Imputed Income for Health Insurance Benefits
Since 2006, divorcing Massachusetts residents have been accustomed to continued health insurance coverage from the former spouse’s employer-provided plans under most circumstances. A recent amendment also requires coverage for children up to age 26. Separation agreements typically provide for one of the divorcing spouses to provide continued coverage for the other spouse and minor children “for so long as eligible” under the employee’s plan. However, recent interpretations of federal tax laws have caused many divorced employees to be charged with “imputed income” on their W-2 forms, and forced to pay additional federal income tax based on the fair market value of the insurance benefits provided to their ex-spouses and children over age 23.
What is Imputed Income?
The federal tax code considers the value of non-cash benefits to be taxable income to the recipient. Most “fringe benefits” have been exempted and fall under the “de minimis” rule and are not taxed, however, benefits of significant value are taxed. Essentially, the fair market value of the benefit is included in an employee’s taxable income and shows up on his or her W-2 form, causing a corresponding increase in federal income tax due. Some typical examples of such benefits which can result in imputed income are: Life Insurance coverage over $50,000; use of a company car for personal use; excessive moving expense reimbursements; day-care or child care over the prescribed limit; tuition assistance over the prescribed limit, etc.
Massachusetts Insurance Laws
Massachusetts modified several insurance statutes in 2006 to provide that upon a divorce, the spouse of the employee would remain eligible for coverage under employer-purchased group health plans without additional premium until the remarriage of one of the parties.
Federal Income Tax Laws
Section 61 of the federal tax code considers most fringe benefits as included in taxable “gross income.” However, section 106(a) excludes from taxable income most employer-provided health plans. The nitty-gritty, however, is found in this Treasury Regulation: “The gross income of an employee does not include contributions which his employer makes to an accident or health plan for compensation (through insurance or otherwise) to the employee for personal injuries or sickness incurred by him, his spouse, or his dependents . . .”
Therein lies the rub. After a divorce, the former spouse is no longer the employee’s “spouse” nor a “dependent.” Similarly, a 24 or 25 year old child cannot be a dependent for federal income tax purposes. Since January 1, 2009, the IRS has taken the position that the fair market value of health insurance benefits provided to a person who is not an employee’s spouse or dependent must be “imputed” to the employee and included in his or her federal gross income: “If the requirements of section 106 are satisfied, employer-provided accident and health coverage for an employee and his or her spouse or dependents is excludible from the employee’s gross income. The fair market value of coverage for any other individual, provided with respect to the employee, is includible in the employee’s gross income.”
It should be noted that the Massachusetts revenue laws do not impute this income for purposes of determining Massachusetts state income tax in the same way; and even better, provides some relief to the problem by a allowing a deduction on the state income tax return for the amount of income imputed on the federal return. However, the federal tax implications alone can be serious. In a typical case, the additional tax burden to the employee could easily be as much as $2,000 per year. Separation agreements should allocate the responsibility for that tax burden.
What about cases where there is no additional cost for the ex-spouse or 25 year old child?
This is the important question facing many divorcing couples in Massachusetts. Keep in mind that the employee may be required to pay for some of the additional coverage for his ex-spouse (or older child) by means of a payroll deduction. What concerns the IRS, however, as imputed income is not what the employee pays, but the value of what the employer contributes to the total cost of the insurance. This, of course, could vary widely from employer to employer, depending on how generous their employee benefits are. Unionized employees and government workers might have higher employer contributions. Some older union contract and government employees may still have full employer contributions. The income imputed to the employee is the value of the benefit provided by the employer. The portion of the benefit paid by the employee is not in the calculus. It is plain to see that a childless employee providing coverage for his ex-spouse is getting a benefit from his employer which has monetary value. However, in Massachusetts an employee with at least one dependent child can add his former spouse to the coverage for no additional cost. This means it costs the employer nothing as well. In Massachusetts, the insurance statutes specifically require the insurance company (or HMO, PPO, etc.) to provide continued coverage for the former spouse “without additional premium.” Therefore, if an employee has already elected a “family” plan for the benefit of at least one minor child, the former spouse essentially rides for free. There is no additional premium either to the employer or the employee for the addition of the ex-spouse. Similarly, if at least one minor child is covered, there is no additional cost to add one more child, such as the 24-year old grad student. The obvious question that arises, then, is what is the “fair market value” to be imputed to the employee when there is no actual cost for the additional benefit to the employer or the employee?
An argument can be made that the incremental cost to provide coverage for the ex-spouse is “zero” and thus no income should be imputed to the employee. The IRS guidance on the subject says the “fair market value” of the additional benefit is what must be imputed. Since, in Massachusetts at least, there is no cost for the added benefit, there is no fair market value for it. Neither the employee nor the employer need pay the insurer any additional premium for the benefit. An argument has been made to the contrary, that the ex-spouse is receiving a measurable benefit, equal to the value of his or her own individual coverage, i.e., what it would cost him or her to go out and buy such coverage. Many HR departments are applying this logic. However, the tax code is concerned with taxing the value of non-cash benefits conferred on the employee which are paid for by the employer when the employer takes a business deduction for such expense. Since in Massachusetts, nothing additional is actually paid by the employer to provide the additional coverage, there should be no imputed income. The price of health insurance is the same whether the ex-spouse is included or not; and in the case of older children, the price of health insurance is the same whether the 25-year old child is included or not (assuming the employee is covering at least one additional child). Since, due to state law, the employee can cover those additional beneficiaries without additional cost to the employer, there is, in fact, zero fair market value to that additional benefit.
What do we do?
Divorcing residents must be forewarned of the possibility of being taxed for imputed income. No one can reliably predict whether a particular employee will be assessed imputed income for health insurance benefits because of at least four reasons: (1) the issue is not widely known (although it is becoming more prevalent); (2) it is not being universally applied; (3) there is great confusion among Payroll, Personnel and Human Resources professionals about it; and (4) there are likely to be changes to federal tax laws altering or clarifying the problem in the coming months. All employers are not created equal. Some have HR departments that take a comprehensive approach to employee records. Others are very small operations. Some companies sub-contract their HR functions to outside agencies. Many HR professionals are operating out of state and have no idea there is no additional cost for the ex-spouse under Massachusetts law. At this time, none of them can be expected to be widely aware of this issue, although it is certain to become more and more common. Even if they are conscious of the tax issue, many employers may be unaware that their employees are covering ex-spouses. A change by an employee to his or her tax withholding or the submission of a Qualified Domestic Relations Order might alert a savvy HR representative, but many times the divorce of an employee goes unnoticed. The employee most often notifies the health insurance carrier directly of a change of address or status. And, the payroll department or payroll vendor is not likely to know whether the employee is providing coverage for a former spouse or non-dependent, only that he or she subscribes to a “family” plan. In-house HR departments of large companies with employees in many states, and outside HR vendors, are presently struggling to develop uniform procedures to apply for employees all over the country. The issue is becoming more and more prevalent – and complex. Wisconsin and Vermont, for example, provide for the extension of benefits to domestic partners, but the added cost is ordinarily absorbed as an element of a “cafeteria” plan. Since the federal filing status of those individuals is almost always going to be “single” because of the Defense of Marriage Act, those cases are easy to spot for payroll and HR administrators, and they are getting most of the publicity.
There are several more important questions which remain unanswered:
(a) How does an employer establish the value of the additional benefit extended to the ex-spouse when he or she is only one of several covered family members? For example, in an actual recent case, the “single” plan cost employees $35 per week; and the “family” plan was $90. Even though the difference to the employee was only $55 per week, the employer assessed imputed income of $125 per week, representing the full fair market value of the employer’s contribution for the coverage extended to his ex-wife. After inquiry, the employer acknowledged that the $125 per week is the employer’s contribution for the whole family, and that since the ex-wife constituted only 25% of the pool of people covered for that employer contribution, the $125 should be reduced accordingly. In any event, even though there was no additional cost to the employer for the continued coverage of the wife, it did not stop the HR department from assessing the imputed income based upon directives from an out-of-state HR advisor.
(b) What happens when health insurance carriers offer hybrid-family plans? More and more insurance plans are now offering “single parent” or “+1” (“Plus One”) plans which cover a parent with one child, but not a spouse, with favorable rates less than the full family plan. With such a plan available, the employee spouse is no longer able to cover the ex-spouse “for no additional premium” since he or she may be eligible to drop down to the cheaper “single parent” coverage. The employer would most certainly require it.
(c) Does the language in your Separation Agreement provide for this event? Most separation agreements have standard language that says the non-employee spouse will reimburse the employee spouse for any “additional cost” for his or her coverage. In another actual recent case, even though the imputed income problem actually resulted in the imputation of over $3,000 in additional income to the employee spouse, the Probate Judge refused to compel the ex-spouse to reimburse him for his additional tax burden, finding that the additional tax burden was not an “additional cost” for the insurance benefit. (The Judge also felt the employer was wrong to impute the income and the employee should fight the employer, not the ex-spouse.) More specific language in the separation agreement could avoid this problem.