On Wisconsin! Badgers Become Last State to Conform to Federal Tax Rule on Adult Child Coverage

One of the nearly immediate benefit mandates under the health reform law is the obligation on the part of health plans to cover eligible employees’ dependent children to age 26. The mandate includes a corollary provision in the federal tax law that makes the extended coverage non-taxable, regardless of the child’s dependency status, if the child is the employee’s natural, step, adopted or foster child. In an odd twist, if the plan continues coverage beyond the child’s 26^th birthday, the non-taxability rule applies to the end of the calendar year in which the child attains age 26.

The non-taxability rule for non-dependent children was a significant change in federal tax rules. The pre-health reform federal rule was that employer-provided health coverage for a child was taxable to the employee (i.e., treated as imputed income) if the child was not the employee’s Tax Code dependent. See our Alert of 9/29/2010 for a more detailed discussion of the rule.

The non-taxability feature created a disconnect between federal tax rules and the tax rules in many states. Some states’ tax laws automatically conform to federal tax law (in other words, if the feds treat something as nontaxable, then so do these states). But many other states do not automatically conform. These other states must change their tax laws to align with the federal rules, if they care to do so. If a state fails to act, we have a lingering mismatch between the federal tax rules and the state’s tax rules. This can be a huge headache for employers, especially multi-state employers, who may have to determine state imputed income tax (and withholdings) on a fringe benefit that is exempt from federal income tax.

In the 19 months since the passage of healthcare reform, all nonconforming states except Wisconsin passed laws to bring their state tax rules in line with the federal rule, with respect to coverage of adult children. Good news! Wisconsin appears on the verge of also amending its state tax law to match the federal rule. A bill has passed both houses in the state legislature and the governor is expected to sign the bill into law.

The change in Wisconsin law will close the curtain on a knotty state tax issue faced by employers under the federal health reform law.