Taxation of Domestic Partner Benefits
The information in this document does not constitute legal advice. For assistance with legal questions specific to your situation, please consult an attorney.
When an employer provides health insurance for the spouse or dependents of an employee, federal tax law allows the value of the health insurance coverage to be excluded from the employee's gross income. However, because the federal definition of spouse is limited by the Defense of Marriage Act of 1996, non-dependent same-sex partners and spouses are treated differently for federal tax purposes.
As a result, when an employer extends health insurance coverage for a non-dependent domestic partner or the dependents of a non-dependent domestic partner of an employee, federal tax law considers the fair market value of that coverage, including the employee's pre-tax contributions, as "imputed income" to the employee. According to a December 2007 report by the Center for American Progress and the Williams Institute, employees with partner health benefits now pay on average $1,069 per year more in taxes than would a married employee with the same coverage. The only exception is when a domestic partner qualifies as a dependent of the employee under IRS definitions.
Additionally, employees cannot use pre-tax dollars to pay for a non-dependent domestic partner's coverage, precluding them from the full benefits of a Flexible Spending Account, Health Reimbursement Account or Health Savings Account.
Because the imputed income increases the employee's overall taxable income, it also increases the employer's payroll taxes — the federal Social Security (FICA) and unemployment insurance tax (FUTA) that employers pay based on employees' taxable incomes. According to the same CAP/Williams Institute report, employers pay a total of $57 million per year in additional payroll taxes because of this unequal tax treatment.
As a result, lesbian, gay, bisexual and transgender individuals that secure employer-provided health insurance coverage for themselves and their unmarried, non-dependent partners face a significant tax penalty; one that, depending on the individual and the imputed value of the health benefit, can be in the thousands of dollars per year and result in the individual paying upwards of 50% more in federal taxes. Meanwhile, employers that extend partner health benefits pay higher payroll taxes and face the administrative burden of maintaining separate payroll functions for income tax withholding and payroll taxes.
Federal Legislation
The Human Rights Campaign advocates that the federal government end the taxation of health benefits provided by employers to any beneficiary covered under an employee's benefits plan, including a non-dependent domestic partner. HRC recruits businesses to join the Business Coalition for Benefits Tax Equity in support of this legislation.
- Tax Equity for Health Plan Beneficiaries Act
- Businesses support the Tax Equity for Health Plan Beneficiaries Act
When does a domestic partner qualify as a dependent for federal tax purposes?
If the employee's domestic partner is a qualifying dependent under IRS definitions, the value of the health insurance coverage can be excluded for federal tax purposes. In general, to qualify as a dependent for purposes of receiving tax-free employer-paid coverage, an individual must reside with the employee for the tax year at issue and receive more than half of his or her financial support from the employee. Notably, a rule that applies in other instances and that limits a dependent's earned income to no more than a specified amount in a given year — commonly referred to as the "gross income test" — does not apply in this instance.[i] Additionally, an employee is not required to claim the individual as a dependent on his or her Form 1040 for such individual to qualify as a dependent for purposes of tax-free employer-paid health coverage.
How and when do employers calculate imputed income?
If employers provide health insurance to beneficiaries other than a tax dependent as defined by the IRS, such as a non-dependent domestic partner, the employer must calculate the estimated fair market value of those health benefits and charge that amount to the employee as "imputed income" on the employee's Form W-2.
The IRS has provided little guidance as to how employers should calculate the fair market value of coverage. The method employers use varies depending on the employer and the type of coverage it provides.
The employer can calculate the difference between the amount an employer would contribute for the employee alone and the amount the employer would contribute for a couple or family. Generally, this is easier for employers that obtain insurance coverage through a third party (know as "fully-insured" or "insured" employer plans), where the employer can base their calculations on "active coverage" rates that the insurance company charges. Employers can also calculate the difference between the actuarial value of insurance for a single person and insurance for a couple or family. Employers that fund and pay for health insurance on their own (known as "self-insured" employer plans that are typically administered or managed by a third-party) base their calculations on COBRA coverage rates, since the active coverage rates are less easily known.
Employers should ensure they use as fair and accurate a method as possible.
- Employers Still Struggle to Determine Imputed Income for Domestic Partner Benefits: Calculating Fair Market Value of Coverage (PDF) [mwe.com]
Tax Example
If an employee makes $32,000 each year, and the employee's non-dependent partner's insurance is valued at $907 per month, the employee's tax liability for the year will be $4,710. However, an employee covering his or her opposite-sex spouse in the same situation would have a tax liability of only $3,155. This represents nearly a 50 percent increase in tax liability.
| Single Employee | Employee with Spouse | Employee with Domestic Partner | |
|---|---|---|---|
| Annual Employee Salary | $ 32,000 | $ 32,000 | $ 32,000 |
| Monthly Employer Contributions for Benefits |
335 | 907 | 907 |
| Annualized Employer Contributions for Benefits |
4,020 | 10,884 | 10,884 |
| Imputed Income | - | - | 6,864 (10,884 - 4,020) |
| Taxable Income | 32,000 | 32,000 | 38,864 |
| Employee's 2006 Tax Liability | 3,155 | 3,155 | 4,710 |
Exceptions
When the employee's domestic partner is a qualifying dependent
Employers should allow their employees to certify that their partner does indeed qualify and treat contributions for that coverage in the same manner as spousal coverage. Employers and employees not already taking advantage of this opportunity should consult a tax attorney.[i]
When the employee's domestic partner is recognized by the state
States that recognize same-sex relationships as equivalent to different-sex spouses generally treat these relationships the same for state tax purposes. Because the federal definition of spouse is limited by the Defense of Marriage Act of 1996, most state or local tax provisions for lesbian, gay, bisexual and transgender families do not apply for the purpose of federal taxes. Both employers and employees may have to calculate multiple iterations of payroll and income taxes for employees in these states.
What Employers Can Do
Until federal law changes, employers will be required to charge the imputed value of domestic partner benefits to employees with domestic partners that are not qualifying dependents. Employers should join the Business Coalition for Benefits Tax Equity that supports federal legislation to end this disparity. Some have considered grossing up affected employees' wages to offset the tax burden.
What other federally-defined employment benefits are denied to domestic partners?
[i] See Internal Revenue Code sections Section 105(b) and 106, and Proposed Treasury Regulation § 1.106-1, which carve-out the gross income test found in subsection (d)(1)(B) of Code Section 152 for purposes of determining who qualifies as an employee's dependent and can thus receive tax-free employer-paid coverage. See also IRS Notice 2004-79 (which provides a good background on the history of Code section 152 and the statutory changes that resulted in the carve-out of the gross income test for purposes of Code sections 105 and 106).
