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By Todd Solomon and Brian Tiemann, McDermott Will & Emery
Many employers have begun the process of evaluating their options and obligations with respect to extending benefit coverage under employer-sponsored benefit plans to same-sex spouses in light of the U.S. Supreme Court's recent ruling on Section 3 of the Defense of Marriage Act. Section 3 of DOMA provided that for all purposes of federal law the word “marriage” meant “only a legal union between one man and one woman as husband and wife,” and the word “spouse” referred “only to a person of the opposite-sex who is a husband or wife.” In June 2013, the Supreme Court ruled in United States v. Windsor1 that Section 3 of DOMA was an unconstitutional “deprivation of the liberty of the person protected by the Fifth Amendment.” The effect of this ruling is that federal law now generally will defer to state law definitions of marriage, including same-sex marriage, which has been legalized in 13 states and the District of Columbia.
As part of evaluating options for extending benefit coverage to same-sex spouses, employers need to consider the financial implications of such benefits. These implications include costs the employer will incur in extending such benefits, as well as the financial impact on employees who opt to utilize such benefits. Many of these costs are dependent upon the spousal benefits the employer currently offers, although the relevant considerations and cost estimates outlined below may be helpful resources.
Employers with defined contribution retirement plans, such as tax code Section 401(k) and Section 403(b) plans, generally can extend spousal rights and benefits to same-sex spouses and partners at no additional cost.
Employees who participate in Section 401(k) plans are entitled to name a beneficiary who will be paid the balance of the employee's benefits under the plan in the event the employee dies before receiving full payment of the plan benefits. Section 401(k) plans include a provision identifying a default beneficiary in the event the employee fails to designate a beneficiary or the beneficiary predeceases the employee. An employee's spouse, including a same-sex spouse recognized for federal purposes, must be recognized as the default beneficiary. In addition, employers can amend Section 401(k) plans to include same-sex partners as default beneficiaries to the same extent as spouses.
Section 401(k) plans may, but are not required, to permit employees to take a distribution of their plan benefits prior to retirement in the event of financial hardship. The circumstances under which hardship distributions from Section 401(k) plans may be permitted are defined by law. Of the specified circumstances, the following include an employee's spouse in determining whether the employee is eligible to take a hardship distribution:
The Pension Protection Act of 2006 permits employers to amend their Section 401(k) plans to include an employee's “primary beneficiary” in the above criteria for hardship distribution determinations. A primary beneficiary is defined as an individual who is named as a beneficiary under the plan and who has an unconditional right to all or a portion of the participant's account balances under the plan upon the death of the participant. The inclusion of primary beneficiaries in hardship distribution determinations allows same-sex partners who are not legally married but who are named as an employee's beneficiary under the Section 401(k) plan to be included in these determinations.
The benefit that may result in the greatest cost increase for employers is extending spousal benefits under defined benefit plans.
A defined benefit plan must pay pension benefits to a married participant in the form of a qualified joint and survivor annuity, unless the participant and his or her spouse elect otherwise. A QJSA is a series of equal, periodic payments over the participant's lifetime with payment continuing to the participant's spouse for the rest of the spouse's life if the spouse survives the participant. The periodic payment to the surviving spouse must be at least 50 percent and not more than 100 percent of the periodic payment received during the joint lives of the participant and his or her spouse. In addition, defined benefit plans must offer a qualified preretirement survivor annuity to all married participants unless the participant and his or her spouse elect to waive the QPSA. The QPSA generally is a series of equal, periodic payments over the participant's lifetime equal to 50 percent of the amount that would have been payable to the participant had the participant survived until benefit commencement.
Employers need to consult their defined benefit plan actuaries to determine whether extending the QJSA and the QPSA to same-sex spouses will result in an increase in the plan's funding requirements. Extending the QJSA to same-sex spouses likely will not result in increased costs for most plans as the QJSA is typically actuarially equivalent to other forms of payment. The QPSA, however, may result in increased costs unless the employer already extended optional forms of payment upon the participant's death for which the participant may elect a beneficiary other than a spouse. Employers with these options offered under their plans may not incur an increase in plan funding requirements.
Employers offering spousal medical, dental and vision coverage likely will need to extend coverage to employees' same-sex spouses. Employees covering a same-sex spouse under the employer's medical, dental or vision plans typically pay the same “married” or “employee plus one” premium that are paid by employees enrolling an opposite-sex spouse. These premium costs will be dependent upon the terms of the employer's existing plans.
Employers located in states where same-sex marriage is legal and with insured medical, dental or vision benefits must extend coverage to same-sex spouses. Some states where civil unions or domestic partnerships are legal also may require employers with insured medical, dental or vision plans to extend coverage to employees' same-sex partners. Although employers with self-insured medical, dental or vision plans technically are not required to extend spousal benefit coverage to same-sex spouses regardless of the state in which the employer is located, employers that continue to provide coverage only to opposite-sex spouses face a significant risk of federal and state discrimination lawsuits if they do not cover same-sex spouses.
Employers that offer spousal medical, dental or vision coverage also must extend continuation coverage under the Consolidated Omnibus Reconciliation Act of 1985. Although same-sex partners are not entitled to COBRA continuation coverage since civil unions and domestic partnerships are not recognized under federal law, many employers extending benefits to same-sex partners will offer COBRA-equivalent continuation coverage for same-sex partners upon termination of employer-provided coverage. Employers typically incur no additional costs to extend COBRA and COBRA-equivalent coverage to same-sex spouses and partners because most employer plans require the employee to pay the full cost of the continuation coverage.
In addition to these costs of extending benefits to same-sex spouses, costs also may increase due to greater enrollment of same-sex spouses now that unequal federal tax treatment of benefits for same-sex spouses has been mitigated.
Employers that extend medical, dental and vision coverage to same-sex spouses and partners also need to understand the federal and state tax treatment of such benefits. The U.S. Department of the Treasury and the Internal Revenue Service recently issued guidance clarifying the federal tax treatment of benefits for same-sex spouses. The guidance, Revenue Ruling 2013-17, provides that same-sex couples legally married in a state with laws authorizing same-sex marriage will be treated as married for federal tax purposes regardless of whether the couple resides in a state where same-sex marriage is recognized (169 PBD, 8/30/13; 40 BPR 2081, 9/3/13). In other words, the Treasury Department and the Internal Revenue Service have adopted a “state of celebration” rule rather than a “state of residence” rule. The new guidance is effective Sept. 16, 2013.
Federal law excludes amounts that an employer pays towards medical, dental or vision coverage for an employee and the employee's spouse and dependents from the employee's taxable income. An employee covering a same-sex spouse under an employer-sponsored medical, dental or vision plan therefore will not incur additional federal income taxes on the value of the coverage, regardless of whether the employee and his or her spouse reside in a state where same-sex marriage is recognized. In addition, an employee may pay for a same-sex spouse's coverage using pretax contributions under a cafeteria plan and can take tax-free reimbursements from flexible spending accounts (FSAs), health reimbursement accounts (HRAs) and health savings accounts (HSAs) to pay for the same-sex spouse's qualifying medical expenses.
However, this same favorable federal tax treatment does not extend to an employee with a same-sex partner, unless the same-sex partner otherwise qualifies as the employee's tax code dependent. Same-sex partners often will not qualify as the employee's dependent due to the narrow definition of dependent under the federal tax code. The employee therefore must pay federal income taxes on the value of the employer-provided coverage for the same-sex partner. In addition, the employee must pay for the same-sex partner's coverage on an after-tax basis.
Despite this change in the federal tax treatment of benefits for same-sex spouses, such benefits may continue to be subject to state income taxation depending upon the laws of the employee's state of residence. In states where same-sex marriage is recognized or where same-sex domestic partnerships or civil unions have been legalized, employees generally will not pay state income taxes on the fair market value of coverage for a same-sex spouse or partner. Employees in these states may be permitted to pay for the same-sex spouse or partner's coverage using pretax dollars for state income tax purposes.
Many of the states where same-sex marriage is not recognized are expected to issue guidance on the state taxation of benefits for same-sex spouses in the coming months. The state income tax codes in the majority of these states rely on an individual's adjusted gross income under federal tax laws to calculate the amount of the individual's state income taxes. Now that benefit coverage for legally married same-sex spouses is no longer subject to federal income taxation, states where same-sex marriage is not recognized will need to clarify whether employees must continue to pay state income tax on the value of benefit coverage for a same-sex spouse. Until such guidance is issued, employers are generally advised to continue imputing income on the fair market value of benefit coverage for same-sex spouses residing in these states. Employees in these states presumably must continue to pay for the same-sex spouse's coverage using after-tax dollars for state income tax purposes. Benefit coverage for unmarried same-sex partners residing in these states will continue to be subject to state income taxation.
Employers that provide such benefits to non-dependent same-sex partners must impute the fair market value of the benefits as income to the employee that is subject to federal and possibly state income tax. Employers that do not impute income to the employee risk liability for amounts that should have been withheld from the employee's taxable wages, as well as potential penalties for failure to comply with federal and state income tax withholding laws.
In calculating the amount of income that must be imputed to an employee for purposes of federal income taxation of employer-provided benefits for a same-sex partner, the IRS requires the “fair market value” of these benefits be included as taxable income. The fair market value is defined under federal tax regulations as “the amount that an individual would have to pay for the particular benefit in an arm's length transaction.” This means that the amount of income that must be imputed is not the amount that the employee contributes to such benefits for his or her same-sex partner or the subjective value of such benefits to the employee or his or her same-sex partner. Rather, the taxable amount that is imputed as income to the employee is determined based on the amount that the employee would have to pay to purchase the benefit coverage for his or her same-sex partner separate from employment.
Although the IRS has not prescribed a set method by which the fair market value of such benefits is to be calculated, it has approved several methods. These methods can be used even in situations where benefit coverage for an employee's same-sex partner is provided at no additional cost to the employee. The most common way to calculate the fair market value of the benefits is to compare the difference between the costs of providing employee-only coverage and employee-plus-one coverage, after deducting any portion of the cost that is paid by the employee. This amount can be calculated as the difference in what the employer pays to provide coverage for a single employee compared to what the employer pays to provide coverage for an employee and a spouse. Although this result is based on a group health plan rate and would be less than the amount the employee would pay for such coverage separate from employment, the IRS has approved the use of the group health plan rate as a means for calculating the fair market value of the benefit. Alternatively, many employers calculate the fair market value of the benefit based on the individual COBRA premium rate that otherwise applies to such benefits (less the 2 percent COBRA administration fee). Use of the COBRA premium rate generally leads to a larger amount of imputed income.
Employers are required to report income that is imputed as a result of medical, dental and vision benefits provided to an employee's same-sex partner on the employee's annual Form W-2. In addition, employers are required to withhold federal payroll taxes from the imputed amount, including federal income, Social Security, Medicare and employment taxes.
The Williams Institute and the Center for American Progress estimated in 2007 that the average employee covering a non-dependent same-sex partner under an employer-sponsored medical, dental and vision plan pays $523 in additional federal income taxes and $248 in additional payroll taxes each year. Employers also incur an average of $248 in additional payroll taxes each year for each employee who must pay federal taxes on benefit coverage for a same-sex partner. The Human Rights Campaign estimated in 2012 that the amount of additional federal taxes an employee had to pay for the non-dependent same-sex partner's coverage had increased nearly 25 percent to $1,069 per employee. This estimates means employers likely also incur a similar increase in additional payroll taxes.
A recent “cutting edge” benefit offered by some employers is a tax gross-up to offset the disparity in tax treatment of benefits for same-sex spouses and partners. Employers offering this benefit gross up the income of an employee covering a same-sex spouse or partner under the employer's medical, dental or vision plans by the approximate amount the employee must pay in additional taxes for the spouse or partner's coverage. The amount of the gross-up can vary based on which taxes the employer takes into account in calculating the gross-up. Some employers gross up only for additional federal income taxes, while others calculate the gross-up to also include additional federal employment taxes and state income and employment taxes as well. Employers may also calculate the gross-up to include the additional taxes the employee must pay on the gross-up itself.
Now that the federal tax treatment of benefits for same-sex spouses is mitigated, the prevalence of employer-provided tax gross-ups for same-sex spouses and partners has yet to be determined. Employers may choose to discontinue tax gross-ups, even for employees residing in states where same-sex marriage is not recognized, since the employee can marry in a state where same-sex marriage is legal and no longer be subject to federal taxation on the value of his or her same-sex spouse's benefits. Some employers may choose to continue providing the gross-up for any state taxes that an employee may pay for the same-sex spouse's coverage.
Many employers recently have extended comprehensive medical and short-term disability benefits to transgender employees by removing exclusions for transgender-specific treatments. The World Professional Association for Transgender Health's Standards of Care for Gender Identity Disorders have served as a resource regarding the treatments and procedures that are medically necessary for a transgender employee to transition to the gender with which the individual identifies. These treatments are often identified as medically necessary to treat gender identity disorder, which is a condition recognized by the American Psychiatric Association that is often used for the diagnosis and treatment of transgender individuals.
The cost of extending comprehensive medical and short-term disability benefits to transgender employees varies based on factors such as the number of individuals who will make claims for such coverage, the services and procedures requested over time and the number of available providers for the requested procedures. The City and County of San Francisco reported that the additional costs of extending comprehensive benefits to transgender employees averaged between $0.77 and $0.96 per year per enrollee.
Individuals receiving transgender-specific treatments under an employer-sponsored medical plan may also incur additional taxes as a result of the treatments. The tax code generally exempts medical care expenses from taxation for both employer payroll and individual income tax purposes. This favorable tax treatment includes medical care related to the diagnosis, treatment or prevention of diseases or for treatment related to any part or function of the body. However, expenses related to cosmetic surgery or similar procedures are generally only extended favorable tax treatment if the procedures are medically necessary to treat a physical deformity existing at birth or arising by accident or disease. Expenses related to cosmetic procedures intended to improve one's physical appearance are not subject to favorable tax treatment.
The taxation of medical care related to the treatment of gender identity disorder can be confusing because many of the treatments are cosmetic in nature as they are intended to align a transgender person's physical appearance with the gender to which the individual identifies. For example, the U.S. Tax Court ruled inO'Donnabhain v. Commissioner of Internal Revenue, 134 T.C. No. 4 (Feb. 2, 2010), that while hormone therapy and gender reassignment surgery for an individual diagnosed with gender identity disorder . In this situation, the doctors concluded that the hormone therapy had allowed the individual to develop breasts that were “within a normal range of appearance.” Breast augmentation surgery was therefore considered a cosmetic procedure for which the expenses were not deductible medical expenses. The court's conclusion was based on the specific facts and circumstances and left open the possibility that breast augmentation could be medically necessary for another individual diagnosed with gender identity disorder, in which case the costs could be deductible medical expenses. The individual in this case also had surgery to feminize her facial features. Although the court did not directly address a deduction for the costs of this surgery since the expenses were incurred in a year prior to the year under review in the case, the court indicated in a footnote that the facial surgery “may have served the same therapeutic purposes as (genital) sex reassignment surgery and hormone therapy.”
Employees residing in states where same-sex marriage is legal are entitled to leave rights under the Family Medical Leave Act to care for a same-sex spouse with a serious medical condition. Public and private employers with at least 50 employees are required to extend FMLA-protected leave to employees who have worked for the employer for at least 12 months and who have worked at least 1,250 hours for the employer in the past 12 months.
The Department of Labor issued guidance in August clarifying that FMLA leave rights will extend only to same-sex spouses residing in states where same-sex marriage is recognized. Same-sex spouses residing in states where same-sex marriage is not recognized and same-sex partners are not entitled to FMLA leave to care for a spouse or partner with a serious medical condition. All employees, however, may take FMLA leave to care for a child, even if the worker has no legal or biological relationship to the child, which allows employees in any state to take FMLA leave to care for the child of a same-sex spouse or partner, even if the employee has not legally adopted the child.2
Employers located in states where civil unions or domestic partnerships are legal also may be required to extend leave protected under state laws to same-sex spouses and partners. For example, the California Family Rights Act requires employers doing business in California and with more than 50 workers in any state to give California employees 12 weeks of unpaid leave to care for a seriously ill domestic partner.
The cost of extending FMLA leave to employees with same-sex spouses will be dependent upon the frequency at which employees request FMLA leave to care for a seriously ill same-sex spouse, the duration of the employee's leave and the employer's costs in temporarily replacing the employee on leave.
Employers also may need to extend other spousal benefits to employees' same-sex spouses. These benefits can include group rates for insurance plans such as supplemental life insurance, long-term care insurance, home insurance and automobile insurance, as well as other benefits such as bereavement leave, moving or relocation expenses, tuition reimbursement, employee discounts and employee assistance programs.
The group rate insurance plans often can be extended to same-sex spouses at minimal cost to the employer if the employee pays the full cost of the benefit. The cost of other benefits will be dependent upon the specific benefit offered by the employer.
Employers need to consider the costs of extending these benefits as they are evaluating the benefits that federal law now requires to be extended to same-sex spouses, as well as other benefits that the employer may elect to extend to same-sex spouses and partners. These costs are dependent upon the cost of benefits the employer currently extends to employees' spouses, as well as the potential tax implications for employees who may be deterred from enrolling a same-sex spouse or partner for benefit coverage if the same-sex spouse or partner has coverage options elsewhere that do not result in the same additional tax consequences for the couple.
Todd Solomon (email@example.com) is a partner in the Employee Benefits Practice Group of McDermott Will & Emery's Chicago office. He is the author of the third through seventh editions of Domestic Partner Benefits: An Employer's Guide, and was the co-author of the book's first and second editions. Brian J. Tiemann (firstname.lastname@example.org) is a member of the Employee Benefits Practice Group in the firm's Chicago office.
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