Generally, when an employer contributes toward the cost of group health insurance for its employees, their spouses and dependents, the amount of the employer’s contribution is excluded from the employees’ gross income.  However, when an employer contributes towards the cost of health insurance for other individuals, such as an employee’s domestic partner, the “fair market value” of the coverage is included in the employee’s gross income.  In other words, the cost of coverage is “imputed” (i.e., added) to the employee’s gross income, and the employee is responsible for paying taxes on that amount.

The only exception to this rule is when a domestic partner qualifies as the employee’s “dependent” for group health plan purposes, which is satisfied by the following tests:

1. Residency — the domestic partner must live with the employee for the entire year.
2. Support — the employee must provide over one-half of the domestic partner’s support for the applicable calendar year.
3. Tax status — the domestic partner does not qualify as a “tax dependent” of any other taxpayer.

Based on the above criteria, it is unlikely that a domestic partner will qualify as an employee’s “dependent” for group health plan purposes.  Therefore, employees covering domestic partners will likely have the fair market value of their former spouse’s coverage added to their income each month.  Employers offering domestic partner benefits should include a tax dependent certification form with enrollment materials so an employee enrolling a domestic partner can certify that their domestic partner qualifies as a dependent for group health plan purposes, if applicable.

Calculating Imputed Income

If a domestic partner covered under an employer’s group health plan does not meet the requirements under the federal Internal Revenue Code (“Code”) to qualify as the employee’s dependent for group health plan purpose, the value of his or her benefit must be imputed to the employee.  That is, the employee must have the fair market value of the non-dependent’s coverage added to his or her gross annual income.

The Internal Revenue Service (“IRS”) has provided no formal guidance for calculating imputed income under these circumstances.  Absent guidance, employers must use a reasonable method for determining the amount that must be imputed into income.  Employees often argue that the value of the imputed income should be determined on an incremental basis.  An example of an incremental approach is to divide the total premium amount by the number of individuals covered with respect to an employee (e.g., employee, domestic partner, and children).  The resulting number is then multiplied by the number of individuals covered with respect to that employee who do not meet the Code definition for either a spouse or a dependent.

To illustrate, assume an employee with family coverage covers himself, his domestic partner and their two children, and the employer contribution for family coverage under the plan is $12,000 per year.  Under the incremental approach, the employee might argue that the imputed value of the domestic partner’s coverage is $3,000 ($12,000 ÷ 4 × 1 = $3,000).

However, the IRS does not believe that an incremental value approach accurately reflects the imputed value to the employee; therefore, this incremental approach is unlikely to be accepted by the IRS.  The IRS appears to believe that this approach neglects to consider the value of the benefit provided to the employee.  The value of the benefit should be a constant, as between employees.  Using an incremental approach, the value of the benefit depends more on the number of individuals covered with an employee than on the benefit provided.

While there are a number of reasonable approaches that an employer may use to impute the value of coverage to the employee’s income, the approach that appears to have the widest acceptance is the “individual coverage” approach.  Using this approach, an employee who covers an individual who does not qualify as a spouse or dependent under federal law would have imputed into his or her income the premium cost that the employer would charge an individual for COBRA continuation coverage (minus the 2% administrative fee) for that level of coverage, for each individual who does not meet the Code definition, capped at the cost of family coverage.  

Example (employee covers non-tax dependent domestic partner): Assume COBRA coverage under the employer’s plan costs $400 per month for self-only coverage (not including the 2% surcharge).  Using the “individual coverage” approach, the employer would impute $4,800 for the year ($400 × 12), which represents the fair market value of coverage provided to one adult (the domestic partner).  The employee continues to make the same pre-tax contribution that he would make if he was covering himself and a spouse.

Example (employee covers dependent domestic partner and the domestic partner’s two children).  Neither the domestic partner nor the children are the employee’s dependents for Code purposes.  Assume COBRA coverage under the employer’s plan costs $400 per month for self-only coverage, $750 per month for employee + children, and $900 for family coverage (not including the 2% surcharge).  Using the “individual coverage” approach, the employer would impute $9,600 for the year ($750 × 12), which represents the fair market value of coverage provided to one adult and two children (the domestic partner and children).  The employee continues to make the same pre-tax contribution that he would make if he was covering a spouse and children. 

Any post-tax contributions made by the employee toward the cost of the non-dependent’s coverage are subtracted from the amount to be imputed.  Therefore, it is not necessary to develop separate pre- and post-tax employee contribution rates.  It does not change the outcome from a tax perspective.  Employees with non-tax dependent domestic partners should pay the same pre-tax contribution as other employees in their tier of coverage, and the employer will impute the full cost of coverage with no need for a reduction due to post-tax contributions. 

When imputed income is required, employers should impute the value of coverage on a regular basis, such as semi-monthly or monthly.