In general, if an employer has adopted a cafeteria plan, their employees are not taxed on the cost of employer-provided benefits for the employee and their tax dependents. However, there are three benefits-related exceptions to this rule:
- Cost of group term life insurance – in certain situations
- Long-term disability (LTD) “gross up” amounts
- Benefits for domestic partners and other individuals who do not meet federal tax law definitions of “dependent”
In these situations, the cost of the benefits provided is considered “imputed income” to the employee and therefore the cost or “fair market value” of the benefits are added to the employee’s gross (taxable) income. This non-cash taxable compensation (i.e. benefit) is treated as income and included in the employee’s form W-2 for tax purposes. Imputed income is subject to Social Security and Medicare tax and employment tax withholding.
An employer must impute income for:
- Life insurance coverage for any employee above $50,000
- Employer-paid coverage for spouses or dependents on amounts greater than $2,000
- If a plan is discriminatory, the cost of coverage in any amount for “key employees”
Life insurance coverage for any employee above $50,000
In 1964, Congress adopted Code §79 which begins by stating a general rule that the cost of group-term life insurance is included in gross income. It then carves out a limited exception for the cost of up to $50,000 of group-term life insurance coverage per employee.
If any employee (highly compensated or non-highly compensated) receives more than $50,000 of employer-provided life insurance, then employers are required to impute income on the cost of coverage in excess of $50,000.
IRS Publication 15-B “Employer’s Tax Guide to Fringe Benefits”, explains in detail how the calculation is determined, however, here is a high level overview:
To calculate the value of the excess benefit coverage:
- Determine the excess of the life insurance (Value of life insurance – $50,000 allowable).
- Divide the excess amount by 1,000.
- Multiply the result by the age-appropriate value in Table 2-2 (page 14 of IRS publication 15-B (2019) table below)
- Multiply that result by the number of months of coverage.
- Subtract after-tax premiums paid by the employee.
Example: an employee is 40 years old and does not pay any of the premiums for life insurance for the whole year*. The value of the life insurance was $75,000.
- Determine excess (Value of life insurance – $50,000 allowable) – $75,000 – $50,000 = $25,000 (excess)
- Divide the excess amount by 1,000 – $25,000 /$ 1,000 = 25
- Multiply the result of #2 by the age value found in Table 2-2 (IRS pub. 15-B page 14 (2019) table below) – 25 x $0.10 = $2.50
- Multiply the result of #3 by the number of months of coverage – $2.50 x 12 (months) = $30.00
$30.00 is the amount to be added to the employee’s W-2 as income for the premiums paid by the company on the excess $25,000.
Table 2-2. Cost Per $1,000 of Protection for 1 Month
Under 25 ………………………. …. $ 0.05
25 through 29 ………………………… 0.06
30 through 34 ……………………….. 0.08
35 through 39 ……………………….. 0.09
40 through 44 ……………………….. 0.10
45 through 49 ……………………….. 0.15
50 through 54 ……………………….. 0.23
55 through 59 ……………………….. 0.43
60 through 64 ……………………….. 0.66
65 through 69 ……………………….. 1.27
70 and older ………………………… 2.06
(*Ideally, imputed income amounts are being taxed over the course of the year, but if they were not, at a minimum, the amount should be included on employees’ W-2 at the end of the year.)
Coverage in excess of $2,000 for spouses or dependents.
If an employer pays for life insurance coverage for an employee’s spouse or dependents in an amount more than $2,000, the entire premium amount is imputed income for the employee.
Note: There is no imputed income for the employee if the coverage amount paid by the employer for the employee’s spouse or dependents is less than $2,000. In this case, it may be considered a “de minimis” fringe benefit and excludable from income. (See IRS Notice 89-110 for more details.)
If a plan is discriminatory, the cost of coverage in any amount for “key employees”
If the group life insurance plan favors either as to eligibility or as to the kind or amount of life insurance benefits to any “key employee” (as defined by paragraph (1) of section 416(i)) then all “key employees” covered under the plan must also include in taxable income the higher cost of the first $50,000 of coverage or Table I cost.
Long-term disability (LTD) “gross up” amounts
If an employer wants their employees to have a tax-free LTD benefit in the event the employee becomes disabled, the employer would need to “gross up” (i.e. increase) the employee’s salary by the amount of the employer-paid premium and report the premiums as taxable wages on the employee’s W-2.
Otherwise, if the disability premium is paid pre-tax, the LTD monthly benefit the employee receives if they become disabled and cannot work, will be taxed just like their income is taxed when they are working. e.g. disabled employee receives 60% of their monthly earnings less taxes.
Most carriers will offer a tax choice plan (will apply a slight load to the LTD rate) when the employer pays for the premium, the employer can either:
- Treat the premium payments as employee paid and include in W-2 income (taxable premiums but non-taxable benefits);
- Treat the premium payments as employer paid with no W-2 income (non-taxable premiums but benefits are taxable); or,
- Give employees the choice between options 1 and 2.
Benefits for Domestic Partners (DP) & Their Children
Most domestic partners do not meet the financial dependency criteria to qualify as an employee’s tax dependent for group health plan purposes. Under federal law, the fair market value of coverage for the cost of the non-tax code dependents (minus any after-tax contributions paid by the employee) would be included (i.e. imputed) in the employee’s gross income for federal (and most state) tax purposes and reported as taxable earnings on their W-2 Form. The imputed income is subject to federal income tax withholding as well as FICA and FUTA.
However, if a domestic partner (and their children) qualifies as the employee’s tax dependent, (something an employee needs to determine, not the employer**) there is no imputed income.
(**Best practice is for an employer to require a signed affidavit from the employee as to whether or not a domestic partner qualifies as a Tax Code dependent.)
This information is an overview and should not be considered tax or legal advice.