An employee can pay premiums for their spouse and dependents on a pre-tax basis. But, it gets trickier when the relationship is one of domestic partnership versus marriage.
It is par for the course that most employers allow employees to pay for their portion of dependents’ healthcare premiums with pre-tax dollars. Unfortunately, there are times when there is a disconnect between a dependent in the eyes of an insurance company and a dependent whose premiums are allowed to be paid for with pre-tax payroll deductions. For non-qualified dependents, their premiums must be paid with post-tax dollars, and any employer contributions toward their premiums must be included in the employee’s W-2 income for tax purposes.
Let’s look at who definitely is qualified for pre-tax purposes and who may not be.
Dependent Defined = Qualified
In 2020, the Affordable Care Act swooped in with a very liberal definition of an eligible dependent child. An employee can pay healthcare premiums with pre-tax dollars for any children who meet this definition. Both of the following must be satisfied:
Prior to the ACA definition in 2020, premiums could only be paid pretax for children eligible under the IRS’ definition if a qualifying child, which has lower age thresholds and additional requirements. To be considered a qualifying child by the IRS, all four of the following must be true:
Married Person Defined = Qualified
Any person qualifying as a married person under the IRS’ definition can have their premiums paid for with pre-tax dollars. To be considered married, the employee and the spouse must meet any one of the following on the last day of the tax year (or date of death if during that tax year):
Domestic Partners and Their Children = May be qualified, may not
A domestic partner is defined as an unmarried opposite sex or same sex partner. Under IRS definitions, most domestic partners will not be considered a tax dependent. While employers can allow employees to cover their domestic partners (and their domestic partner’s children) on the group benefit program, the Federal tax treatment of employer-provided health premiums can be quite challenging.
Employees can only pay for their domestic partners’ premiums pre-tax if the domestic partner happens to qualify as a tax dependent. Likewise, the healthcare premiums for a domestic partner’s dependent child(ren) can only be paid with pre-tax dollars for a child that is the dependent of the employee, or a dependent of a qualifying tax dependent domestic partner.
For example, assume:
The employee is allowed to pay for the child’s premiums on a pre-tax basis, because the child is considered a tax dependent due to having been adopted by the employee.
In this case, the employee portion of healthcare premiums is $100 for the employee, $500 for the domestic partner, and $300 for the child. The employee can pay for healthcare premiums for themself and the child pre-tax ($400 of the total) and must pay for the domestic partner with post-tax dollars ($500 of the total).
This can seem quite confusing, but there is a simple rule that should be followed. If an adult is able to have their premiums paid with pre-tax dollars, any qualified dependent of that adult will be eligible to have their premiums paid with pre-tax dollars.
When can a domestic partner qualify?
To qualify for pre-tax coverage under the health plan, the domestic partner must meet all four of the following:
The employer can rely on the employee to certify that their domestic partner is a tax dependent and/or that their domestic partner’s children are tax dependents. It is recommended that employers obtain this certification in writing annually. The IRS has an interactive tool to help employees determine if their dependents are considered tax dependents under IRS tax rules (this should only be used for determining if a domestic partner is a tax qualified dependent for healthcare, since the pre-tax premium rules for a child’s qualification are much more liberal under the ACA). Once an employee walks through the IRS’ tool, they can click on the Printer Friendly icon to provide their employer with a printout of the determination along with their answers to all questions answered.
Calculating Imputed Income - Employer Portion of Premiums
No good deed goes unpunished. A company that pays all or part of the healthcare premium for dependents must treat those dollars as taxable income to the employee. Therefore, the amount is subject to Federal income tax withholding and employment taxes and must be reported on the employee’s Form W-2.
How to determine the amount of imputed income can be a bit challenging. The IRS does not provide any guidance on how to determine this amount, and there are definite pitfalls with some calculation methods. Let’s look at an example:
Assume that an employee and their domestic partner are covered under a health plan and the employer covers 100% of the premium. The domestic partner is not a qualified tax dependent. The cost of the plan is $500 for a single employee and $1200 for an employee plus family. The employer could use an easy calculation of EE+FAM minus EE, or $1200-$500 = $700. This would result in $700 of imputed income.
Now take this same scenario and assume the employee and domestic partner also have a child on the plan, and the child qualifies as a dependent of the employee. Since the cost of the plan is $500 for a single employee and $1200 for an employee plus family, how would the employer calculate the imputed income?
This same type of challenge arises when an employee has multiple children, some who are qualified dependents and others who are not. Because of this, some payroll vendors recommend using the COBRA rates (minus the 2% administration fee) as the amount of applicable imputed income. While this can work most of the time, a review of the prior scenario with a slight twist can expose the pitfall.
Assume the employee is covering a domestic partner and child on the plan with the employer paying 100% of the $1200 in family premiums. Neither the domestic partner nor the child qualifies as a dependent of the employee. The cost of the plan is $500 for a single employee and $1200 for an employee plus family, therefore, the cost of “comparable” COBRA coverage for just the spouse and child would be $1200. Using this method, the employee would not receive any portion of the employer-paid premiums as a pre-tax benefit.
One other method that would work favorably is a percentage of premium methodology. Under this calculation, the employee rate would be removed from the overall family premium being charged for the family coverage. Then a percentage of that dependent-only premium would be counted as imputed income, based on the number of non-qualified dependents. Reviewing the three case studies already noted above, this method would result in the following imputed income (with premiums of $500 for a single employee and $1200 for an employee with a family, and employer paying 100% of the premium):
An employee and their domestic partner are covered. The domestic partner is not a qualified tax dependent. The dependent-only premium is $1200 minus $500 = $700. There is one dependent and they are non-qualified, therefore 100% of the dependent-only premium ($700) should be imputed.
An employee and non-qualified domestic partner also have a child on the plan, and the child qualifies as a dependent of the employee. The dependent-only premium is $1200 minus $500 = $700. There are 2 dependents and one is non-qualified, therefore 50% of the dependent-only premium ($350) should be imputed.
An employee is covering a domestic partner and child on the plan, and neither the domestic partner nor the child qualifies as a dependent of the employee. The dependent-only premium is $1200 minus $500 = $700. There are two dependents and they are both non-qualified, therefore 100% of the dependent-only premium ($700) should be imputed.
The Bottom Line
Providing group-sponsored healthcare to non-qualified dependents can add complexity to payroll, but in many cases the benefits outweigh the extra work. In some cases, employers offer benefits to only “qualified” dependents, thereby skirting the complexities of non-qualified dependents and the tax implications. Prior to the Supreme Court of the United States ruling in favor of same-sex marriage in 2015, it was frowned upon as discriminatory to exclude only non-qualified domestic partners and their non-qualified children from eligibility in the healthcare program. However, now with a path to “qualification” due to the Obergefell v. Hodges SCOTUS ruling, it has become more common to see this “class out” in employer plans.
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I love numbers. I'm a math geek. I read benefits industry articles and periodicals for relaxation (but, honestly, I'm still a fun gal). I also like to share what I've learned and you'll find it all here.