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To Tax or Not to Tax A Discussion on Imputed Income Blog Header.jpg

To Tax or Not to Tax: A Discussion on Imputed Income

Employers that sponsor health and cafeteria plans must think about a few things when it comes to eligibility for health coverage:

  1. Which individuals do they wish to cover under their health plans (e.g., major medical, vision, and dental plans) as a business matter?
  2. Who can be offered benefits on a tax-advantaged basis?
  3. Are there any imputed income issues for the individuals they wish to cover (i.e., do any individuals fail to qualify as Code §105(b) dependents)?

Regardless of state law and other plan considerations, a cafeteria plan may only offer pre-tax accident or health coverage to employees, spouses, children under age 27 at the end of the taxable year, and individuals who otherwise qualify as an employee's tax dependents for health coverage purposes. Offering benefits on a tax-free basis to those who do not qualify for the tax advantage could disqualify the plan. There are three possible types of tax dependents:

  • Employee’s Child
  • Qualifying Child
  • Qualifying Relative

The ACA requires employers’ coverage only for employees and dependents. Still, employers can extend coverage to whomever they choose as long as the carrier or stop-loss carrier agrees and the employer is willing to pay the premium. Be aware that this does not mean that the IRS will recognize it as a tax-free benefit under the Cafeteria Plan.

The question of domestic partners often comes up. Domestic partners may qualify as tax-free dependents under a Cafeteria Plan but only if they meet specific criteria. The criteria are contingent upon the domestic partner being recognized as a tax dependent under the Internal Revenue Code. To qualify:

  • Relationships must not violate local laws
  • The individual must be a citizen or resident of the U.S. or resident of Canada or Mexico
  • The individual must receive over half of their support from the employee

If the plan covers someone not eligible for the tax advantage, the employee's contribution for coverage for that individual becomes post-tax. What often gets missed is the employer’s contribution. The employer contribution for the individual is imputed income and must be added to the employee's taxable income. This amount should be included in Box 1 of the W-2.  However, since imputed income is not considered wages, it isn't subject to FICA or FUTA taxes.

Recommendations & Best Practices
  1. When in doubt, if the employee claims a domestic partner is tax dependent, keep the employee’s contribution post-tax and impute the employer’s contribution. Let the employee figure it out on their taxes. The same principle applies to a grandchild or other qualifying child if unclear.
  2. Keep your clients informed and aware so they can avoid tax trouble!
  3. Ensure plan documents regarding eligibility for dependents and others are clear and consistent.

It’s important to know that employers and administrators may be unaware of imputed income situations and may be held responsible for prior years. We recommend they consult with their tax accountant on how to proceed if employers find themselves in this situation. Since questions continue to arise, we’ve recently added language to our wrap plans addressing imputed income for domestic partners and other unusual situations, emphasizing the importance of understanding when to tax or not to tax. If it’s still feeling a little unclear, don’t hesitate to contact us. We’re here to help!

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