October 01, 2018
Author: Christopher G. Stevenson
Organization: Drummond Woodsum
I. Background and Important Terms
1. Cafeteria Plan: Employees are permitted to pay for their share of the cost of employer provided health insurance on a pre-tax basis (free from income tax, social security and Medicare tax) if the employer has a section 125 cafeteria plan in place. The cafeteria plan is a written plan document that describes the administration and basic features of the plan. The health insurance coverage purchased on a pre-tax basis under the cafeteria plan can cover the employee, the employee’ spouse and the employee’s dependents. The portion of coverage paid for by the employer is a tax-free benefit to the employee.
2. Health Flexible Spending Account (FSA): A health flexible spending account (health FSA) is an optional component of a cafeteria plan that allows employees to pay for their share of uninsured medical or dental costs on a pre-tax basis. Employees can set aside additional salary on a pre-tax basis to pay for uninsured medical costs of the employee, the employee’s dependents and the employee’s spouse (the employer can make contributions to the FSA account as well). The health FSA is a written plan document that describes the administration and basic features of the plan. An employee is permitted to contribute up to $2,500 of salary per year to a health FSA, increased periodically by the IRS for inflation.
For example, if an employer’s dental plan requires an employee to pay $1,000 out of pocket in order to get braces for his child, the employer could establish health FSA in order to allow the employee to set aside the $1,000 of salary to pay for the braces on pretax basis. The tax savings to the employee is significant. For example, if the employee’s federal income tax rate is 25% and the employee is subject to FICA (7.65% combined), paying for the $1,000 deductible on a pre-tax basis through an FSA would save the employee $370.1 Similarly, the employer does not have to pay employment taxes on the salary contributed by the employee to the health FSA.
3. Health Savings Account (HSA): A Health Savings Account (HSA) is similar to an FSA however the HSA can only be established by an employee who is covered by a high deductible health plan (HDHP). If the employee is covered under a non-HDHP of his/her spouse the employee is not eligible for coverage under a HAS. For plans offering self only coverage, in order to be a HDHP the plan must have an employee deductible of between $1,250 and $6,350 (however coverage for certain preventative services can be provided without a deductible). For plans offering coverage for the employee and at least one other individual, in order to be a HDHP the plan must have an employee deductible of between $2,500 and $12,700. Both the employee and the employer can contribute to the HSA. Employees can contribute salary to an HSA tax-free under an employer’s cafeteria plan or the employee can contribute his/her own outside funds. The total maximum amount that may be contributed to an HSA is $3,300 for individuals covered under a self-only plan and $6,550 for employees covered under all other plans, plus an additional $1,000 if the employee is at least 55 years old by the end of he plan year. The employee can receive a tax deduction for contributions to an HSA and employer contributions can be tax-free. Amounts contributed to an HSA are held by a qualifying trustee, usually a bank but not the emplyer, and rollover from year-to-year until the employee uses them. The HSA is portable and travels with the individual even if he/she terminates employment.
4. Health Reimbursement Account (HRA): A Health Reimbursement Account (“HRA”) is a non-elective, employer-funded medical reimbursement plan that reimburses participants for eligible medical costs up to a prescribed dollar amount. Reimbursements under an HRA are excluded from the participant’s income provided the HRA complies with applicable IRS guidelines.2 One major difference between a health FSA and an HRA is that a Health FSA can be funded with both employer and employee contributions, while an HRA is funded solely with employer contributions. Another major difference between a Health FSA and an HRA is that an HRA can be used to reimburse employees tax-free for the cost of their health insurance premiums, while a health FSA cannot. Also, as oppose to Health FSAs which have historically been subject to the “use it or lose it rule” discussed below, amounts remaining in HRAs at the end of the year can generally roll over and are available in later years. These amounts may remain available to the participant in years following the employee’s termination of employment.
5. Which Health Costs are Eligible to be Paid For Through an FSA, HRA, and HSA?
Employees can use balances in their FSA, HRA or HSA to pay for any IRS-qualifying medical costs. IRS-qualifying medical costs can be found in IRS Publication 969 listed on the IRS’s website are www.irs.gov. These accounts are commonly used to pay for uninsured medical costs such as:
• Employee deductibles commonly due to hospitals for surgeries and other procedures
• Co-payments due for doctor, dentist, and optometrist visits
• Braces, filings, crowns, cleanings, and other uninsured dental costs
• Laser eye surgery
• Out-of-pocket costs for prescription drugs
II. United States v. Windsor
1. Pre-Windsor: Domestic Partners, Same-Spouses, and Health Benefits
a. Before DOMA: Prior to the enactment of the Defense of Marriage Act (DOMA), employer-provided accident or health benefits to a domestic partner or member of a civil union was tax-free provided the individual qualified as a spouse under state law.3 An individual’s marital status as determined under state law is recognized in the administration of federal tax laws.
b. DOMA: In September of 1996, the Defense of Marriage Act (DOMA) was signed into law.4 Section 3 of DOMA defined the term “spouse,” for purposes of all federal laws, regulations and interpretations, as only a person of the opposite sex who is a husband or a wife. Thus, prior to Windsor, DOMA § 3 displaced state law with respect to marital status for federal tax purposes. In other words, even if a state recognized same-sex marriage, an employer’s provisions of accident or health plan coverage to an employee’s same-sex spouse was a taxable benefit to the employee, unless the same-sex spouse qualified as a tax dependent. Similarly, an employee in a same-sex marriage or civil union could not pay his or her share of employer-provided health insurance to the domestic partner on a pretax basis through a cafeteria plan (unless the spouse qualified as a tax dependent). In this situation, the employee had to pay for his/her share of the same-sex spouses coverage with after-tax wages, and any employer contributions to the cost of that coverage was taxable income to the employee and reported as wages on his/her employee’s Form W-2.5
Similarly, an employee in a same-sex marriage could not seek tax-free reimbursement for same-sex spouse’s otherwise eligible medical expenses through a health FSA or HRA.
2. United States v. Windsor, 133 S.Ct. 2675 (2013)
a. Factual Background: The Defense of Marriage Act (DOMA), enacted in 1996, stated that, for the purposes of federal law, the words “marriage” and “spouse” refer to legal unions between one man and one woman. In the aftermath of DOMA, some states legalized same-sex marriage. Also, a few federal courts ruled DOMA unconstitutional under the Fifth Amendment, but those courts had disagreed on the rationale behind DOMA’s unconstitutionality. Edith Windsor and Thea Spyer were in a relationship for nearly 46 years. The couple registered as “domestic partners” in New York in 1993 when New York. In 2007, Spyer and Windsor were married in Ontario Canada but continued to reside in New York City. The state of New York deemed their marriage to be valid. Spyer died in 2009. At the time of Spyer’s death, New York did not yet allow same sex marriage.6 In her last will and testament, Spyer left her entire estate to Windsor.
Windsor subsequently sought to claim the estate tax exemption for surviving spouses.7 She was barred from doing so, however, by a federal law, under DOMA, which excludes a same-sex partner from the definition of “spouse” as that term is used in federal statutes. Windsor paid the taxes but filed suit to challenge the constitutionality of this provision. Windsor paid $363,053 in estate taxes and sought a refund. The Internal Revenue Service denied the refund, concluding that, under DOMA, Windsor was not a “surviving spouse.” 8
b. The Decision: In a 5:4 decision, the Supreme Court held that §3 of DOMA was unconstitutional. The Court stated that the purpose and effect of DOMA is to impose a “disadvantage, a separate status, and so a stigma” on same-sex couples in violation of the Fifth Amendment’s guarantee of equal protection. The Court also stated that states have the authority to define marital relationships and that DOMA goes against legislative and historical precedent by undermining that authority.
3. Qualifying “Spouse” in the Wake of Windsor:
a. State of Celebration Rule: Following Windsor, the IRS has ruled that it will recognize same sex marriages provided the marriage was valid under the law of the state were the marriage was entered into. This means that if a same sex couple enters into valid marriage in Maine, and subsequently moves to another state that does not recognize same sex marriages, the same sex spouse would be treated the same as an opposite sex spouse for federal tax purposes. For example, if the employer in the other state provided health insurance benefits to the employee’s same sex spouse, the employee would not be taxed on the value of those health benefits. Similarly, if the employer offered a health FSA or HRA, the employee could seek tax-free reimbursement for his/her spouses qualifying medical expenses.
4. Qualifying “Child” in the Wake of Windsor
For purposes of tax-free health benefits, a “qualifying child” is defined as an individual who (1) bears a specified relationship to the employee (relationship test); (2) has the same principle abode as the employee for more than half of the year (residency test); (3) meets certain age requirements (age test); (4) has not provided more than half of his or her own support for the year (limited self-support test); and (5)has not filed a joint tax return (other than a claim for refund) with his or her spouse for the year (martial/tax filing status test).9
Prior to Windsor, the biological child of a same-sex spouse was not considered a qualifying step-child of the other spouse, and was therefore ineligible for cafeteria plan, HRA, FSA, and HSA benefits. In the wake of Winsor, it is clear that if the employee adopts his/her same-sex spouses biological child, the child would be generally treated the same as a biological child of the employee and generally eligible for tax-free health benefits. On the other hand, it is still somewhat unsettled whether in the wake of Windsor, the child of the employee’s same-sex spouse would be considered to be a step-child of the employee, generally eligible for tax-free benefits if that child was not formally adopted or did not apply as the employee’s step child under state law. However, at least one IRS official has informally commented that in this case, the spouse’s biological child should be eligible for tax-free benefits even if he/she was not formally adopted or did not qualify as a step-child under state law.10 Therefore, unless guidance is issued to the contrary, it appears that a an employee is generally eligible to receive tax-free health insurance coverage and FSA/HRA/HSA reimbursements for his/her spouses biological child irrespective of whether or not the child qualifies as the employees step-child under state law.
5. Special Cafeteria Plan and FSA Enrollment Rights; Plan Amendments, HSA and DCAP Contribution Limits
Generally, an employee must decide to participate in a cafeteria plan and/or FSA prior to the beginning of the year during the plan’s open enrollment. Once the decision is made it is final for the balance of the plan year unless there is a qualifying change of status event. In the wake of Windsor the IRS confirmed that it would treat a participant who was married to a same-sex spouse as of the date of the Windsor decision as if he/she experienced a change of status event for purposes of the Cafeteria Plan and health FSA participation rules.11 For example, the employee could elect to increase his/her health FSA salary deferral in order to have additional contributions available to seek reimbursement for his/her spouse’s qualifying medical expenses.
On the other hand, in the wake of Windsor both spouses’ contribution to an HSA must be considered against the IRS prescribed maximum contribution (in 2014 the combined contribution for spouses cannot exceed $6,550). If prior to Windsor, both spouses were contributing this maximum to separate HSA’s for separate coverage for each spouse and each spouse’s separate dependents, the spouses’ total contribution would exceed the IRS prescribed maximum. In this case, the IRS announced that for the balance of the health plan year that included the Windsor decision, each spouse could reduce his/her contribution for the balance of the plan year and any excess could be returned to the spouse.12
Similarly, the dependent care FSA limits that apply to married couples ($5,000) in 2013 for couples filing a joint return) apply to same sex spouses in the 2013 taxable year and beyond. As a result, if separate elections were made by same sex spouses for 2013 and the total exceeds this limit, each spouse can reduce his/her contribution for the balance of the plan year. Also, if the total contribution for the year still exceeds the $5,000 maximum, the balance will be considered an excess contribution and included in the spouses’ gross income pursuant to the normal dependent care FSA requirements for excess contributions.13
6. Refunds and Withholding Related to Employer-Provided Health Coverage
The Windsor decision has retroactive effect for purposes of tax law. Under the decision section 3 of DOMA is treated as invalid and unconstitutional since the law’s inception in 1996. The decision effectively means that employees with same sex spouses should have never had to pay imputed income tax and employment taxes (Social Security and Medicare) on the value of any employer-provided health benefits to the employee’s spouse and should have been able to pay for the employee’s share of the cost of coverage on an income tax and employment tax-free basis. This means that same-sex spouses can seek income tax refunds of these amounts for any tax year in which the period of limitations has not expired (generally, the later of the three (3) years from the date the return was filed or two (2) years from the date the tax was paid). For example, if in 2012 an employee received employer provided health insurance for the employee’s same-sex spouse valued at $5,000 and paid $2,000 for the remaining cost of this coverage, the employee could file an amended income tax return for 2012 showing $7,000 less in taxable wages for the year.
Similarly, refunds of Social Security and Medicare tax paid on these amounts may be recovered by the employer by filing an amended employment tax return for any year in which the period of limitations has not expired (generally three years from the returns due date). The IRS announced that under a special alternative procedure, the IRS will permit employers to file a claim for a refund for excess employment taxes for an entire year for which the limitations period has not expired by filing a single amended employment tax return for the fourth quarter of each such.
For example, in order to collect excess employment taxes paid on same sex spouses medical benefits in 2012, the employer could file a single amended Form 941-X for the fourth quarter of 2012, claiming a refund of all excess employment taxes paid in 2012.14 The employer could continue this procedure for each year for which the limitations period has not expired.
Alternatively, the employer could file amended employment tax returns for each quarter of each year in which the limitations period has not expired. For each such year the employer must still furnish Form W-2c to correct each affected employees Form W-2, obtain a written statement from the employee that the employee has not also pursued, and will not also pursue, a refund of the excess employment taxes on the employee’s own accord. Lastly, for seeking a refund of excess income tax withheld on same sex spousal benefits, the employee must file an amended income tax return. Such excess income tax withholdings cannot be corrected by the employer on Form 941-X.
7. Practical Steps for Employers to Take in the Wake of Windsor:
a. Consult with legal counsel to determine whether you should or want to offer same sex coverage to health and welfare plans. Although Windsor decided that section 3 of DOMA was unconstitutional, the ruling does not require employers to treat same sex spouses the same as other spouses. In other words, Windsor does not require employers to offer spousal health benefits. Also, the ruling does not in fact require employers to offer same sex spouses the same health benefits as opposite sex spouses but of course such disparate treatment of same sex spouses could result in other constitutional challenges or other state law violations.
b. Make any necessary amendment to the definition of “spouse” in your cafeteria plan and wrap plan document (and possible amend the definition of “children” and “dependents as well).
c. Confirm your third party administrators/providers are updating policies and providing required notices to same sex spouses (e.g., initial COBRA notices and notices to those already in the COBRA election period).
d. Make sure your insurance policies are consistent with the above.
e. Ensure your payroll systems are updated to reflect proper tax treatment of group coverage for same sex spouses and their children.
1 If Employee A is not covered by an FSA, in order to be left with $1,000 after-tax to pay the deductible, Employee A would have to receive $1,485 in salary, pay 25% in income taxes and 7.65% in FICA, or $485 in this example, and be left with $1,000 to pay for the braces. If employee B is covered by an FSA, employee B could set aside the $1,000 pre-tax to pay for the braces and have an extra $485 in his gross income as compared to employee A. The extra $485 of gross income works out to an extra $370 of net take home pay after income taxes (25%) and FICA (7.65%) are taken out.
2 IRS Notice 2002-45, 2002-28 I.R.B. 93.
3 PLR 9603011 (citing Rev. Rul. 58-66, 1958-1 C.B. 60).
4 Pub.L. 104–199, 110 Stat. 2419
5 See Priv. Ltr. Ruls. 200339001 (June 13, 2003), 985011 (Spet. 10, 1998), and 9717018 (Jan. 22, 1997). The IRS applied DOMA to conclude that same-sex domestic partners could not be a spouse for purposes of Code section 106.
6 Although Windsor does not specifically mention the text of any New York Marriage Act, New York Governor David A. Paterson directed all state agencies in May 2008 to “begin to revise their policies and regulations to recognize same-sex marriages performed in other jurisdictions, like Massachusetts, California and Canada.” Jeremy W. Peters, New York to Back Same-Sex Unions from Elsewhere, N.Y. TIMES, May 29, 2008, http://www.nytimes.com/2008/05/29/nyregion/29marriage.html.
7 Windsor did not qualify for the marital exemption from the federal estate tax, which excludes from taxation “any interest in property which passes or has passed from the decedent to his surviving spouse.” 26 U.S.C. § 2056(a).
8 Since Windsor, the IRS ruled that for federal tax purposes, it will recognize a marriage of same-sex individuals that was validly entered into in a state whose laws authorize the marriage of two individuals of the same sex even if the married couple is domiciled in a state that does not recognize the validity of same sex marriage. Rev. Rul 2013-17, 2013-38 I.R.B., Sept. 16, 2013. The DOL and HHS have followed the IRS’s example and have stated that the respective agencies will recognize “spouses” and “marriage” based on the validity of the marriage in the state of celebration, instead of the state of domicile. EBSA Technical Release 2013-04.
9 26 U.S.C. §152(c).
10 Informal, nonbinding remarks of Rachel Levy, Office of Tax Policy, March 7, 2014 ECFC Annual Conference.
11 IRS Notice 2014-1.
13 26 U.S.C. §129(a)(2)(B).
14 IRS Notice 2013-61.