Employers have been working hard to properly tax employees for the cost of medical benefits that employers provide for domestic partners, since domestic partners are not considered to be dependents for purposes of federal income taxation.
However, a reference in the Internal Revenue Service’s guidance issued under the federal COBRA subsidy has caused some practitioners and employers to question whether the rules have changed. The answer to the above question is No!
Making sense
The reason for the above question is Q&A-25 contained in IRS Notice 2009-27. In this Q&A an individual is eligible for the federal subsidy as a result of an involuntary termination of employment. The cost of COBRA coverage is $1,000. The example assumes that the $1,000 cost applies for the individual and two assistance-eligible dependents.
The Q&A further assumes there is “another” individual, who is not an assistance-eligible dependent, for whom there is no additional cost for COBRA coverage. This individual could be a domestic partner, although reference to a domestic partner is not contained in the Q&A.
The question is whether the $1,000 COBRA cost applies to all assistance-eligible individuals or if a portion of the cost must be allocated to the non-assistance, eligible individual. On these facts the IRS concluded that since there is no additional cost for the non-eligible individual, no portion of the cost must be allocated to such individual.
Thus, the employee is eligible for the full federal subsidy on the full $1,000 COBRA cost and may receive a $650 federal COBRA subsidy, with the $350 balance being paid by the former employee. Prior to Notice 2009-27, most practitioners believed it was reasonable to allocate a portion of the cost of COBRA to the domestic partner, thus reducing the federal subsidy.
Domestic partner coverage
The above facts exist in many employer plans. Employers require employees to pay for a portion of the cost of medical coverage.
Assume that an employee has family coverage for the employee and two dependents. If the employee subsequently enters a domestic partner relationship, there is frequently no additional cost for the employee to add a domestic partner. Therefore, an argument exists that no income need be imputed to the employee for the employer cost for the domestic partner coverage.
Once again, this Q&A has caused practitioners and employers to question the need to impute income to an employee when a domestic partner receives “employer” subsidized medical coverage.
The answer, however, is that the guidance issued under the stimulus package does not apply in the context of regular medical benefits and the need to impute income to domestic partners continues to exist. The reason for this distinction is that the federal subsidy was intended to place approximately $24 billion in the hands of individuals who lose their jobs and need economic relief.
The fundamental tax rules have not changed. Therefore, to the extent that an employer subsidizes a portion of the cost of medical coverage for a domestic partner who is not a “dependent” for purposes of the Internal Revenue Code, imputed income is still required.
The moral is that the federal COBRA subsidy guidance must be narrowly read to only apply in the context of the federal subsidy and will not change general tax principles.
In this context, confusion still exists with regard to the manner in which income must be imputed to domestic partners. To review these rules assume the employer cost for single employee coverage is $6,000 per year, and an employee is required to pay $1,200 for single coverage (i.e., 20% of such cost).
Further assume that the additional cost for spouse or domestic partner coverage is $4,000, and the cost to the employee for domestic partner coverage is $800 (i.e., 20% of the $4,000 additional cost).
Tax treatment
Based upon the above facts the tax treatment for employer and employee contributions is as follows:
• The employee may pay the employee cost for single coverage in the amount of $1,200 with pre-tax dollars under an employer’s flexible benefit or cafeteria plan established under Section 125 of the Internal Revenue Code.
• The employer provides tax-free medical coverage to the employee in the amount of $4,800.
• The employee may pay for the $800 cost of domestic partner coverage with after-tax employee contributions. This result is required since domestic partners are not treated as dependents for purposes of the Internal Revenue Code.
• The $3,200 cost for domestic partner coverage paid by the employer must be imputed into the employee’s income and included in the employee’s Form W-2.
Additional issues for consideration by employers include the following:
• The above rules apply for purposes of federal income and FICA taxes.
• The States of California, New Jersey and Massachusetts would not tax the employee on the imputed income of $3,200.
• Other state taxation issues must always be considered.
“Good faith” compliance
Employers must consider excluding the imputed income for domestic partner coverage from gross income for retirement purposes. Otherwise, employees with domestic partners will receive greater retirement benefits than their peers, due to the imputed income.
The above example is helpful to clarify the rules for domestic partners, but different interpretations of the basic rules do exist. For the moment, all employers are encouraged to seek “good faith” compliance with the imputed income rules until guidance is issued.
Frank Palmieri can be reached at fpalmieri@p-ebenefitslaw.com.
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