Tax Law Updates

April 2008

IRS Releases Two Sets of Guidance Early in 2008 Related to Qualifying Relatives

Is a child a qualifying relative under Code Section 152?

[IRS Notice 2008-5, 2008-2 I.R.B. 256 (Jan. 14, 2008)]

For a copy: http://www.irs.gov/pub/irs-drop/n-08-05.pdf

The IRS Notice provides guidance to assist with the determination of whether a child is an individual's dependent because the child is a qualifying relative. As you may recall, as modified by the Working Families Tax Relief Act (WFTRA), in order to be an individual's tax dependent, a child must either be a qualifying child or a qualifying relative under Code Section 152. For a child to be an individual's qualifying relative, the child must not be the qualifying child of any other taxpayer (the "not anyone's qualifying child" test).

This notice clarifies that a child who would otherwise be an individual's dependent will not fail the "not anyone's qualifying child" test if the child's parent (or another person who could potentially claim the child as a qualifying child) is not required to file a federal income tax return and either (1) does not file such a tax return, or (2) does so solely to obtain a refund of withheld income taxes. The clarification is in response to the IRS concern that the "not anyone's qualifying child" test might lead to unintended tax consequences. The guidance is effective for taxable years beginning after December 31, 2004, which is the same effective date of WFTRA's changes to Code Section 152. In addition, the clarifying guidance has the potential to allow some unrelated children (ie. children of dependent domestic partners) to receive tax-free health coverage through employer sponsored plans when the requirements of the notice are met.

Clarification on the availability of dependent care tax credit and other benefits based on “Qualifying Relatives.”

[Chief Counsel Advice 200812024 (Feb. 8, 2008)]

For a copy: http://www.irs.gov/pub/irs-wd/0812024.pdf

Chief Counsel Advice (CCA) 200812024 has been issued by the IRS, which provides guidance on whether a taxpayer may claim the dependent care tax credit (DCTC) under Code Section 21 or certain other family tax law benefits, based on a member of the taxpayer's household who is a "qualifying relative" under Code Section 152(d) and Notice 2008-5.

As you may recall, Code Section 21 provides a credit against tax liability based on certain employment-related dependent care expenses incurred during the taxable year for the care of one or more "qualifying individuals." The term “qualifying individual”, for purposes of DCTC and for the income exclusion under Code Section 129 for Dependent Care Assistance Plans (DCAP), is as follows:

(1) a dependent as defined in Code Section 152(a)(1) (i.e., a qualifying child) who has not attained age 13; or

(2) a spouse or dependent (i.e., a qualifying child or a qualifying relative according to the modified definition that includes dependents of Code Section 152 dependent, married dependents

filing a joint return, and individuals with gross income that equals or exceeds the limit that would otherwise apply to qualifying relatives) who is physically or mentally incapable of self-care and has the same principal place of abode as the taxpayer for more than half of the year.

This CCA clarifies that an individual may not claim the DCTC with respect to a dependent who is a qualifying relative unless the qualifying relative is physically or mentally incapable of self-care.

Please note: CCA is written advice or instructions prepared by the IRS Office of Chief Counsel and issued to field or service center employees, and they may not be used or cited as precedent.

New Nondiscrimination Rules Leave Employers Puzzled

If the New Nondiscrimination Testing Rules are not effective until January 1, 2009…What Should I be doing now?

The 2007 proposed regulations provide additional guidance on the nondiscrimination rules that apply to cafeteria plans under Code § 125. While the regulations are not proposed to apply until plan years beginning on or after January 1, 2009, they can be relied on for guidance until final regulations are issued.* The regulations clarify key nondiscrimination terms and concepts. They also confirm that testing must be completed annually. Currently there are no corrective provisions that permit an employer to make adjustments after the plan year is over, if the plan fails the testing. Many employers and administrators will begin to apply the provisions of the regulations now, so that testing procedures are in place (and any necessary plan design changes can be made) before the 2009 plan year.

* Preamble to 2007 Proposed Cafeteria Plan Regulations, 72 Fed. Reg. 43937 (Aug. 6, 2007).

As Part I of a three part series of articles on the topic, we begin the series by providing a summary of the key terms. This will provide some insight as to why you may report the highly compensated and key employees differently compared to prior plan years. Part II of the series will address the new testing requirements and provide some insight to why you will be asked to provide plan details not previously required under the old nondiscrimination testing procedures. Part III of the series will discuss the consequences of a failing test, as well as address plan design pitfalls that may create testing problems under the new regulations.

The new regulations define or clarify the following key terms:

“Contributions and Benefits (C & B) Test:

-In addition to the other required nondiscrimination tests, the new regulations provide that a cafeteria plan must give each similarly situated participant a uniform opportunity to elect qualified benefits, and that highly compensated participants’ must not actually disproportionately elect qualified benefits.

Highly Compensated Participant (defined by Code § 125(e)(1))

-An individual who is (a) an officer, (b) a 5% shareholder, (c) highly compensated, or (d) a spouse or dependent (as defined in Code § 125(e)(1)(D)) of the highly compensated participant. You will be classified as a Highly Compensated Participant after satisfying only one of the criteria above.

-A participant is classified as “highly compensated” if the participant who in the preceding plan year, or the current year in the case of first year of employment, was a more-than-5% owner of the employer at any time during the current or preceding plan year, applying the attribution rules of Code § 318 (in general, these rule count any ownership of the employee’s spouse, parents, children, and grandchildren when determining the ownership percentage); or for the preceding plan year had compensation in excess of the Code § 414(q)(1)(B) threshold ($105,000 for 2008); or if elected by the employer, was in the top (20%) paid group of employees.

-This definition is used only for the Contributions and Benefits (C & B) Test.

Highly Compensated Individual

-A highly compensated individual who is eligible to participate in the cafeteria plan using the same criteria as the highly compensated participant. There is no difference between “individuals” and “participants” in this context.

-This definition is used only for the Eligibility Test.

Officer

-Any individual or participant who for the preceding plan year was an officer and new employees who are officers during the current plan year. Whether an individual is an officer is determined based on all the facts and circumstances.

-Generally, an “officer” means an administrative executive who is in regular and continued service, and it implies a continuity of service, exclusive of those employed for a special or single transaction. An employee with the title of officer, but not the authority of an officer, is not considered to be an officer for Code § 125 purposes. Similarly, an employee who does not have the title of an officer, but who has the authority of an officer, is an officer.

-It appears that the limitation on the number of officers under Code § 416 does not apply when determining who is an officer for Code § 125 purposes.

-It also appears that there is no exception for governmental entities that sponsor cafeteria plans, so they too will have officers for purposes of determining who is a highly compensated participant. But for purposes of the Key Employee Concentration Test, the term key employee “shall not include any officer or employee of an entity referred to in section 414(d) (relating to governmental plans).” Code § 416(i)(1)(A).

Five Percent Shareholder

-An individual who either in the preceding or current plan year owns more than 5% of the voting power or value of all classes of stock of the employer. Note: An individual who owns exactly 5% of the share would not qualify under this definition.

-An individual’s stock ownership is determined without attribution. Therefore, the Code § 318 attribution rules will not apply in defining a more-than-5% shareholder. However, there is attribution via the spouse or dependent rule.

Spouse or Dependent

-A spouse or a dependent (as defined in Code § 125(e)(1)(D))21 of an individual who is an officer, a more-than-5% shareholder, or highly compensated also falls within the group of highly compensated individuals subject to the cafeteria plan tests. The definition of dependent is the same as the one that applies when determining who is a tax dependent for health coverage purposes.

Key Employee

-A participant who is a key employee within the meaning of IRC § 416(i)(1) at any time during the preceding plan year. Key employees are: (a) officers with compensation more than $150,000; (b) more than 5% owners; and (c) more than 1% owners with compensation over $150,000. Compensation is based on the preceding plan year.

Compensation

-Compensation as defined in IRC § 415(c)(3). The Code specifically provides that in determining an employee’s compensation for these purposes, the following are counted (i.e., added back in): (a) salary reductions under a cafeteria plan (Code § 125); (b) compensation reductions under a qualified transportation fringe benefit plan (Code § 132(f)(4)); and (c) elective deferrals under a 401(k) plan, a salary reduction simplified employee pension plan (SARSEP), a Code § 408(p) SIMPLE plan, a Code § 403(b) tax-sheltered annuity, and a Code § 457 plan.

Please keep in mind: The definitions of “highly compensated individual” and “highly compensated participant” used for purposes of Code § 125 testing are not the same as the definition of “highly compensated individual” used for testing a self-insured medical reimbursement plan under Code § 105(h) or the definition of “highly compensated employee” used for testing a DCAP or 401(k) plan. Neither is the definition the same as the definition of “Key” used for running the Key Employee Concentration Test.

Stay tuned for Part II of our series on the nondiscrimination testing rules, where we discuss in more detail the new testing requirements. Please feel free to contact our offices if you have any questions or concerns.

January 2008

What's on the Horizon for Employee Benefits in the New Year?

                                                                                                    by Sue Sieger, CFCI

Benefits Design Group, Inc. has been designing benefit plans for over twenty years. As I look back, the industry has evolved from what we now refer to as “vanilla” benefit plans, with just basic flexible spending accounts for medical and childcare expenses, to now where the complexity of plan design can be overwhelming. The rising cost of healthcare leaves both employers and employees frustrated and discouraged as business revenues and compensation cannot keep pace with the record increases to insurance premiums.

Why have healthcare costs continued to rise? According to Price Waterhouse Coopers, the three major factors driving cost are inflation, an aging population, consumer demand, and advances in medical technology and treatments. The Towers and Perrin annual health care survey for 2008 indicates a 7% increase, bringing the average corporate health benefit cost to $9,312 per employee. More employers are passing on the rate increases to their employees and that often will force employees off the health plan altogether or out into the open individual health insurance market. Both can create adverse selection, resulting in only the sickest employees of the group remaining on the employer-sponsored plan, driving rates up even faster.

According to the US Census Bureau, the number of Americans lacking health insurance rose by nearly 8.6 million to 47 million from 2000 to 2006, with children and workers from every income level losing coverage. This increase was driven primarily by the continued erosion in employer-provided health insurance. In 2006, 2.3 fewer Americans received health benefits from their employers than in 2000.

How can we stop what seems like a landslide? Well, as you all know 2008 is an election year and all the presidential candidates have their own view on how to fix the system that seems beyond repair. However, implementing change once you get into office is not always that simple. So, I don’t expect any new “silver bullets” out of Washington anytime soon. The current administration introduced the Health Savings Account (HSA) in 2004 to develop a system of accountability that seems to most, a polar opposite to the “free care mentality” instigated by the HMOs years ago. Premium savings were supposed to help fund the HSA; however, not everyone has seen significant premium relief. If the employer does not sponsor an HSA qualified high deductible health plan (HDHP), everyone is not guaranteed coverage on the individual market. Getting the public to understand the differences in the cash flow in an HSA world doesn’t fit neatly into everyone’s pocket book either. Yet, I don’t see that universal health care or government run health care will get us where we want to go either.

In 2008, we will continue to see a focus on wellness and preventative measures as a way to curb health care costs. More states will implement mandates to address shortfalls in the system. Voluntary insurance products that supplement shortfalls in the health insurance, like accident, sickness, cancer, disability, etc. will gain in popularity. Consumer-driven health care will continue to gain momentum; however, I think we will see more growth in health reimbursement accounts (HRA) than health savings accounts (HSA) this coming year. HRAs allow employers to bridge the gaps between the old way of thinking and the new. This type of transition lends an opportunity to reeducate employees (consumers) about the cost of health care and provides employers the opportunity to direct the funds towards medical expenses, as claims substantiation is required to obtain tax-free reimbursements.

HSAs take a greater leap of faith. All medical expenses, including office visits and prescriptions cost will be applied towards the high deductible. The accounts are individually owned and work like traditional checking accounts and will be subject to bank fees. The contributions are tax deductible in the year they are made and unused balances carry forward from one year to the next. The withdrawals are not policed by anyone and recordkeeping is maintained by the account holder. This system of self-reporting and large out-of-pocket expenses may be more than most taxpayers bargained for.

2008 will continue to be a year where creative benefit plan design will provide the greatest opportunity to stretch both employee benefit budgets, as well as employee paychecks. Scrapping old plans altogether and/or replacing them with just HSA designs may not be the best alternative. Redesigning the older benefit models to work in tandem with the new models will offer the greatest opportunity for savings for both the employer and the employee. Please contact one of our employee benefit plan consultants to discuss employee benefit plan solutions for your organization!



More States Pass Cafeteria Plan Laws

Click here for Link

IRS Publication 503 Updated for 2007

(Child and Dependent Care Expenses)

 [IRS Publication 503 (Child and Dependent Care Expenses (for 2007 Tax Returns))]

For A Copy Click here

The IRS has updated Publication 503 (Pub. 503) for use in preparing 2007 tax returns. Pub. 503 explains the requirements that taxpayers must meet to claim the dependent care tax credit (DCTC) under Code Section 21 for child and dependent care expenses. Dependent Care Participants should use caution when using Pub. 503 as a reference, as the tax credit rules are not identical to the cafeteria plan applications. For example, the DCTC and DCAPs have different calendar year maximums. Under DCAP rules, the participant can claim up to $5,000 in qualified dependent care expenses in a calendar year regardless of the number of qualifying dependents. Married participants filing jointly can only claim $5,000 in aggregate expenses. The DCTC allows a credit which is based upon up to $3,000 in qualified dependent care expenses for one qualifying individual and up to $6,000 in qualified expenses for two or more qualifying individuals.

Pub. 503 has been updated to incorporate provisions of the final dependent care regulations. Some of the more significant new and revised items:

Qualifying Individuals. Revision to include explanation surrounding the special rules for determining who can treat a child as a qualifying individual when parents are divorced, separated, or living apart.

Earned Income Definition. Revision, consistent with the final dependent care expense regulations, provides that for purposes of the DCTC, earned income no longer includes nontaxable employee compensation. (Special rules apply to nontaxable combat pay.)

Employment-Related Expenses. Revision to the explanation of when an expense can be considered employment-related, as it relates to a temporary absence from work or while working part-time. In addition, changes and clarifications have been made to incorporate other topics included in the final dependent care expense regulations (e.g., fees and deposits, transportation expenses, and expenses for care while a parent who works nights is sleeping and the other parent is working).

Alternative Minimum Tax (AMT). Since Pub. 503 went to print, legislation has been enacted allowing the credit against the AMT for 2007 (Tax Increase Prevention Act of 2007, H.R. 3996 (Dec. 26, 2007)).

IRS Releases 2007 Version of Pub. 502

(Medical and Dental Expenses)

[IRS Publication 502 (Medical and Dental Expenses (for 2007 Tax Returns))]

For a copy click here

The IRS has released the 2007 version of Publication 502 (Pub. 502), which describes what medical expenses are deductible by taxpayers on their federal income tax returns. Under Code Section 213(a), a taxpayer may claim a deduction for certain unreimbursed medical expenses to the extent they exceed 7.5% of the taxpayer's adjusted gross income.

A brief summary of the changes are as follows:

Transportation. The standard mileage rate for use of an automobile to obtain medical care is 20 cents per mile for 2007. (Note: 2008 limit is 19 cents per mile.) Pub. 502 also clarifies that the costs of operating a specially equipped car for nonmedical reasons are not deductible as medical expenses.

Insurance Premiums. Includes clarification that dental insurance premiums are deductible. It also confirms that premiums for health or long-term care insurance can't be deducted if taxpayers elected to pay for them with tax-free distributions from a retirement plan made directly to the insurance provider and these distributions would otherwise have been included in income. (Special rules apply to retired public safety officers.)

Note: Pub. 502 can be used to help determine which medical expenses are considered to be tax deductible; however, it should be used with caution, as some portions of Pub. 502 would provide a wrong answer if applied to health FSAs, HSAs, or HRAs.

IRS Releases Updated Model HSA Trust and Custodial Account Forms

[IRS Form 5305-B (Health Savings Trust Account) (Nov. 2007); IRS Form 5305-C (Health Savings Custodial Account) (Nov. 2007)]

For a copy of Form 5305-B Click here

For a copy of Form 5305-C Click here

Treasury and the IRS have released updated versions of IRS Forms 5305-B ("Health Savings Trust Account") and 5305-C ("Health Savings Custodial Account"). Whereas, the model forms are not required, they may provide a good starting point. The model forms can be customized to include additional provisions, such as definitions, restrictions on rollover contributions, investment powers, voting rights, trustee's or custodian's fees, state law requirements, treatment of excess contributions, distribution procedures (including frequency or minimum dollar amount), use of debit, credit, or stored value cards, return of mistaken distributions, and descriptions of prohibited transactions.

The 2007 version factors in updated minimum annual deductibles, annual out-of-pocket limits, annual contribution limits and catch up contributions. In addition, the model form includes the ability to record "qualified HSA distributions" from health FSAs and HRAs (these contributions aren't subject to the maximum annual HSA contribution limit), as well as contributions of "qualified HSA funding distributions" from IRAs (these contributions are subject to that limit). The 2007 versions also include updated dollar limits for HSA contributions (including age 55 catch-up contributions), as well as updated high deductible health plan (HDHP) minimum annual deductibles and HDHP annual out-of-pocket maximums.

2007 Version of Form 8889 Released for use by HSA Account Holders

[IRS Form 8889 (Health Savings Accounts (HSAs)) and Instructions (2007)]

For a copy of Form 8889 Click here

For a copy of the Instructions Click here

The 2007 versions of Form 8889 and its Instructions reflect changes to the HSA contribution rules that were made by the Tax Relief and Health Care Act of 2006 (TRHCA) and that generally became effective on January 1, 2007. Beginning with the 2007 taxable year, HSA account holders (and beneficiaries of deceased account holders) will use the Form 8889 to not only report HSA contributions and distributions, they will also use it to calculate any income and additional 10% tax that must be reported on Form 1040 for the failure to be an HSA-eligible individual during the 13-month testing period that is required when (1) contributing a qualified HSA distribution, (2) contributing a qualified HSA funding distribution, and (3) making a full-year HSA contribution in reliance upon the no-proration rule. The 2007 version of Form 8889 also reflects the 2007 contribution limits and a new reporting line for qualified HSA funding distributions. But the Instructions have been significantly expanded to highlight the new TRHCA rules, including applicable testing periods, and to explain related reporting issues.

Even Without Symptoms of Illness Diagnostics May Be Medical Expenses

[Rev. Rul. 2007-72, 2007-50 I.R.B. 1154 (Dec. 10, 2007)]

For a copy Click here

Medical care, under § 213(d)(1)(A), includes amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body. A “diagnosis” can include a procedure to determine that a disease is absent. Both FSAs and HRAs provide tax-free reimbursements to employees for expenses that qualify as “medical care” under § 213(d).

This recent IRS revenue ruling explains that amounts paid for certain diagnostic procedures and devices can qualify as medical care expenses under Code Section 213(d), even when incurred by an individual without symptoms of illness; without a physician’s recommendation; and/or even when less expensive procedures are available. The ruling analyzes three different expenses incurred by an individual who had no symptoms of illness:

1) Annual physical exam (including a doctor's services and lab tests) was ruled as diagnostic and qualifies as a medical care expense, even when the individual lacks symptoms of illness;

2) Expensive full-body electronic scan, obtained without a doctor's recommendation, that examines the internal organs to identify disease or other abnormalities and serves "no non-medical function" is also diagnostic and likewise is a medical care expense, even though the individual obtained the scan without a doctor's recommendation. The ruling notes that a doctor's recommendation--while important in determining whether an expense is for medical or personal purposes--is not needed when an expense is "wholly medical in nature and serves no other function in everyday life" (as was the case with the scan in the ruling). In addition, an individual is not limited to using the least expensive medical care available; an individual can be reimbursed from their FSA or HRA for expensive procedures even when a less expensive procedure is available (subject to the limits of those accounts); and

3) Home Pregnancy test kit is also classified as a medical care expense, even though it does not detect disease but rather tests the healthy functioning of the body.

Late December AMT Patch Will Cause Delays in Income Tax Filing

What is the AMT? The AMT came into being with the Tax Reform Act of 1969. Its purpose was to target a small number of high-income taxpayers who could claim so many deductions they owed little or no income tax. A growing number of middle-income taxpayers are discovering they are subject to the AMT.

The IRS and many tax professionals are expecting a challenging 2008 tax return filing season. Congress passed the Alternative Minimum Tax (AMT) patch on December 19, 2007. The patch gives taxpayers higher AMT exemption amounts. The patch also allows taxpayers to use most of the nonrefundable personal credits to offset their AMT liability. The patch will keep as many as 25 million Americans from paying AMT, according to the U.S. Treasury Department.

That’s good news for taxpayers; however, due to the timing this will likely cause a delay in the start of the upcoming filing season by about one month for some 13.5 million taxpayers filing five AMT-related forms. The IRS did not have enough time before the start of the 2008 filing season to reprogram its computers for the patch. When the 2006 patch expired, the IRS’ computers defaulted to the old law, without the patch. The IRS predicts it will need seven to ten weeks to reprogram its systems for the patch. The IRS has promised to process returns accurately and to issue refunds as quickly as possible.

In a recent news release, the IRS said that it has been able to reprogram its systems to start processing most returns in mid-January. The IRS announced shortly after passage of the AMT legislation that taxpayers filing any of the following forms (manually or electronically) must wait until February 11, 2008 to file:

Form 8863, Education Credits

Form 5695, Residential Energy Credits

Form 1040A, Schedule 2, Child and Dependent Care Expenses for Form 1040A Filers

Form 8396, Mortgage Interest Credit

Form 8859, District of Columbia First-Time Homebuyer Credit

Taxpayers filing these forms will have to delay filing in order to allow the IRS time to reprogram its computer system. Other AMT-related forms, such as Form 6251, Alternative Minimum Tax-Individuals, will be processed beginning on January 14, 2008.

The IRS is revising many of its forms for the AMT patch. Electronic forms can be revised simply but printed forms have already been sent to the printer. Among the forms that must be revised are Form 6251 - Alternative Minimum Tax; Form 1040, Schedule R - Credit for Elderly or Disabled; Form 1116 - Foreign Tax Credit; and Form 2441 - Child and Dependent Care Tax Credit. The IRS has indicated that it will not need to reprint the 2007 Forms 1040.

When Can a More-Than-2% Shareholder of Subchapter S Corporation Deduct Health Insurance Premiums?

[IRS Notice 2008-1 (Dec. 14, 2007)]

For a copy Click here

IRS Notice 2008-1 provides an explanation of when more-than-2% shareholder-employees in a Subchapter S corporation (S corporation) can deduct health insurance premiums that are paid or reimbursed by the corporation. Code Section 106 provides an exclusion from gross income for employer-provided accident or health plan coverage that is provided to an employee; however, because more-than-2% S corporation shareholders are treated as partners of a partnership--not as employees for this purpose, accident and health insurance premiums that S corporations pay or furnish on behalf of more-than-2% shareholder-employees in consideration for services rendered are includible in the shareholders' gross income.

More-than-2% shareholders may be able to deduct premiums under Code Section 162 for insurance that constitutes medical care, if the plan that provides the medical care coverage is "established by the S corporation." (Certain additional requirements--e.g., restrictions regarding earned income and eligibility for certain coverage--must also be met.) A plan is established by the S corporation if, in the current taxable year, the corporation either makes the premium payments or reimburses the shareholder for substantiated premium payments. In addition, the premiums must be included in the shareholder's gross income by reporting the premium payments or reimbursements as wages on the shareholder's Form W-2 for the same taxable year for which the deduction is sought. In turn, the shareholder must also report the payments or reimbursements as gross income on his or her federal tax return. The notice also explains how more-than-2% shareholders who didn't claim deductions for benefits described in the notice can file amended tax returns to claim the deduction for prior tax years.

Note: The notice does not specifically address cafeteria plan or health reimbursement arrangements; however, please keep in mind that more-than-2% shareholder-employees of S corporations can't directly participate in such plans under the Code 125 and 105 regulations because of their shareholder status. In addition, because of ownership attribution rules, spouses and certain other family members of more-than-2% shareholders can't participate, either. S corporations may, however, have cafeteria plans for their other employees.

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Tax-Law updates 2002

Tax-Law updates 2003

Tax-Law Updates 2004-2005

Tax-Law Updates 2006-2007

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