As discussed in the chart, “State Taxes and Married Same-Sex Couples,” most states that do not recognize same-sex marriage are requiring same-sex married couples to file their tax returns as single (or head of household, if they qualify for that status). However, Virginia has now gone further, denying certain Virginia businesses state income tax deductions for fringe benefits they provide to same-sex spouses. As discussed below, the language used is muddy, and the holding is probably considerably less broad than it appears. However, businesses in Virginia need to be aware of its potential effect on them. And to the extent that other states take the same route, businesses in states other than Virginia would also be affected.
The new Virginia policy states as follows:
In addition to the impact on individual income taxpayers, Virginia’s deconformity from the federal recognition of same-sex marriage may also impact the business deductions of certain corporations, pass-through entities, and sole proprietorships. Under the newly established federal policy, employers may claim a federal deduction for payments of fringe benefits to employees’ same-sex spouses and dependents. Since Virginia does not recognize same-sex marriage, these businesses must adjust the deductions they claim for Virginia income tax purposes accordingly.
By its terms, the reference to “these businesses” in the final sentence is unclear. It might refer to “employers” in the second sentence, or to “certain corporations, pass-through entities, and sole proprietorships” in the first sentence.
However, it appears that what the Virginia Department of Taxation meant to say was that owners of pass-through entities (Subchapter S corporations, partnerships, and sole proprietorships) will now be denied a deduction for health benefits for a same-sex spouse who is not a dependent of the owner–not that all employers will be denied a deduction for all fringe benefits for same-sex spouses. The reason is that, as discussed below, a general corporate deduction for fringe benefits was not “a newly established federal policy,” nor was it in any way dependent on the marital status of the parties.
Section 162 of the Internal Revenue Code provides a deduction for “ordinary and necessary business expenses” of an employer, including “a reasonable allowance for salaries or other compensation for personal services actually rendered.” “Other compensation” includes fringe benefits provided due to employment (regardless of whether they are provided to the employee or to some other party). Thus, for taxable corporate employers, the deduction for fringe benefits does not depend on the relationship of the employee and the party to whom benefits are provided.
For example, suppose that an employer provides an all-expenses-paid trip to an employee and a companion of the employee’s choice, as an incentive for the employee’s work performance. Such a trip would clearly be a fringe benefit. Assuming that the cost of the trip to the employer represents reasonable compensation to the employee, the employer can deduct the cost of the trip. The employee will be required to pay taxes not only on the value of his or her own trip, but on the value of the companion’s trip, but the employer deduction does not depend on the relationship between the employee and the companion.
However, section 162(l) specifies that in the case of partnerships, sole proprietorships, and Subchapter S corporations (“pass-through entities”),
there shall be allowed as a deduction under this section an amount equal to the amount paid during the taxable year for insurance which constitutes medical care for—
(A) the taxpayer,
(B)the taxpayer’s spouse,
(C) the taxpayer’s dependents, and
(D) any child (as defined in section 152(f)(1)) of the taxpayer who as of the end of the taxable year has not attained age 27.
The reason for this rule is that a partnership, sole proprietorship, or Subchapter S corporation does not itself pay taxes. Its owners pay taxes on their ratable share of its profits, not on “compensation” as defined in a corporate context. This rule is intended to put owners of pass-through entities in a position similar to corporate employees, who can exclude from income employer-paid health premiums for themselves, their spouses, their children under age 27, and their dependents.
The Internal Revenue Service currently provides guidance on the application of these rules to registered domestic partners (who are not treated as married for purposes of federal tax law). It states as follows:
If one of the registered domestic partners is a self-employed individual treated as an employee within the meaning of section 401(c)(1)(the employee partner) and the other partner is not (the non-employee partner), the employee partner may be allowed a deduction under section 162(l) for the cost of the employee partner’s health insurance paid out of community funds. If the non-employee partner is also covered by the health insurance, the portion of the cost attributable to the non-employee partner’s coverage is not deductible by either the employee partner or the non-employee partner under section 162(l).
Thus, apparently what the Virginia Department of Revenue meant to say was that it would treat same-sex married couples the same way that the IRS treats registered domestic partners for purposes of the deductions for health insurance by pass-through entities–not that it would deny all employers deductions for all fringe benefits provided to same-sex partners. An individual owner of such a business could not take a Virginia income tax deduction for health benefits provided to his or her same-sex spouse.