After the historic June 26, 2013, Supreme Court ruling that Section 3 of the Defense of Marriage Act (aka DOMA) was unconstitutional, many LGBT couples happily committed to legal marriage in 2013 and even more are considering nuptials in the near future. However, many couples, for a variety of reasons, have not yet taken the plunge. Our LGBT tax consulting experts have identified several economic and tax considerations LGBT couples may want to quantify when assessing the financial impact of marriage. This is the third post, in a series of blogs, which address these issues. Last week, we discussed the adoption credit and why finalizing an adoption before reading your vows could save thousands of dollars in taxes. In our first post of this series we debunked the myth that the higher earning partner should always claim the kids for their dependency exemptions.
Remember, no individual blog in this series should be viewed singularly as there are many variables that would impact a couple’s decision to get married, and many of these issues are intertwined. To discuss your specific situation, call on us and someone from our dedicated LGBT services team will contact you.
Today, we address imputed income on employer-provided health insurance for non-spouse partners. We will identify which couples may be able to go back to prior years and amend their returns to claim refunds for this imputed income, discuss a way to eliminate imputed income going forward, and go over a clever way to offset the imputed income with a deduction.
In general, an employee can exclude from income the cost of employer-provided coverage under an accident or health plan for the employee, his or her spouse and dependents. However, for coverage provided to someone other than the employee’s spouse or dependents, the difference between the value of the coverage and payments made for the coverage must be included in the employee's gross income. This is often referred to as imputed income and has affected same-sex couples for years based on the IRS’s prior position that same-sex partners, even those who were legally married, were not “spouses” under the law. Income tax and payroll (FICA) tax must be withheld on this imputed income, even though the employee won’t receive any additional cash wages. Here is an example to illustrate:
Sara and Jessica live in New York City and are unmarried. Sara’s employer, Parker Inc., provides health insurance coverage for both Sara and Jessica at no cost. Assume Parker, Inc. pays $10,000 a year for Sara’s coverage and $10,000 a year for Jessica’s coverage. Under the law, Sara’s coverage is tax-free but Jessica’s is not since she is neither Sara’s spouse nor her dependent. The difference between the value of Jessica’s coverage ($10,000) and the cost paid by Sara ($0) is taxable income to Sara. This $10,000 of imputed income is included on Sara’s W-2 and is subject to federal and payroll tax withholding, which could cost Sara up to $4,725 of tax. Had Sara and Jessica been in a legal marriage recognized by the federal government, none of the coverage would be taxable.
Refund Opportunity from Prior Years
Since the SCOTUS DOMA ruling and IRS Guidance are retrospective, same-sex couples that were legally married in prior years, but were required to impute income on health benefits since the federal government didn’t recognize their marriage, may be able to amend their returns. Had Sara and Jessica been married while Parker provided the taxable health insurance, they could go back to any years still open under the statute of limitations and amend their returns to request a refund for the income tax paid on the $10,000 of imputed income. Also know, for those couples who were already legally married before the SCOTUS and IRS rulings, their employers should have taken steps to secure payroll tax refunds for any period where the statute of limitations remained open.
How to Eliminate Imputed Income
Once the IRS released guidance in the summer of 2013 after the Supreme Court’s DOMA ruling, it became clear that the easiest way to eliminate imputed income on the health benefits is for a couple to get married. If Sara and Jessica go ahead and tie the knot the whole issue is avoided going forward since Jessica will now be considered Sara’s spouse, making her health insurance coverage from Parker tax-free.
However, not everyone in the LGBT community is jumping at the chance to get married. With that in mind, the rest of the post will address a specific planning-idea/refund-opportunity for employee partners who are or were unmarried at any time during tax years 2010-2013 and whose employers imputed income for their self-employed partner’s health benefits. This issue may also apply to couples in the year of marriage.
A Tax Deduction to Offset Imputed Income
The concept in general is simple. Since the health insurance premiums for the self-employed partner are paid with “after-tax dollars” of the employed partner (due to the imputed income concept) the premiums could be deductible as self-employed health insurance, a valuable above-the-line deduction. This would lower the self-employed partner’s adjusted gross income (AGI), and may increase their ability to qualify for certain tax credits or deductions that would have otherwise been limited by AGI thresholds of phase-outs.
NOTE: While this tax planning concept could apply to a partner who is not self-employed, it is less likely that the tax impact will be meaningful due to the 7.5% (10% in 2013 and forward) AGI threshold for unreimbursed medical and dental expenses paid by the taxpayer.
Going back to our example, Sara and Jessica are unmarried and Parker is providing health insurance for both of them at no cost to Sara. Assume Jessica is a freelance writer with self-employment income reported on Schedule C. Sara is still required to impute income on the coverage Parker provides to Jessica since they are not spouses. In this instance, Jessica may be able to take a tax deduction for self-employed health insurance premiums paid, even though Parker provides the coverage at no cost (other than income tax costs).
There are two separate technical aspects that support this tax position. And The Tax Warriors® love the details…
First, in Lang v. Comm'r, T.C. Memo 2010-286 (T.C. 2010) the Tax Court found that the taxpayer was entitled to a deduction for a portion of medical expenses the taxpayer’s mother paid directly to the taxpayer’s medical care providers on the taxpayer’s behalf because the payments were treated in substance as a gift to the taxpayer, who was then treated as having used the same to pay her medical expenses. This case applied the concept of substance over form which was favorable to the taxpayer. It seems reasonable that this concept could be expanded to include gifts between un-married partners. Thus, the amount of imputed income included in the employed partner’s wages for the self-employed partner’s health benefits (effectively paid with after-tax dollars) would be deductible to the self-employed partner as if they paid them personally.
The second concept relates to Internal Revenue Code (IRC) Section 162(l). This code section allows for a deduction for insurance which constitutes medical care for the taxpayer, to the extent the taxpayer has earned income from their self-employed activity. This code section has an exception that prevents the deduction for premiums paid when the taxpayer is eligible to participate in any subsidized health plan maintained by an employer of the taxpayer or their spouse. Since the partners in this scenario are not married, the 162(l)(2)(B) exception does not apply.
Gift tax is not an issue, since payments made to any person who provides medical care with respect to a donee are excludable from gift tax as qualified transfers (see IRC Section 2503(e)).
With the rising cost of medical insurance, it is likely the above-the-line deduction for self-employed health insurance that many LGBT couples may be overlooking could range from $5,000 to more than $10,000 annually. This could equate to thousands of dollars in tax savings per year! For unmarried couples who missed this deduction in the past, time may be running out to amend your 2010 tax return so don’t waste any time, contact your tax advisor today!
We strongly recommend consulting with a reputable LGBT family law attorney and tax advisor to evaluate the legal and financial impact of marriage on your family. You can use our LGBT Tax Consulting & Financial Planning webpage as a resource to help you and your partner/spouse make important decisions regarding your family finances. If you would like to discuss your specific situation, call on us and someone from our dedicated LGBT services team will contact you.