerns when a merger or acquisition is announced center around benefits. 

Fortunately, the IRS agrees with employees. Benefits shouldn’t have to be squandered just because a company has merged with or been purchased in an asset sale by another company. Participants who elected to reduce their salary to contribute to healthcare flexible spending accounts (FSAs) for unreimbursed medical expenses need assurances that their healthcare FSA will be kept whole. This great tax savings for employees is sometimes overlooked in all the details of a merger or acquisition (M&A) transaction. 

Generally, at the time of the merger or acquisition, employee healthcare FSAs fall into two categories: Employees who have money in their accounts, but not enough expenses incurred to draw all the funds; and participants who have received reimbursements in excess of their year-to-date contributions. The IRS uses Revenue Ruling 2002-32 to explain exactly how to transfer those balances to the new employer.

By using specific facts and circumstances within the revenue ruling, the IRS guides the buyer and the seller in an asset sale on continuation of participants’ healthcare FSA coverage when they become the buyer’s employees. However, if the acquisition is a stock sale, benefits continue as is unhindered.

The first example allows for continuation of coverage under the seller’s healthcare FSA with salary redirections made under the buyer’s plan, while the second example illustrates how coverage and salary reductions are handed off to the buyer.

Coverage Continues Under Seller’s Plan
The facts in this company asset sale are as follows:

• The selling company maintains a healthcare FSA plan.
• During the plan year, a buyer acquires a portion of the seller’s assets.
• The seller’s employees are terminated and become the buyer’s employees.

The two parties agree that transferred employees will continue in the seller’s healthcare FSA plan and salary reductions made by the buyer’s new employees for the healthcare FSA will continue as if made under the seller’s plan. The buyer must have an existing healthcare FSA plan or be prepared to adopt a new healthcare FSA plan. Healthcare FSA participants will continue to seek reimbursement from the seller for the remainder of the plan year.

Example: Joe works for Cellar Sales. He made a $1,200 annual election to the healthcare FSA plan that started on January 1st. On July 1st, Joe’s division was sold and he became an employee of Buy Right. Joe has contributed $600 to his healthcare FSA account, but has incurred no medical expenses to date. Prior to Revenue Ruling 2002-32, Joe would have been considered a terminated employee from Cellar Sales and would have either forfeited his $600 or been able to elect COBRA continuation coverage, if applicable.

The seller and buyer agree to have the transferred employees continue to participate in the seller’s healthcare FSA for a specified period – generally through the end of the plan year. Joe’s new paycheck from Buy Right will continue to take his healthcare FSA pre-tax reductions and deposit them into Joe’s Cellar Sales’ healthcare FSA account. Joe will continue to send future claims to Cellar Sales.

The buyer’s new employees are not considered to have lost coverage of the seller’s plan and no COBRA is offered. However, if the seller’s healthcare FSA is not considered an excepted benefit, which occurs when the employer does not offer an ACA-compliant employer-sponsored group health plan or employer contributions to the healthcare FSA exceed $500 or are in excess of the participant’s election, then the employer must offer full COBRA continuation coverage at the beginning of the first day of the new plan year following the current plan year. That’s when former employees would lose coverage after terminating employment—which is a COBRA qualifying event.

As an example, at the start of the new plan year, a COBRA beneficiary can make a new election, and does, for $1,200. The COBRA premium can be 102 percent of the premium, which in this case, would be $102 per month. The participant generally has 18 months of COBRA coverage, unless special circumstances apply. These include the employee’s death, divorce, or entitlement to Medicare and child’s loss of dependent status; which result in a 36-month maximum coverage period.

Coverage is Transferred to Buyer’s Plan
In this scenario, the facts are the same as in scenario one, except the buyer agrees to provide coverage for the new employees. Again, the buyer must have an existing plan or will adopt a new plan with salary reductions starting through the buyer’s payroll account.

The buyer must amend its healthcare FSA plan to provide that transferred employees who elected to participate in the seller’s healthcare FSA become participants in the buyer’s healthcare FSA as of the beginning of the seller’s current plan year at the same level of coverage. The buyer must also amend its healthcare FSA to provide reimbursement for expenses incurred by transferred employees at any time during the seller’s healthcare FSA coverage (even though expenses may have occurred prior to the sale). 

Here, the buyer agrees to adopt a continuation of the seller’s plan. The buyer “steps into the shoes” of the seller for purposes of the healthcare FSA plan. When the buyer assumes sponsorship of the cafeteria plan covering the employees of the seller, elections under the plan continue because there is no allowable change in status that would permit a change in the election.

All affected plan participants’ accounts consisting of contributions and earlier reimbursements are transferred to the new employer. Participants will request reimbursement for expenses incurred either before or after the acquisition from their new employer. The participants enjoy uninterrupted coverage.

Example: Let’s look at Joe again with a different set of facts and circumstances. Although Joe has contributed $600 to Cellar Sales’ healthcare FSA plan, his balance will be transferred to his new employer. Thus, instead of sending his claims to Cellar Sales, he will turn in claims to his new employer Buy Right.

Even if Joe incurred eligible expenses in March of the plan year, his claim would be submitted to Buy Right and reimbursed from Buy Right’s healthcare FSA plan—because his account balance was transferred to the new company.

Additional Rules
Transferring the participants’ accounts means just that. Unless the participant has a valid change of status, no midyear election changes are allowed because of the merger or acquisition. However, keep in mind, both the buyer and seller must have a healthcare FSA plan at the time of the sales and the FSA plans must also allow for the same period of coverage. In other words, both plans must provide coverage based on the same plan year.  

Of course, in both scenarios, the seller and the buyer should document the arrangement outside of the healthcare FSA plan document and spell out appropriate financial terms. These arrangements would take into consideration contributions and reimbursements received before the merger. 

The information contained in this article is not intended to be legal, accounting, or other professional advice. We assume no liability whatsoever in connection with its use, nor are these comments directed to specific situations.

The IRS issued proposed regulations 26 CFR Parts 1 and 301 in January, 2017, regarding the definition of a dependent. These proposed regulations provide guidance and clarification for the current definitions under Internal Revenue Code (IRC) Section 152 plus other conditions introduced by the Working Families Tax Relief Act of 2004 (WFTERA) and by the Fostering Connections to Success and Increasing Adoptions Act of 2008 (FCSIAA). 

At first glance, it seems this is a change to the definition of dependents, however, after a careful read, it becomes clear that these are proposed regulations. Regulations that follow, clarify, and detail how to interpret and apply the regulations to the various applicable IRC code sections. Thus, IRC code section 152 stays the same.

Although the IRS did not change the code sections, we’ll step through an abbreviated definition of “Qualifying Child” and “Qualifying Relative” and then highlight some of the changes applied to the existing regulations.  

There are 5 tests for a Qualifying Child (QC):
The Relationship test requires the QC to be a child of the taxpayer or descendant of such a child; or a brother, sister, stepbrother, or stepsister of the taxpayer; or a descendant of any of these relatives.

The Residency test requires the QC to have the same principal place of residence as the taxpayer for more than one-half of the taxable year. There are additional rules relating to principal residence and temporary absence explained later in this article.

The Age test requires the QC to be younger than the taxpayer and not to have attained age 19, or, if a student, age 24. The age requirement is treated as satisfied if the individual is permanently and totally disabled at any time during the calendar year.

The Support test prohibits the QC from providing more than one half of their own support.

The Joint Return test prohibits the QC from filing a joint return, other than solely to claim a refund of estimated or withheld taxes, with the individual’s spouse.  

There are updated “Tiebreaker rules” when more than one taxpayer claims the same child that satisfies the definition of a qualifying child. These rules are explained later in this article.

There are 4 tests, a condition and some exceptions for a Qualifying Relative (QR):
The Relationship test requires the QR to bear a specific relationship to the taxpayer, including requiring the same principal place of abode as the taxpayer and to be a member of the taxpayer’s household for the taxable year of the taxpayer.

The Gross Income test requires the QR to have gross income that is less than the exemption amount. However, the income of disabled or handicapped individuals is not counted for services at a sheltered workshop that has availability of medical care and the income is incident to the medical care.

The Support test requires the QR to receive over one-half of their support from the taxpayer, with certain exceptions, noted below.

The QR cannot be a qualifying child of the taxpayer or of any other taxpayer for any taxable year beginning in the calendar year in which such taxable year begins. 

Additional conditions apply to both descriptions of a qualifying child or a qualifying relative.

Exceptions:

• If an individual is a dependent of a taxpayer for a taxable year, the individual is treated as having no dependents for purposes of section 152 beginning in the calendar year in which the taxpayer’s taxable year begins.
• If the individual is married and files a joint return, other than solely to claim a refund of estimated or withheld taxes, that individual is not treated as a dependent.
• An individual who is not a citizen or national of the United States is not treated as a dependent of a taxpayer unless the individual is a resident of the United States or of a country, Canada or Mexico, contiguous to the United States.
• The limitation does not apply to an adopted child if the child has the same principal abode as the taxpayer if the taxpayer is a citizen or national of the United States.

Highlighted Changes
The new proposed regulations reflect current law by amending the previous regulations relating to the surviving spouse and head of household filing statuses, the tax tables for individuals, the child and dependent care credit, the earned income credit, the standard deduction, joint tax returns, and taxpayer identification numbers for children placed for adoption.

The proposed regulations also change the IRS’ position regarding:

• The category of taxpayers permitted to claim the childless earned income credit; and, 
• The adjusted gross income of a taxpayer filing a joint return for purposes of the tiebreaker rules. 

In general, for purposes of five different provisions, the tiebreaker rules for determining which taxpayer may claim a child as a qualifying child apply as a group, rather than on a section-by-section basis.

The new regulations change the emphasis for determining whether a person is a dependent from looking at who provided a qualifying child’s support to looking at the qualifying child’s principal place of residence. In addition, there is an important distinction in support between a qualifying child and a qualifying relative. While the qualifying child may not provide more than half of their own support, a qualifying relative must receive over half their support from the taxpayer.

A child is considered to have the same principal place of residence as a taxpayer even during a taxpayer’s temporary absence. The definition of “temporary absence” is described as a failure to occupy a common residence because of illness, education, business, vacation, military service, and other special circumstances. Added to the new regulations is a requirement that it is reasonable to assume that the absent person will return to the household.

 The new regulations also expand on the method for determining a taxpayer’s adjusted gross income under the “tiebreaker” rules. This rule is employed when a child can be claimed by more than one taxpayer. If the qualifying child meets the definition for two or more taxpayers, the eligible taxpayer who is a parent may claim the individual as a qualifying child. If there is no eligible parent, then the qualifying child may be claimed by the eligible taxpayer with the highest adjusted gross income. 

 For instance, two sisters live together and take custody of their niece. Both may be eligible to claim the child as a qualifying child, but the sister with the highest adjusted gross income would be the only taxpayer to claim the child as a qualifying child for tax purposes. Plus other rules may apply under different circumstances.  

Governmental payments to a parent that aid a family with dependent children by providing food stamps and housing has been confirmed that such aid was provided by the government and does not count as support provided by the parent.

For the Earned Income Credit, if an individual meets the definition of a qualifying child for more than one taxpayer and the individual is not treated as the qualifying child of one of the taxpayers under the tiebreaker rules, then that taxpayer may be an eligible individual and may claim the childless EIC if he or she meets the other requirements.

The proposed regulation will apply to taxable years beginning after final regulations are published, but can be relied upon now.

The information contained in this article is not intended to be legal, accounting, or other professional advice. We assume no liability whatsoever in connection with its use, nor are these comments directed to specific situations.