United States: The Challenge Of Providing Health Benefits For Domestic Partners

As the political and social climate in the United States has changed, and the growing economy has (at least until recently) increased competition among employers for skilled workers, there has been a dramatic increase in the number of "domestic partner" benefits offered by employers to unmarried heterosexual or homosexual couples since the first major reported benefits were offered by the Village Voice in 1982. One of the most frequently requested benefits is inclusion of domestic partners in an employer-provided health plan. According to the Human Rights Campaign Foundation, a gay rights organization, over 35,000 companies now offer health benefits for domestic partners.

Employers offering such benefits have expanded from municipalities in San Francisco and Seattle, to the high-technology giants like Microsoft and Apple Computers, to the automobile industry, when in December 2000 it was reported in USA Today that the "big three" auto companies reported that they would offer health benefits for domestic partners. Employers must deal with a number of special planning and tax issues when they provide domestic partner benefits. Three major issues they need to consider are (1) whether such benefits can be offered without jeopardizing the tax-advantaged status of the employer’s health plan, (2) whether such benefits can be excluded from income of the employee and domestic partners who receive them, and (3) how to structure the plan’s eligibility requirements to ensure administrative and financially feasibility. This article discusses these issues and how they are handled by employers in general.

Most employers have provided health benefits to employees and their "traditional" families - spouses and children. Employees with domestic partners (generally defined for purposes of this article as heterosexual or homosexual couples who share basic living arrangements but are not married either formally or by common-law marriage) have sought employer-provided health insurance because of its significant advantages. First, the cost of group coverage for an employee and his or her domestic partner - even if not subsidized by the employer - is significantly less than individually purchased coverage. In addition, the Internal Revenue Code ("Code") provides tax advantages for the employees who receive such coverage. Any payments made by the employer for the provision of such coverage are tax-free to the recipient employee or dependent under section 106 of the Code. Further, any reimbursements by the employer to the employee for medical expenses are exempt from income under Section 105(b) of the Code.

These tax advantages generally apply, however, only to coverage of and payments with respect to employees and their "dependents." A dependent is defined in section 152 of the Code as the taxpayer's spouse, traditional family member, or an individual "who, for the taxable year of the taxpayer, has as his principal place of abode the home of the taxpayer and who is a member of the taxpayer’s household." Code § 152(a)(9). In addition, the dependent must receive over half of his support from the employee/taxpayer. Code § 152(a). While domestic partners generally reside in each other’s household, it is harder for one of them to meet the requirement that they receive over half of his support from the employee/taxpayer, especially if both partners work. And even though some domestic partners might qualify as receiving half their support from another, the employer might feel that monitoring this requirement is too difficult or intrusive. Another obstacle is section 152(b)(5) of the Code, which prohibits dependent status if the relationship is in violation of local law. The IRS has not defined the scope of this italicized phrase and will likely not do so. In a recent field service advice, the IRS made it clear that although the definition of "dependent" for purposes of determining the federal income tax consequences of providing health benefits to domestic partners was determined under Section 152, it is local law, and not any principle under section 152, that would govern in determining whether the relationship was in violation of local law for purposes of section 152(b)(5). See Field Service Advice FSA 199911012 (Dec. 10, 1998). Thus, given this uncertainty and the fact that old antisodomy and similar laws still exist in many states, some employers have been reluctant to rely on the definition of "dependent" under section 152 to cover same-sex domestic partners.

As a practical matter, therefore, most employers try to design domestic partner policies assuming that most partners will not be "dependents" as defined in section 152. With a few exceptions, because "domestic partner" is not defined by the tax law, a clear definition of domestic partner in the employer’s plan is necessary. This is because employers, insurance carriers, and any other service providers will want to avoid the adverse selection that would occur if all employees could sign up any "partners" they chose without established criteria. Criteria often used in health plans include requirements that the domestic partners (a) have been in a committed and exclusive relationship with one another, usually for a minimum period of 3 time, such as a year or six months, (b) live together in the same principal residence, and intend to do so indefinitely, (c) are over 18, unmarried, legally competent to contract; and (d) are not related by blood. Some employers require that the domestic partners agree to be jointly responsible for basic living expenses, such as food and shelter. This was one of the requirements under the San Francisco Domestic Partnership Ordinance, S.F. Admin. Code Chapter 62, Sections 62.2(a) and (b). Another criterion sometimes imposed is that the employee provide the domestic partner with over half of the partner’s financial support. Often, representations that these criteria are met are made in an affidavit signed by the partners under penalty of perjury. The affidavit usually contains a clause whereby the employee will notify the employer if any information changes (for example, the partners break up). To further document the relationship, the employers may require proof in the form of joint bank account statements, wills, mortgages or leases, or utility bills.

In some cases, employers will only cover domestic partners who are registered under state- or city-sponsored "registries" of domestic partners. However, this technique has problems because the registry may be more or less inclusive than the employer prefers, and because the criteria in the registry can change and is beyond the control of the employer.

Once eligibility criteria have been established, the employer must deal with the tax consequences of these benefits. Here, the Internal Revenue Service ("IRS") has provided some limited guidance in the form of private-letter rulings. Note that while helpful, a private letter ruling provides protection only to the taxpayer who requests it. However, such rulings are used by other taxpayers as indicators of the IRS’s view of certain tax issues.

The IRS first discussed the tax consequences of employer-provided domestic partner health benefits in a private letter ruling issued to the city of Seattle.¹ Priv. Ltr. Rul. 9034048 (May 29, 1990). The IRS pointed out that Section 106 of the Code, and its underlying regulations, exclude from an employee’s gross income any payments made by the employer for health coverage of the employee, his or her spouse, or dependents, as defined in section 152. See Treas. Reg. § 1.106-1. Further, all reimbursements for such medical expenses are excludable under section 105(b) of the Code. The IRS went on to say that medical coverage or reimbursements for persons other than an employee, spouse, or dependents is not excludable from income, and would be taxed as compensation or other income under section 61 of the Code. Thus, in the Service’s view, an income exclusion for domestic partner benefits depends on whether such individual can be deemed a spouse or dependent under Section 152.

The IRS has consistently refused to rule on the question of whether the domestic partners covered under this plan are dependents as defined in Section 152, relying on Ensminger v. Commissioner, 610 F.2d 189, 191 (4th Cir. 1979), certiorari denied, 446 U.S. 941 (1980), for the principle that the status of a spouse or dependent is a factual issue to be determined under state law. Note, however, that the Defense of Marriage Act, P.L. 104-199. enacted in 1996, amended the United States Code to provide that in determining the meaning of any Act of Congress or federal agency ruling or regulation, the word "spouse" refers only to a person of the opposite sex who is a husband or wife. The scope of this Act (and indeed, its constitutionality) remains to be seen.

Although the rulings were initially not specific on this point, the IRS finally specifically ruled that an employer’s health plan can add domestic partners who are not dependents as defined in Section 152 without jeopardizing the tax-free receipt of income by employees or dependents under the plan as a whole. Priv. Ltr. Rul. 9603011 (Oct. 18, 1995). Prior rulings had consistently stated that employees and dependents were not taxed on the cost of coverage or benefits received, and never hinted that the results would change by the addition of domestic partners to the plan. See Priv. Ltr. Rul. 9109060 (Dec. 6, 1990). The IRS has also ruled that employers’ plans can cover a domestic partner’s dependents, although such individual would not qualify as the employee’s dependents. Priv. Ltr. Rul. 9717018 (Jan. 22, 1997).

Priv. Ltr. Rul. 9034048 (and subsequent rulings) did set forth the IRS’s position as to how non-spouse dependents should be taxed if they did not qualify as dependents. The IRS has made it clear that if domestic partners are not "dependents," the value of employer-provided health care coverage provided to them is not excluded from income under Code Sections 105 and 106. Therefore, if an employer offers such coverage to employees with domestic partners, the employer must impute income to those employees electing coverage. In addition, the amount includible in the employee’s income will constitute "wages" under Code Sections 3401(a) and 3121(a), and is therefore subject to employer and employee taxation under the Federal Insurance Contributions Act (FICA) and will constitute wages under the Federal Unemployment Tax Act (FUTA). Finally, the employee would be subject to any withholding taxes on that income. See, e.g., Priv. Ltr. Rul. 9850011 (September 10, 1998), Priv. Ltr. Rul. 9109060, and Priv. Ltr. Rul. 9717018, (January 22, 1997).

The amount of imputed income will equal the amount of the fair-market value of the coverage minus the amount, if any, paid by the employee. Treas. Reg. § 1.61-2(b). The IRS will not issue rulings as to what constitutes the fair-market value of such coverage. However, the IRS has implied that such fair market value will be measured by examining the value of group coverage, not the more expensive individual coverage. Priv. Ltr. Rul. 9603011. But see Priv. Ltr. Rul. 9034048 (where IRS originally stated that the value should be based on individual policy rates). See also Priv. Ltr. Rul. 9717018.

Commentators have suggested alternative ways to value domestic partner coverage. One method might be to assume the additional cost is equal to the cost of individual coverage. Another would be to value the marginal cost of coverage; for example, if an employee has individual coverage and adds his domestic partner, the additional cost of changing from individual coverage to "family coverage" or "employee plus one" (depending on how the plan is structured) might be the imputed income. Obviously if the employee with the domestic partner paid for this coverage there would be no imputed income and, in fact employers sometimes require the employee to pay for the coverage to avoid withholding and related obligations. This payment must be done on an after-tax basis, rather than through salary reduction.

Furthermore, the IRS has made it clear that amounts received by or on behalf of domestic partners as a reimbursement or payment of medical benefits under the plan will not be included in the income of the employee or domestic partner, to the extent that either coverage was paid for by employee contributions to the plan or if the fair-market value of the coverage was included in the employee’s income. Priv. Ltr. Rul. 9603011; Code § 104(a)(3). This means that neither the partner nor the employee will be taxed on any benefit payments later paid with respect to the partner under the health plan. On the other hand, if the value of the coverage was not properly included in gross income, the actual benefits received by the domestic partner are includible in the employee’s gross income.

Finally, the IRS has not ruled on the ability of the employer to deduct the costs of any domestic coverage that it provides. However, since there is no specific requirement that payment of health benefits other than to an employee be limited to spouses or dependents, presumably any employer contributions would be deductible under Section 162 of the Code. See Treas. Reg. § 1.162. However, self-employed individuals likely cannot deduct the cost of domestic partner coverage, because such deduction is limited to 60 percent of the amount paid during the year for coverage of the employee, spouse, or dependents. See Code § 162(l).

Employers will have additional practice and administrative questions once they understand the tax consequences of providing health care coverage for domestic partners of employees. In particular, employers will want to know how covering such individuals in a health plan affects the status of the health plan under other laws, and the rights of domestic partners who are now plan participants. While a discussion of all these issues is beyond the scope of this column, some of the major considerations for employers are briefly discussed below.

Under Title X of the Consolidated Omnibus Budget Reconciliation Act of 1985, Public Law 99-272 (COBRA), employees and their qualified beneficiaries can elect to continue coverage under the employer’s health plan in certain circumstances under which coverage would normally end (for example, termination of employment or death of the employee). The COBRA requirements are set forth in both the Code and the Employee Retirement Income Security Act (ERISA), 29 U.S.C. Section 1001 et seq. See Code § 4980B (2000) and ERISA § 601 et seq. However, the COBRA continued health care coverage requirements do not apply to domestic partners. Only a "qualified beneficiary," defined in the Code as a spouse or dependent child of the employee, is entitled to COBRA continuation rights. See Code § 4980B(g)(1)(a) and ERISA § 607(3)(A). Note that COBRA sets forth minimum benefits that must be provided by an employer subject to its requirements. An employer can always provide greater benefits to participant than the law requires. As such, group health plans could voluntarily provide COBRA coverage to domestic partners.

The Health Insurance Portability and Accountability Act of 1996, Public Law 104-191 (HIPAA), protects certain health insurance coverage of employees and their dependents when they change or lose their jobs. For example, HIPAA requires the former employer to certify the extent to which the former employee had coverage, and it requires new employers to accept such prior coverage for purposes of a plan’s preexisting conditions limitation exclusions to the extent that they are permitted under HIPAA. HIPAA’s rules are also contained both in ERISA and the Internal Revenue Code, and neither statute clearly states whether a non-spouse dependent would be excluded from its protection. The Code at Section 5000(b)(1) says that HIPAA applies to "group health plans," defined as plans covering "employees and their families," but there is no specific definition of "family." ERISA applies the HIPAA rules to plans covering employees and dependents (as defined under the terms of the plan); HIPAA also has special rules for newly eligible dependents. A discussion of the various HIPAA rules is beyond the scope of this column, but employers will need to consider how domestic partners will be treated under the general administrative procedures they establish to comply with HIPAA.

Often employers establish "cafeteria plans" under Section 125 of the Code to permit employees to pay for health care and other employee benefits on a pre-tax basis. Any domestic partners who are not considered "dependents" under Code Section 152 would be taxed on the benefit provide to them because such benefits would not be "qualified benefits" excludable from income. Thus, cafeteria plan participation is not particularly useful for domestic partners. Similarly, amounts paid from medical expense spending accounts for domestic partners would not be excludable from income, because such amounts are defined under the Code as expenses otherwise deductible under Section 213 of the Code. Expenses for a non-dependent are not deductible under Section 213.

A more prevalent issue for employers involves the use of voluntary employee beneficiary associations, or VEBAs, which very generally are tax-exempt trust funds that are often used to fund employee or retiree health benefits. See Code § 501(c)(9). VEBAs are used to fund health care coverage to members of the VEBA or their "designated beneficiaries." A domestic partner would not qualify as a beneficiary because that definition relies on the definition of "dependent" under Section 152. See Treas. Reg. § 1.501(c)(9)-3(a).

The VEBA rules state that a VEBA is disqualified (and thus loses its tax-exempt status) unless 90% of its members are employees or dependents. See Treas. Reg. §§1.501(c)(9)-2(a)(1) and 1.501(c)(9)-2(b). A domestic partner would thus not qualify as a "member" of a VEBA. The other 10 percent of the VEBA’s "non members" must share an "employment-related bond" with the VEBA's members. An example given in the regulations allows proprietors and owners of businesses to be VEBA members even if they are not employees, as long as they do not constitute more than 10 percent of the membership. Treas. Reg. § 1.501(c)(9)-2(a)(1). Similarly, a VEBA must not fund more than a de minimis amount of benefits that are not permitted to be offered under a VEBA.

These limits make it clear that a VEBA's status could be jeopardized if domestic partners become covered under the underlying health plan. It is our understanding from informal discussions with IRS personnel that the IRS will likely not attack the qualification of a VEBA if "de minimis" benefits are paid to domestic partners from a VEBA. The IRS has given no formal definition of what benefits are de minimis, however, and whether one measures the number of people covered or the benefits received. One private-letter ruling issued in 1998 held that in the particular circumstances cited therein, coverage of a non-dependent domestic partner would not affect the exemption of the VEBA as long as the benefits paid with respect to such individuals did not exceed 3 percent of the total benefits of the VEBA. Priv. Ltr. Rul. 9850011 (Sept. 10, 1998). The IRS recently issued another private letter ruling, PLR 200108010 (Nov. 17, 2000), dealing with the treatment of domestic partners in a multiemployer VEBA. There, the IRS allowed use of certifications by employees/members that their domestic partners met the requirements for "dependents" under Section 152 of the Code. The ruling also permitted nondependent domestic partners to participate as long as the benefits provided were de minimis. It also concluded that the multiemployer VEBA was the employer for purposes of the employment taxes on wages resulting from coverage provided to the nondependent domestic partners.

VEBAs are also subject to general non-discrimination requirements, but since VEBAs may contain eligibility classifications that are reasonable, one would assume that allowing a defined group of domestic partners to participate would be reasonable, particularly if, as in some cases, the employer is accommodating a local ordinance. Some limited protection might also be provided if the existence of this classification is highlighted on the Form 1024 determination letter that is sent to the IRS to obtain a ruling that the VEBA is tax-exempt.

If an employer prefers to provide domestic partners with these benefits outside the VEBA to avoid any risk to the employee VEBA, as many employers do, that fact should clearly be stated in the plan’s summary plan description (SPD), which requires a description of funding. There may be some recordkeeping and administrative complications if this approach is taken.

If the employer’s plan is self-funded, and subject to the nondiscrimination rules of section 105(h), it should make sure that the class of individuals that elects domestic partner benefit coverage does not consist of a disproportionate number of highly compensated individuals (generally defined as the top 5 officers, 10-percent shareholders and top one-fourth of the workforce). This is because Section 105(h) of the Code, which applies to self-insured plans, provides that highly compensated individuals will not be able to exclude benefits payable to them under a discriminatory medical reimbursement plan. While the definition of "discriminatory" under Section 105(h) is not precise, the regulations look to see if a plan benefit is available or otherwise discriminates in favor of highly compensated individuals. See Treas. Reg. § 1.105-11(e)(2) and (3). The penalty for having a discriminatory benefit is the loss of the exclusion for the reimbursement to the highly compensated individuals, which could be significant if the reimbursement is for a major medical expense. One might argue the benefit in this case is the "coverage" of the domestic partners on which income is imputed, but since the law is so unclear in this area and the regulations focus on the benefits received, it is risky to rely on that position.

Some employees have limited domestic partner benefits to cities where ordinances require such benefits. Both the VEBA rules and section 105(h) nondiscrimination rules provide that classification may be based on geography, and it seems likely that selecting beneficiaries in cities with ordinances as a type of trial/demonstration program is also a reasonable classification of employees.

Similarly, some employers limit domestic partner eligibility for benefits under a plan to "same-sex" partners in order to control costs. In particular, employers with retiree health benefits are unwilling to shoulder the burden of adding domestic partners who could marry but do not do so because they would lose Social Security benefits. It also limits any potential liability for covering couples who could otherwise marry but who choose to live together without marriage due to tax or other reasons. Finally, this restriction limits the number of potential domestic partners in the VEBA, helping to ensure that benefits to such partners remain de minimis.

The California state labor commissioner has opined informally that a state government plan's limitation of benefits to same-sex partners was unlawful discrimination. Also, the San Francisco ordinance applies to both opposite-sex and same-sex partners. The California courts have recently taken the position that such ordinances, to the extent that they relate to employee benefit plans subject to ERISA, could be preempted. See Air Transport Association. v. City and County of San Francisco, 992 F. Supp. 1149 (N.D. Cal. 1998), and S.D. Myers, Inc. v. City and County of San Francisco, 1999 U.S. Dist. LEXIS 8748 (N.D. Cal. 1999). Note, however, that the courts have also found exceptions to this ERISA preemption, for example, if the issuer of the ordinance is acting as a consumer, and not as a regulator, which may be the case with respect to many employers. In the Air Transport Association case, for example, the court made it clear that ERISA preemption applied in that instance because air transportation was so heavily regulated, but said that ERISA preemption might not apply in cases where the city was merely a consumer of services. Similarly, the court in Myers found that ERISA preemption did not apply because the plaintiffs in that case (who were challenging the San Francisco Domestic Partnership Ordinance) could not show irreparable harm and so had no standing to sue. (Moreover, ERISA preemption would not apply to non-ERISA benefits such as bereavement leave.)

Civil rights groups continue to challenge "same-sex" domestic partner plans, but although this issue has just begun to be litigated, at least two court cases have held that employee benefit plans covering spouses and unmarried homosexual partners, but not unmarried heterosexual partners, do not violate Title VII of the Civil Rights Act. See Foray v. Bell Atlantic a/k/a/ NYNEX Corp., 56 F. Supp. 2d 327 1999 U.S. Dist. LEXIS 8494 (S.D. N.Y. 1999), and Cleaves v. City of Chicago, 21 F. Supp. 2d 858, 861 (N.D. Ill. 1998). Nevertheless, employers could face a legal challenge if they limit such benefits to same-sex partners who "cannot otherwise be married."

Note that in light of recent events, same-sex partner could also be excluded from participation in areas where a partner may officially register as a dependent or participate in a civil union ceremony. Foe example, in Vermont, where same-sex couples can register to receive all of the benefits and privileges of marriage under state law, some employers have stated that domestic partners must actually register to benefit under their health plan - much like the rule adopted by some that opposite-sex domestic partners can only benefit if they are married.

There are other practical, non-tax issues to be considered by employers that cover domestic partners. If the employer has an insured plan, if it uses a reinsurer, HMO, or any other contractual provider of services, it should inform those providers of any proposed eligibility criteria so that everyone is clear as to whether such persons are covered under the service and insurance contracts. The insurance contracts should clearly state the employer’s adopted policy.

Finally, while employers naturally want to protect their employees' privacy, an employer should also protect itself by informing participants that while it will consider any domestic partner application/affidavit to be confidential personnel information, it may be necessary to disclose an employee's domestic partner relationship to medical, dental, or other vendors, as well as to authorized personnel for purposes of calculating deductions and income inclusion. Some employers require a written acknowledgment of this fact. In doing so, employers should be aware that HIPAA has strict confidentiality requirements that allow limited disclosure of medical information; these rules should be reviewed.

Many employers that provide domestic partner benefits find that it is a great way to remain competitive and promote employee goodwill and morale. There are tax costs associated with the provision of such benefits, and employees who are offered such coverage must compare the tax costs with the savings associated with coverage being provided at group health rates. Although covering domestic partners is not a simple matter, employers can do so with carefulplanning and up-front communication with employees and service providers about the scope and effect of such coverage. 16

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