WASHINGTON—A seemingly straightforward provision in the health care reform law that requires employers to extend coverage to employees' adult children is presenting some complex compliance challenges, experts say.

The problem centers on state taxes that employees may owe on the coverage, which employers must calculate and withhold from employees' pay.

Under the politically popular provision, employers are required to extend coverage to employees' adult children up to age 26—regardless of whether the child is financially independent or no longer attends college, for example.

That mandate, which went into effect Jan. 1 for calendar-year plans, required virtually every employer to expand coverage. Prior to the new requirement, employers typically extended coverage until the child turned age 19, or 22 or 23 if a full-time student at a college or university. Employers also required the child to be a dependent of the employee.

Internal Revenue Service guidance issued after approval of the health care reform law made it clear that employers could provide the coverage tax-free to the employee through the end of the calendar year in which the adult child turns 26.

Prior to the Patient Protection and Affordable Care Act, the U.S. Tax Code allowed tax-free coverage of employees' children to age 19, or to age 24 if the dependent child was a full-time student.

But that relatively straightforward change is generating problems for employers because the expanded coverage may be taxable under some states' laws, with little guidance on how to calculate the tax liability.

Compounding the problem is that some states may amend their laws retroactively to eliminate the tax issue, but at this point no one knows which states will act.

“It is a big problem, but only recently has it started to get some visibility,” said Rich Stover, a principal with Buck Consultants L.L.C. in Secaucus, N.J.

While most states automatically conform their tax laws to federal tax law anytime it changes, roughly 15 to 20 states do not. Unless those states update their tax laws, employees who have added their adult children to their policies will face additional state taxes.

For example, California law sets a five-part test, all parts of which must be satisfied for the coverage to be excluded from employees' taxable income. Among other things, the child must be younger than 19, or 24 if a full-time student, and not provide for more than half of his or her own “support.”

As a result, if an employee added an adult child who did not satisfy the test, the portion of the insurance premium attributable to the child would be considered taxable wages and subject to California taxes, according to guidance by the California Employment Development Department.

But the precise value of the coverage and how much income would be added to employees' W-2 wage and income statements isn't clear and varies by state.

For example, the Wisconsin Department of Revenue says if the adult child is not a dependent, the coverage's “fair market value” would be considered income. But Wisconsin regulators also haven't provided guidance for employers to calculate the fair market value. “The Department of Revenue cannot determine the fair market value of the coverage,” the agency said, noting that is something employers and insurance providers should do.

Other states are providing guidance, but in some cases it raises more questions than answers, experts say.

In California, income attributed to the employee for coverage of a nondependent adult child would be the difference between the premium paid including that child and the premium paid without the child, according to the EDD.

But it isn't clear how the calculation would be made if the health care plan were self-funded and no insurance premiums were paid.

“The lack of guidance and variance of state rules on the reporting issue has become a very real and huge issue,” said Michael Thompson, a principal with PricewaterhouseCoopers L.L.P. in New York.

“This is creating a big reporting issue, and one employers now are starting to grapple with,” said J.D. Piro, a principal with Aon Hewitt Inc. in Norwalk, Conn.

The problem could ease as more states pass legislation make their tax law conform with federal law concerning the tax treatment of coverage provided to employees' adult children.

“My hunch is most states will conform their laws,” but state action will take some time, said Cathy Stamm, a principal with Mercer L.L.C. in Washington.

For example, it took Wisconsin seven years to mesh its tax law to follow a 2003 federal law that excludes health savings account contributions from employees' taxable income. Wisconsin approved the change in law just last month.

“Inevitably, some states, through the passage of legislation, will solve the problem, but we don't know which ones” will take that step, said Andy Anderson, a partner with Morgan, Lewis & Bockius L.L.P. in Chicago.

Employers with employees in nonconforming states will have to decide what approaches to take, consultants say. Some may wait and hope their states take action to bring state law into line with federal law on the issue.

“There is still sufficient time for states to act for 2011,” Aon Hewitt's Mr. Piro said.