Further Guidance on State Imputed Income for Dependent Healthcare Coverage

This Insight article is in follow-up to our last Benefit Insight article on the topic on the Taxation of Dependent Coverage at the state level. This Insight is designed to further outline two possible strategies for compliance on what has become a hot topic for benefit and payroll managers.

Prior to outlining the strategies, it is important to note that as of this writing there is no industry consensus on the best strategy for employers to follow. This Insight focuses on imputed income associated with group health plan coverage of adult children and does not focus on imputed income associated with group health plan coverage of domestic partners or other dependents. This Insight does not constitute tax or legal advice and employers are advised to seek counsel from qualified tax advisors familiar with their applicable state income tax laws.

The “dependent taxation” issue has arisen because some states have not yet, and may never, amend their income tax codes to conform to the federal income tax code. The Patient Protection and Affordable Care Act (PPACA) amended the tax code as of March 30, 2010 to provide favorable tax treatment of health coverage extended to adult children up to December 31 of the year in which they turn age 26.¹ In states that do not match the new federal standard, employers may be required to report, as taxable income to the employee, the fair market value of coverage, minus any post-tax employee contributions, extended to an adult child if the child does not qualify for tax-free health coverage under the state’s income tax code.

As there are conflicting resources on this topic, we have listed those states that do not or may not currently conform to federal tax code. In compiling the list, we omitted any state where there is no state income tax; states that we believe are in alignment with the federal tax code; and states that have more generous tax treatment than the federal code.
 

Employer Compliance Options

There are generally two strategies for compliance with the state by state imputed income requirements. Each strategy has advantages and disadvantages, and the best course of action may vary by employer. Again, employers should consult with tax and legal counsel in developing their compliance strategy.


Option 1: Immediate Imputing of Income – More Conservative Approach

The first approach to state compliance would be to immediately begin imputing income for adult children who do not qualify for tax-free health coverage under the state income tax code for states that have not currently conformed. This strategy will ensure the employee’s imputed income is subject to withholding throughout the year rather than just once, at year-end.

There are a number of administrative steps involved in this approach. First and foremost, employers will need to inventory the states in which they offer coverage to adult children and determine whether the state has currently conformed to the federal income tax code. If the state has conformed, then only if the employer covers dependents beyond age 26 should the employer further review the state’s income tax code.

If the state has not conformed, the employer will next need to identify all enrolled adult children and determine whether each child is a qualified tax dependent of the employee relative to each state’s income tax code for purposes of tax-free health coverage. As the employer usually will not have all the information required to make this determination, communication with employees covering adult children will become necessary.

A reasonable approach usually would be to supply the definition of a tax-qualified dependent for tax-free health coverage purposes to employees by state and ask the employee to attest to the status of their adult child. If an adult child does not qualify for tax-free health coverage under a state’s income tax code, the employer will then (i) calculate the fair market value of the coverage provided to that child, subtract any after-tax employee contributions towards the adult child’s coverage, and report the resulting amount as imputed income on the employee’s paycheck; and (ii) withhold appropriate state income taxes from the imputed income. With respect to methods for reporting the income on an employee’s yearly wage statements (W-2 or a state’s equivalent), employers should consult the relevant states’ tax authorities for guidance.

The downside of this approach is that a state could amend its income tax code to conform to the federal income tax code on a retroactive basis (i.e., to January 1 of the calendar year, or earlier). If this were to happen, the employer potentially would have to correct its prior over reporting of imputed income and over withholding of state income tax. If this situation occurs, the relevant states’ tax authorities should be consulted for guidance.


Option 2: Delayed Imputing of Income – More Practical Approach

A second approach is for employers to wait to calculate imputed income amounts until year-end, reporting imputed income on the employee’s final paycheck for the calendar year and withholding appropriate state income taxes from the employee’s final paycheck. This strategy allows the employer time to monitor state legislative activity throughout the year, avoiding unnecessary administration in states that ultimately conform.

A potential risk of this approach is that it may not comply with a state’s unique rules, if any, regarding the timing of imputing and withholding state income taxes on this type of imputed income. At this time, we are not aware of any such rules, but employers should consult payroll, legal and/or tax counsel to determine if any such rules exist in the states under review. Employers should still communicate this issue to employees residing in non-conforming states, giving them the opportunity to identify children that do not qualify for tax-free health coverage at the state level and adjust their withholding exemptions if necessary.

The downside of this “wait and see” approach is that waiting until year-end to impute income could result in a significant amount of imputed income reported on the employee’s final paycheck that likely will be subject to state income tax withholding. This most likely would result in the employee receiving a reduced amount of take-home pay (or perhaps no pay) on their final paycheck. This potentially could create an employee relations issue because the reduced final paycheck of the calendar year would coincide with the December holiday season when some employees incur greater expenses than at other times of the year. It also is possible that the final paycheck will not be sufficient to cover all taxes owed. With respect to methods for reporting the income on an employee’s yearly wage statements (W-2 or a state’s equivalent), employers should consult the relevant states’ tax authorities for guidance.

Whether you begin immediate imputing of income or take a ‘wait and see’ approach, employers cannot afford to adopt a ‘do nothing’ strategy. Short of the passage of retroactive federal tax reconciliation bills in all non-conforming states in 2011, employers will need to understand the impact that reform legislation has had on their organization, initiate dialogue with payroll, leadership and employees, and build a reasonable strategy which will lead to compliance.

As stated above, this Insight does not constitute tax or legal advice and employers are advised to seek counsel from qualified tax advisors familiar with their applicable state income tax laws.

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¹  The “dependent taxation” issue also arises in states with dependent coverage mandates that require coverage of adult children under insured plans (or self-funded, non-ERISA plans, such as governmental plans) beyond the age required by PPACA (i.e., beyond age 26). Relevant states include Illinois, New Jersey, Pennsylvania, and Wisconsin.