Taxation of Domestic Partner Coverage
FEDERAL AND STATE TAX CONSEQUENCES OF DOMESTIC PARTNER HEALTH PLAN COVERAGEJANUARY 2012
Many employers provide health plan coverage to their employees’ domestic partners (and sometimes the domestic partner’s child). This coverage may be taxable on a federal level to the employee depending on:
- Whether the domestic partner or child satisfies the conditions to be a Code §105(b) tax dependent for the entire taxable year in question.
- How coverage is paid for (pre-tax or after tax).
In some cases an employer may need to impute the fair market value of coverage provided to domestic partners (and their children). If income is imputed due to employer-paid health coverage, the domestic partner's coverage will be treated as having been purchased with after-tax dollars for purposes of Code §104(a)(3), with the result that any health benefits paid on behalf of the domestic partner (or child) under the plan will be tax-free to both the employee and the domestic partner.
As well, as more and more states grant various rights to same gender or opposite gender domestic partners, taxation issues on a state level should also be addressed.
DEFINING FEDERAL TAX DEPENDENT
SAME GENDER PARTNERS AS THE EMPLOYEE’S DEPENDENT
To be a federal tax dependent of an employee, a domestic partner must meet the requirements of a “qualifying relative” under Code §105(b). The partner must:
- Have the same principal place of abode as the employee and be a member of the employee's household.
- Receive over half of his or her support from the employee.
- Not be anyone's qualifying child.
- Be a (1) citizen of the U.S., or (2) a resident of the U.S. or a country contiguous to the U.S.
In many cases, employees are not able to show that they provide more than half of the support for the partner and thus the partner would not qualify as a §105(b) dependent. The IRS allows employers to rely on the certification of the employee regarding the dependent status of their partner, relieving the employer from collecting income and support information.
CHILDREN OF SAME GENDER PARTNERS AS THE EMPLOYEE’S DEPENDENT
The children of domestic partners (who are not otherwise children of the employee) will be entitled to receive tax-free health coverage only if they qualify as Code §105(b) tax dependents by being an employee's “qualifying child” or “qualifying relative”. In most cases, such a child will most likely not have the necessary family relationship with the employee to qualify as the employee's “qualifying child”. The child will typically either be the qualifying child of the domestic partner or of the child's other parent. And since one of the conditions of the qualifying relative test is that a qualifying relative cannot be the qualifying child of any other taxpayer, the child of a domestic partner will usually fail to satisfy the qualifying relative test for the same reason.
On the other hand, in cases where the same gender couple adopts a child, or where a child is treated as a stepchild under state law, the child will typically qualify as the employee’s dependent.
DETERMINING THE FAIR MARKET VALUE OF HEALTH COVERAGE PROVIDED
As a general matter, when income must be imputed because health coverage is provided to domestic partners (or children) who are not Code §105(b) tax dependents, the amount includible in the employee’s gross income is the fair market value of the coverage (less any after-tax payments by the employee). However, no official guidance addresses how to determine the value of health coverage for this purpose. Employers may want to consider the following approaches:
- The more cautious approach is to use the plan’s COBRA applicable premium for self-only (individual) coverage when coverage is added for an individual who is not a Code §105(b) tax dependent. This means that when coverage is added for more than one such individual, the COBRA premium for that number of individuals (e.g., the rate for self-plus-one or family coverage) would be used.
- Another possibility would be to determine the value based on the incremental cost of adding coverage for the individual. For example, if the monthly premiums for self-only and self-plus-one coverage are $160 and $310, respectively, and the employee and one domestic partner are covered, the fair market value of the domestic partner's coverage would be $310 minus $160 or $150. But in some cases, the incremental cost of adding coverage for an individual may be very small, or even zero (i.e., if the employee already has family coverage). In this event, because the individual’s coverage is not valueless, the employer may want to use the COBRA applicable premium.
- Some employers may also rely on actuaries to determine the fair market value of coverage.
Regardless of which approach is used, any amount paid for the coverage on an after-tax basis by the employee would be subtracted from the fair market value to arrive at the amount includible in the employee’s gross income.
FEDERAL TAX CONSEQUENCES WHEN A DOMESTIC PARTNER (OR CHILD) IS A TAX DEPENDENT FOR HEALTH COVERAGE
In general, when a domestic partner (or child) is an employee's Code §105(b) tax dependent, the value of the domestic partner's health coverage and any benefits provided under the health plan will be tax-free to the employee and domestic partner.
More specifically, the following are the tax consequences when a domestic partner (or child) is the employee’s Code §105(b) Code §105(b) tax dependent:
- Employer Pays for the Entire Cost of Coverage. When the employer pays the entire cost of the domestic partner's (or child's) health coverage, the value of the coverage is not taxable to the employee.
- Salary Reductions and Employer Flex Credits Are Used to Purchase Coverage. When the domestic partner (or child) qualifies as a Code §105(b) tax dependent, the employee can make any required employee contributions for the health coverage with pre-tax salary reductions under a cafeteria plan. The employee can also use employer flex credits under the cafeteria plan to pay any required employee contributions for the domestic partner's health coverage on a pre-tax basis.
- Employee Pays for Coverage With After-Tax Dollars. When an employee pays for the domestic partner's (or child's ) health coverage with after-tax dollars, the employee will have no imputed income, and any health benefits paid on behalf of the domestic partner will be tax-free to both the employee and the domestic partner.
DOMESTIC PARTNERS (OR CHILDREN) WHO WERE NEVER FEDERAL TAX DEPENDENTS FOR HEALTH COVERAGE
When health coverage is provided to a domestic partner (or child) who is not the employee's Code §105(b) tax dependent, the tax consequences vary, depending on how the coverage is paid, as follows:
- Employee Pays for Coverage With After-Tax Dollars. When an employee pays with after-tax dollars for coverage of a domestic partner (or child), the coverage will not be taxable to the employee, provided that the employee pays at least the fair market value of the coverage. An employee who pays less than the fair market value for the coverage is taxed on the difference. Where health coverage is provided on an after-tax basis for the domestic partner (or child) but on a pre-tax basis for the employee, separate payroll slots must be maintained for pre-tax and after-tax coverage, and an allocation must be made as to the amount of premium attributable to the domestic partner (or child) coverage.
- Employer Pays for Entire Cost of Coverage. If an employer pays for the domestic partner's (or child's) health coverage, then the value of the health coverage is includible in the employee’s income. The employee will have imputed income reported on Form W-2 equal to the value of the domestic partner's (or child's) coverage. This amount will also be subject to income tax withholding and employment taxes (e.g., FICA and FUTA).
- Salary Reductions and Employer Flex Credits Can Be Used to Purchase Coverage If Benefits Are Treated as Cash. Cafeteria plan rules permit non-Code §105(b) tax dependent health coverage to be offered under a cafeteria plan as a taxable benefit. When such coverage is offered under a cafeteria plan, the employee must be treated, for all purposes under the Code (including, for example, reporting and withholding purposes), as receiving, at the time that such benefit is received, cash compensation equal to the full value of such benefits (i.e., the fair market value of the coverage) at such time and then purchasing the benefit with after-tax employee contributions. In other words, the employee has to elect the coverage as a taxable benefit before the beginning of the plan year (or other coverage period). Thus, with proper plan design, a participant may use salary reductions or employer flex credits to purchase health coverage for a domestic partner who is not a Code §105(b) Code §105(b) tax dependent as a taxable benefit under the cafeteria plan—the coverage will be treated as a cash election and will be taxed at the time it is received.
- Employee Cannot Pay for Coverage on a Pre-Tax Basis. An employee cannot pay for domestic partner (or child) coverage on a pre-tax basis under a cafeteria plan.
DOMESTIC PARTNERS (OR CHILDREN) WHO CEASE TO BE FEDERAL TAX DEPENDENTS FOR HEALTH COVERAGE DURING THE PLAN YEAR
A domestic partner (or domestic partner's child) who fails to satisfy the conditions for being a Code §105(b) tax dependent during any portion of a taxable year will fail to qualify as a Code §105(b) tax dependent for the entire taxable year. In that event, the employee will be required to include the value of employer-provided domestic partner (or child) coverage in the employee's gross income. In the event a domestic partner (or child) loses Code §105(b) tax dependent status mid-year (e.g., because of income changes or a dissolution of the partnership), the employer should impute in income the value of the domestic partner (or child) coverage provided between the beginning of the year and the date that Code §105(b) tax dependent status was lost. The employer should also immediately cease allowing for pre-tax payment of health coverage for the domestic partner (or child). Failure to do so, and failure to impute income in this fashion, could jeopardize the cafeteria plan's qualified status. In addition, expenses may not be reimbursed by the Health FSA.
STATE TAX TREATMENT OF COVERAGE PROVIDED TO SAME GENDER COUPLES
A number of states recognize same gender marriages, same gender domestic partnerships, opposite gender domestic partnerships (California only) and civil unions. Individuals in these relationships are often granted the same state and local tax treatment of employer-provided benefits as individuals in opposite gender marriages. These state rules apply only to the state tax and not the federal tax treatment of benefits as described above.
As of the end of 2011, states that provide state tax benefits for same gender couples similar to those afforded to opposite gender couples are:
- District of Columbia
- New Jersey
- New York
- Rhode Island
Employers who provide benefits to the partners of employees in same gender relationships in these states should consult with their tax and payroll advisers as to how to handle the state taxes for that particular state. State tax treatment of these benefits in other states may also vary from state to state but often mirrors the federal tax treatment of benefits.