Guest Article

(From the April 16, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Bill Would Create Gross Income Exclusion for Domestic Partner Benefits

A senior member of the U.S. House of Representatives' Committee on Ways and Means has introduced legislation to establish a gross income exclusion for employer-provided health benefits covering employees' domestic partners. Representative Jim McDermott (D-WA), the tax-writing committee's third ranking Democrat and Chairman of the Subcommittee on Income Security and Family Support, introduced the "Tax Equity for Health Plan Beneficiaries Act of 2007" (H.R. 1820) on March 29, 2007. Early supporters of the proposal include the Human Rights Campaign (HRC) and The Business Coalition for Benefits Tax Equity, which counts 27 major employers among its members as of January 31, 2007.

Effect on Employers

Employers are interested in this issue -- and in this proposed legislation -- in part because of the tax and reporting burdens associated with providing domestic partner benefits. To the extent employers pay for coverage provided to employees' domestic partners, the value of that coverage must be reported as imputed income to employees on their Forms W-2. And that imputed income is subject to wage withholding, Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes. Thus, a gross income exclusion for domestic partner benefits could save money for employers and their employees with domestic partners.

According to the HRC, more than 9,000 employers currently offer domestic partner health benefits. This total includes 266 of the Fortune 500, 78 of the Fortune 100, 299 colleges and universities, 144 city and county governments, and 13 state governments. And the number of employers offering domestic partner health benefits is growing. In 2004, 64 Fortune 100 and 216 Fortune 500 companies offered domestic partner health benefits.

Legal Background

In general, employees' gross incomes and wages do not include the value of employer-provided health benefits. See IRC §§ 106(a), 3121(a)(2), 3306(b)(2), and 3401(a). This exclusion also applies if the employer extends coverage to employees' spouses and dependents. See Treas. Reg. § 1.106-1. If employees are required to pay all or part of the premium for employer-provided coverage, they may do so on a pre-tax basis through an IRC § 125 cafeteria plan. Also, employees may use health flexible spending arrangements (FSAs) and health reimbursement arrangements (HRAs) to pay medical expenses incurred by themselves, their spouses or dependents on a tax-favored basis.

Employers may extend health benefits to their employees' domestic partners as well. However, the value of these benefits must be included in the employee's gross income unless the domestic partner is the employee's tax dependent, as defined by IRC § 152. Likewise, employees may not use an IRC § 125 cafeteria plan to pay premiums for a non-dependent domestic partner's coverage on a pre-tax basis, or use a health FSA or HRA to pay medical expenses incurred by a non-dependent domestic partner on a tax-favored basis.

In order for a domestic partner to be an employee's IRC § 152 tax dependent, the domestic partner must be the employee's "qualifying relative" under IRC § 152(d). The general requirements for qualifying relative status are as follows:

Because of the federal Defense of Marriage Act (DOMA), employees' same-sex spouses are treated as domestic partners for purposes of these rules. In other words, the value of employer-provided health benefits for an employee's same-sex spouse must be included in the employee's gross income -- and the employee may not pay premiums attributable to coverage for his or her same-sex spouse on a pre-tax basis -- unless the same-sex spouse qualifies as the employee's IRC § 152 dependent.

Summary of H.R. 1820

In brief, H.R. 1820 would amend IRC § 106 to make the gross income exclusion for employer-provided health benefits applicable "with respect to an eligible beneficiary and any qualifying child who is a dependent of the eligible beneficiary." It also would make corresponding changes to IRC §§ 3121(a)(2) [FICA], 3306(b)(2) [FUTA], and 3401(a) [income tax withholding]. The bill would leave it to employers to define the term "eligible beneficiary." As a result, the reach of the gross income exclusion could extend to domestic partners and beyond, if the employer is willing. For example, the bill as introduced would allow employers to provide coverage on a tax-free basis for employees' parents or non-dependent children.

The bill would not amend IRC § 125 to allow employees to pay their share of premiums for coverage provided to "eligible beneficiaries" on a pre-tax basis. However, the bill would direct the Treasury Department to issue guidance permitting employees to use their health FSAs and HRAs to pay medical expenses incurred by their "eligible beneficiaries."

A Word About Health Savings Accounts

Similar to health FSAs and HRAs, employees can use health savings accounts (HSAs) to pay medical expenses on a tax-favored basis. Employees who are HSA account holders also may use their HSAs to pay medical expenses incurred by their spouses and IRC § 152 dependents on a tax-favored basis. See IRC § 223(d)(2)(A). But if HSA account holders use their HSAs to pay medical expenses incurred by anyone else -- including non-dependent domestic partners -- the distribution will be treated as taxable income and, if the account holder is less than 65 years old, subject to a ten percent penalty tax.

As introduced, H.R. 1852 would not change the IRC § 223 rules for HSAs.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Laura Morrison 202.879.5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.