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Domestic Partner Benefits Trigger Federal Tax Hit

Benefits are taxed because Uncle Sam doesn't recognize the relationship.

Be careful what you wish for.

Employees have asked their companies to offer health benefits to their domestic partners, and many companies have agreed. But while approximately 3,500 U.S.-based companies now offer benefits to cohabitating domestic partners, employees should be aware that those extra benefits might be considered taxable income.

Company-paid health benefits for the employee and the employee's spouse and dependents are not taxable income. But because the federal government does not consider a domestic partner to be a spouse, the difference between what the employer pays for a partner's benefits and what comes out of the employee's paycheck on the partner's behalf is taxable income, says Bill Massey, an editor at

RIA

, an information provider to tax professionals.

That could be a big chunk of money. To keep things simple, let's say that taxable amount is $300 a month. That gives you another $3,600 of income, thereby bumping up your federal tax bill by around $1,000 if you're in the 28% tax bracket. State taxes could make the number uglier.

The gay community has pushed for years to get health benefits for a partner in a committed relationship. And with the number of committed, unmarried heterosexual couples growing as well, this has become a very hot issue for employers in today's ultracompetitive job market.

Companies can elect to offer domestic partner health benefits only to same-sex partners or to same-sex and opposite-sex partners. For instance, Detroit's Big Three automakers (

General Motors

,

Ford

and

DaimlerChrysler's

Chrysler division), offer only same-sex benefits, but

Morgan Stanley Dean Witter

and

Merrill Lynch

offer benefits to same-sex and opposite-sex partners.

Dow Jones

, the publisher of

The Wall Street Journal

, recently announced plans to extend health care and other benefits to domestic partners in 2001. Today, about 19% of workers have the option of getting health benefits for their domestic partner, according to a survey by the

Kaiser Family Foundation

and the

Health Research and Educational Trust

. For a listing of companies that offer these benefits, check out this

section of the

Human Rights Campaign's

Web site.

Your employer will report that extra income for your partner's benefits on your

Form W-2

-- Wage and Tax Statement

TST Recommends

, notes Betsy Billard, of

Billard Kash

, a division of

American Express Financial Advisors

in New York. Because that extra money comes through on your W-2, not only will you owe federal and possibly state taxes on that money, but

FICA tax also will be withheld. That's the 7.65% of your total wages that's set aside for

Social Security

and

Medicare

.

So while these bonus benefits may look attractive, make sure they're worth the extra cost to your paycheck, says Billard.

There may be some options to help lessen your

state

tax bill. If your partner qualifies as your dependent or is recognized under state law as your spouse, then those medical benefits may be state tax-free.

Your domestic partner qualifies as a dependent only if you provide more than one-half of that person's support for the year. In addition, that person must reside at your home and be a member of the household.

But here's where things get funky. There's a quirk in the tax law that says that even if your partner meets the other dependency tests, he or she won't be considered a member of your household if your "relationship" isn't recognized under the law, says Massey.

That's why this won't work on the federal front: Uncle Sam does not recognize same-sex marriages. According to the 1996

Defense of Marriage Act

, the word "marriage" means a legal union between one man and one woman as husband and wife, and the word "spouse" refers only to a person of the opposite sex who is a husband or a wife, says Massey. Thus, a taxpayer and a same-sex domestic partner aren't married for federal tax purposes.

So this won't help you on the federal level. But you may be able to avoid paying state taxes on those benefits if your state recognizes your union.

It's Not All Bad

While the health benefits issue needs some consideration from committed domestic partners, creating a will should be a no-brainer.

"It's amazing how many married couples don't have wills, let alone unmarried couples," says Sean Cherry, a partner at

Financial Asset Management

in Palm Beach Gardens, Fla. Heterosexual married people have the luxury of a spousal rollover. At death, the living spouse most likely will get everything, unless a will states otherwise.

This is not the case with "unmarried" couples. Without a will, the next of kin will inherit everything at death. So to ensure that your partner is cared for after you're gone, draft a will and get your wishes in writing -- especially if you own property together, like a home. If both names are not on the title of the house and there is no will, at death the house will go to the next of kin.

But the beneficiary selections on your IRAs and 401(k)s supersede the wishes in your will. So make sure they are current, Billard says.

Although you can't file your tax return jointly, the upside is you don't have to sweat the marriage penalty. The infamous heterosexual headache hits dual-income couples who make a fair amount of money. Under the current tax system, they actually pay more as a married couple than they would have had they skipped the trip down the aisle. (See this previous

Tax Forum for more details.)

So while Uncle Sam may keep some extra tax because of your partner's benefits, you still end up with more in your pocket filing as single folks than your legally married brethren.

Send your questions and comments to

taxforum@thestreet.com, and please include your full name. Tax Forum appears Tuesdays, Thursdays and Saturdays.

TSC Tax Forum aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.