The Patient Protection and Affordable Care Act (the Patient Protection Act) and the Health Care and Education Reconciliation Act of 2010 (the Reconciliation Act) add a number of new taxes and make various other revenue-increasing changes to the Code in order to help finance health care reform. Among the other provisions, the acts codify the economic substance doctrine, fix an unintended consequence of the cellulosic biofuel producer credit, modify the itemized deduction for medical expenses, repeal the deduction for federal subsidies for certain retiree prescription drug plans, and modify the time for payment of corporate excise taxes in 2014.
In addition to imposing new taxes, the acts make several health care–related changes to the Code that benefit certain taxpayers, including a credit to offset part of the costs of health insurance for low- to middle-income individuals and families and a credit to offset part of the costs to small businesses of providing health insurance for their employees.
Tax on Individuals Without Essential Coverage
Beginning in January 2014, the Patient Protection Act requires nonexempt U.S. citizens and legal residents to maintain minimum essential coverage. This includes government-sponsored programs, eligible employer-sponsored plans, plans in the individual market, grandfathered group health plans, and other coverage as recognized by the secretary of Health and Human Services (HHS) in coordination with Treasury.
Individuals who fail to maintain minimum essential coverage in 2016 are subject to a penalty equal to the greater of:
- 2.5% of household income in excess of the taxpayer’s household income for the tax year over the threshold amount of income required for income tax return filing for that taxpayer under Sec. 6012(a)(1); or
- $695 per uninsured adult in the household.
The fee for an uninsured individual under age 18 is one-half the fee for an adult. The total household penalty may not exceed 300% of the per-adult penalty. The total annual household payment may not exceed the national average annual premium for a “bronze level” health plan offered through the taxpayer’s state exchange that year for the taxpayer’s household size. (Bronze is the lowest level of coverage qualified health plans are required to offer in the insurance exchanges that states must establish under the act.) Individuals are subject to a reduced annual penalty amount in 2014 and 2015. Taxpayers with income below the income tax filing threshold and all members of Indian tribes are exempt from the penalty.
The penalty is assessed through the Code and is accounted for as an additional amount of federal tax owed. However, the use of liens and seizures otherwise authorized for collection of taxes does not apply to the collection of this penalty, and noncompliance is not subject to criminal penalties.
Penalty on Employers Not Providing Employee Coverage
Under the Patient Protection Act, an applicable large employer that does not offer coverage for all its full-time employees, offers minimum essential coverage that is unaffordable, or offers minimum essential coverage that consists of a plan under which the plan’s share of the total allowed cost of benefits is less than 60% is required to pay a penalty if any full-time employee is certified to the employer as having purchased health insurance through a state exchange for which a tax credit or cost-sharing reduction is allowed or paid to the employee.
Applicable large employer: An employer is an applicable large employer for any calendar year if it (or its predecessor employer) employed an average of at least 50 full-time employees during the preceding calendar year. In counting the number of employees for purposes of determining whether an employer is an applicable large employer, a full-time employee (meaning, for any month, an employee working an average of at least 30 hours or more each week) is counted as one employee and all other employees are counted on a prorated basis in accordance with regulations that will be issued. The aggregation rules of Code Secs. 414(b), (c), (m), and (o) apply in determining whether an employer is an applicable large employer. The determination of whether an employer that was not in existence during the preceding calendar year is an applicable large employer is made based on the average number of employees that it is reasonably expected to employ on business days in the current calendar year.
Penalty for employer without coverage: An applicable large employer that fails to offer its full-time employees and their dependents the opportunity to enroll in minimum essential coverage under an employer-sponsored plan for any month is subject to a penalty if at least one of its full-time employees is certified to the employer as having enrolled in health insurance coverage purchased through a state exchange for which a premium tax credit or cost-sharing reduction is allowed or paid to such employee or employees. The penalty equals the number of full-time employees over a 30-employee threshold during the applicable month (regardless of how many employees are receiving a premium tax credit or cost-sharing reduction) multiplied by one-twelfth of $2,000.
Penalty for employer with coverage: An applicable large employer that offers, for any month, its full-time employees and their dependents the opportunity to enroll in minimum essential coverage under an employer-sponsored plan is subject to a penalty if any full-time employee is certified to the employer as having enrolled in health insurance coverage purchased through a state exchange for which a premium tax credit or cost-sharing reduction is allowed or paid to such employee or employees. For each full-time employee receiving a premium tax credit or cost-sharing subsidy through a state exchange for any month, the employer is required to pay an amount equal to one-twelfth of $3,000. The penalty for each employer for any month is capped at an amount equal to the number of full-time employees during the month (regardless of how many employees are receiving a premium tax credit or cost-sharing reduction) in excess of 30, multiplied by one-twelfth of $2,000.
Excise Tax on High-Cost Employer-Sponsored Health Care
This provision of the Patient Protection Act, popularly known as the “Cadillac tax,” imposes an excise tax on insurers if the aggregate value of employer-sponsored health insurance coverage for an employee (including, for purposes of the provision, any former employee, surviving spouse, and any other primary insured individual) exceeds a threshold amount. The tax is equal to 40% of the aggregate value that exceeds the threshold amount. For 2018, the threshold amount is $10,200 for individual coverage and $27,500 for family coverage. The threshold amounts will be adjusted for inflation and for age and gender premium differences in years after 2018.
Employer-sponsored health insurance coverage is health coverage under any group health plan offered by an employer to an employee without regard to whether the employer provides the coverage or the employee pays for the coverage with after-tax dollars. In determining the amount by which the value of employer-sponsored health insurance coverage exceeds the threshold amount, the aggregate value of all employer-sponsored health insurance coverage is taken into account, including coverage in the form of reimbursements under a health flexible savings account (FSA) or a health reimbursement account (HRA), contributions to a health savings account (HSA) or an Archer medical savings account (MSA), and certain other supplementary health insurance coverage.
Additional Hospital Insurance Tax on High-Income Taxpayers
Under the Patient Protection Act, the employee portion of the hospital insurance tax part of FICA, currently amounting to 1.45% of covered wages, is increased by 0.9% on wages that exceed a threshold amount. In the case of a joint return, the additional tax is imposed on the combined wages of both the taxpayer and the taxpayer’s spouse. The threshold amount is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case. For self-employed taxpayers, the same additional hospital insurance tax applies to the hospital insurance portion of SECA tax on self-employment income in excess of the threshold amount. The provision applies to remuneration received and tax years beginning after December 31, 2012.
Medicare Tax on Investment Income
The Reconciliation Act added a new Sec. 1411 that imposes a tax on individuals equal to 3.8% of the lesser of the individual’s net investment income for the year or the amount the individual’s modified adjusted gross income (AGI) exceeds a threshold amount. For estates and trusts, the tax equals 3.8% of the lesser of undistributed net investment income or AGI over the dollar amount at which the highest trust and estate tax bracket begins. For married individuals filing a joint return and surviving spouses, the threshold amount is $250,000; for married taxpayers filing separately it is $125,000; and for other individuals it is $200,000.
Net investment income is defined as investment income reduced by deductions properly allocable to such income. Investment income includes income from interest, dividends, annuities, royalties, rents, and net gains from disposition of property, other than such income derived in the ordinary course of a trade or business. However, income from passive activities and from a trade or business of trading in financial instruments or commodities is included in the definition of net investment income. In the case of the disposition of a partnership interest or stock in an S corporation, only net gain or loss attributable to property held by the entity that is not property attributable to an active trade or business is taken into account. Income, gain, or loss on working capital is not treated as derived from a trade or business. Investment income does not include distributions from a qualified retirement plan or amounts subject to SECA tax.
Annual Fee on Health Insurance Providers
The Patient Protection Act provides for an annual fee that will apply to any covered entity engaged in the business of providing health insurance for U.S. health risks for calendar years beginning after 2013. The fee that each covered entity owes will be based on the applicable amount for the year. The applicable amount is $8 billion for calendar year 2014, $11.3 billion for calendar years 2015 and 2016, $13.9 billion for calendar year 2017, and $14.3 billion for calendar year 2018. For calendar years after 2018, the applicable amount is indexed to the rate of premium growth.
The aggregate annual fee will be apportioned among the covered entities based on a ratio designed to reflect their relative market share of U.S. health insurance business. For each covered entity, the fee for a calendar year is an amount that bears the same ratio to the applicable amount as (1) the covered entity’s net premiums written during the preceding calendar year for health insurance for any U.S. health risk bears to (2) the aggregate net written premiums of all covered entities during the preceding calendar year for such health insurance.
For purposes of the fee, a covered entity generally is an entity that provides health insurance for U.S. health risks during the calendar year in which the fee under this section is due. The act specifically excludes certain entities from the definition of covered entity, including self-insuring employers, government entities, and certain nonprofits and voluntary employees’ beneficiary associations.
Annual Fee on Pharmaceutical Manufacturers and Importers
The Patient Protection Act imposes a fee on each covered entity engaged in the business of manufacturing or importing branded prescription drugs for sale to any specified government program or pursuant to coverage under any such program for each calendar year beginning after 2010. Fees collected under the provision are credited to the Medicare Part B trust fund.
The aggregate annual fee for all covered entities is the applicable amount. The applicable amount is $2.5 billion for calendar year 2011, $2.8 billion for calendar years 2012 and 2013, $3 billion for calendar years 2014–2016, $4 billion for calendar year 2017, $4.1 billion for calendar year 2018, and $2.8 billion for calendar year 2019 and thereafter. The aggregate fee is apportioned among the covered entities each year based on each entity’s relative share of branded prescription drug sales taken into account during the previous calendar year.
Excise Tax on Medical Device Manufacturers
Under the provision, a tax equal to 2.3% of the sale price is imposed on the sale of any taxable medical device by the manufacturer, producer, or importer of the device. A taxable medical device is any device, defined in Section 201(h) of the Federal Food, Drug, and Cosmetic Act (21 U.S.C. §321(h)), intended for humans. The excise tax does not apply to eyeglasses, contact lenses, hearing aids, or any other medical device determined by HHS to be of a type that is normally purchased by the general public at retail for individual use.
HHS may determine that a specific medical device is exempt under the provision if the device is generally sold at retail establishments (including over the internet) to individuals for their personal use. The exemption for such items is not limited by device class as defined in Section 513 of the Federal Food, Drug, and Cosmetic Act. For example, items purchased by the general public at retail for individual use could include Class I items such as certain bandages and tipped applicators, Class II items such as certain pregnancy test kits and diabetes testing supplies, and Class III items such as certain denture adhesives and snakebite kits. Such items would be exempt only if they were generally designed and sold for individual use. It is anticipated that HHS will publish a list of medical device classifications that are of a type normally purchased by the general public at retail for individual use.
Excise Tax on Tanning Services
The Patient Protection Act imposes a tax on indoor tanning services. The tax is equal to 10% of the amount paid for indoor tanning services. For purposes of the provision, the act defines indoor tanning services as services employing any electronic product designed to induce skin tanning but excludes phototherapy services performed by a licensed medical professional. The tax is paid by the tanner and should be collected by the person being paid for the services. If the tanner does not pay the tax at the time he or she pays for the service, the person who performs the service is liable for the tax.
Codification of the Economic Substance Doctrine
The Reconciliation Act includes a provision that codifies the judicially created economic substance doctrine and makes underpayments due to transactions that do not have economic substance subject to the Sec. 6662 accuracy-related penalty.
Economic substance test: New Sec. 7701(o) provides that in the case of any transaction to which the economic substance doctrine is relevant, the transaction is treated as having economic substance only if:
- The transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position; and
- The taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction.
The first test is an objective test and the second is a subjective test; both tests must be met in order for the transaction to have economic substance. For individuals, the test applies only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income.
The potential for a transaction’s profit is taken into account in determining whether the economic substance test is met only if the present value of the reasonably expected pretax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. Fees and other transaction expenses must be treated as expenses in determining pretax profit. The IRS will issue regulations requiring foreign taxes to be treated as expenses in determining pretax profit in appropriate cases.
In the analysis of whether the transaction has a substantial nontax purpose, any state or local income tax effect related to a federal income tax effect is treated as a federal income tax effect. In addition, a purpose of achieving a favorable accounting treatment for financial reporting purposes is not taken into account as a nonfederal income tax purpose if the origin of the financial accounting benefit is a reduction of federal income tax.
The determination of whether the economic substance doctrine is relevant to a transaction and when to utilize an economic substance analysis is not changed, leaving the present law standards in place. According to the Joint Committee on Taxation, Congress does not intend to “alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages” (Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010,” as Amended, in Combination with the “Patient Protection and Affordable Care Act” 152 (JCX-18-10) (March 21, 2010)).
Under the provision, whether a particular transaction meets the economic substance test is a question of facts and circumstances. The fact that a transaction meets the requirements for specific treatment under any Code provision does not affect the economic substance determination. In addition, a court retains the power to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the doctrine.
Increased penalties: The Reconciliation Act greatly increases the potential penalty for engaging in transactions that lack economic substance. It does so by making underpayments due to the disallowance of tax benefits from these transactions subject to the Sec. 6662 20% accuracy-related penalty and increases the penalty rate to 40% if taxpayers do not adequately disclose the transactions on their returns. The act also disallows the use of the Sec. 6664 reasonable cause exception for underpayments due to transactions lacking economic substance, thus eliminating the principal defense to the application of the accuracy-related penalty.
Change to Cellulosic Biofuel Producer Credit
The Reconciliation Act includes a provision that specifically excludes from the definition of cellulosic biofuel any fuels that (1) are more than 4% (determined by weight) water and sediment in any combination or (2) have an ash content of more than 1% (determined by weight). This exclusion prevents taxpayers from taking the cellulosic biofuel producer credit for fuels with significant water, sediment, or ash content, such as black liquor (a byproduct of paper production used by paper mills as an energy source). The availability of the credit for black liquor had been criticized as a loophole.
Reduction of Itemized Deduction for Medical Expenses
The Patient Protection Act increases the threshold for the itemized deduction for unreimbursed medical expenses from 7.5% of AGI to 10% of AGI for regular income tax purposes. However, for the years 2013–2016, if either the taxpayer or the taxpayer’s spouse has turned 65 before the end of the tax year, the increased threshold does not apply, and the threshold remains at 7.5% of AGI. The alternative minimum tax threshold for deduction remains at 10% of AGI.
Deductions for Federal Subsidies for Retiree Prescription Plans
Sponsors of qualified retiree prescription drug plans are eligible for subsidy payments from HHS for a portion of each qualified covered retiree’s gross covered prescription drug costs. A qualified retiree prescription drug plan is employment-based retiree health coverage that has an actuarial value at least as great as the Medicare Part D standard plan for the risk pool and that meets certain other disclosure and recordkeeping requirements. These qualified retiree prescription drug plan subsidies are excludible from the plan sponsor’s gross income for the purposes of regular income tax and alternative minimum tax (including the adjustment for adjusted current earnings). Prior to the passage of the Patient Protection Act, covered retiree prescription drug expenses were deductible under Sec. 139A, despite the fact that the subsidies were also excludible from income.
The Patient Protection Act eliminates the rule in Sec. 139A that the exclusion for subsidy payments is not taken into account for purposes of determining whether a deduction is allowable for retiree prescription drug expenses. Thus, the amount otherwise allowable as a deduction for retiree prescription drug expenses is reduced by the amount of the excludible subsidy payments received.
Example: Company A receives a subsidy of $28 for eligible drug expenses of $100. The $28 is excludible from income under Sec. 139A, and the amount otherwise allowable as a deduction is reduced by the $28. Thus, if A otherwise meets the requirements of Sec. 162 for its eligible drug expenses, it would be entitled to an ordinary business expense deduction of $72.
Time for Payment of Corporate Estimated Taxes for 2014
In general, calendar-year corporations are required to make quarterly estimated tax payments of their income tax liability on April 15, June 15, September 15, and December 15. In the case of a corporation with assets of at least $1 billion (determined as of the end of the preceding tax year), payments due in July, August, or September 2014 are increased to 157.75% of the payment otherwise due, and the next required payment is reduced accordingly. The Reconciliation Act increases the required payment of estimated tax otherwise due in July, August, or September 2014 by 15.75 percentage points.
Premium Assistance Credit
For years after 2013, the Patient Protection Act provides for refundable tax credits that eligible taxpayers can use to help cover the cost of health insurance premiums for individuals and families who purchase health insurance through a state health benefit exchange. An eligible individual will enroll in a plan offered through an exchange and report his or her income to the exchange. Based on the information provided to the exchange and on his or her income, the individual will receive a premium assistance credit. Treasury will pay the premium assistance credit amount directly to the insurance plan in which the individual is enrolled. The individual will then pay to the plan in which he or she is enrolled the dollar difference between the premium tax credit amount and the total premium charged for the plan. Alternatively, eligible individuals can pay for the insurance out of pocket and claim the credit on their tax returns.
Eligibility for the premium assistance credit is based on the individual’s income for the tax year ending two years prior to the enrollment period. The premium assistance credit is available for individuals (single or joint filers) with household incomes between 100% and 400% of the federal poverty level (for the family size involved) who do not receive health insurance through an employer or a spouse’s employer. The credit amount is determined by HHS, based on the percentage of income the cost of premiums represents, rising from 2% of income for those at 100% of the federal poverty level for the family size involved to 9.5% of income for those at 400% of the federal poverty level for the family size involved.
Small Business Tax Credit
The Patient Protection Act (as amended by the Reconciliation Act) provides tax credits, beginning in years after 2009 for small businesses and individuals, designed to increase levels of health insurance coverage as part of the Sec. 38 general business credit. Small businesses—defined as businesses with 25 or fewer employees and average annual wages of less than $50,000—would be eligible for credits of up to 50% of nonelective contributions the businesses make on behalf of their employees for insurance premiums. Tax-exempt organizations would get a 35% credit against payroll taxes.
Employers with 10 or fewer employees and average wages of less than $25,000 would get 100% of the credit; the credit is phased out up to the 25-employee limit. The $25,000 average annual wages figure will be indexed for inflation after 2013. Five-percent owners under the Sec. 416 top-heavy plan rules and 2% S corporation shareholders are not included in the definition of “employee,” but leased employees are counted.
The credit is phased in from 2010– 2013. During the phase-in years, the maximum credit is 35% of the employer’s eligible premium expense (25% for tax-exempt employers).
As anyone who watches the news knows, the fight to pass this legislation over the past year was filled with controversy. Now that the legislation has been enacted, opposition to it continues. Members of Congress have stated their intention to work for its repeal (Bacon, “GOP Lawmakers, Candidates Pledge to Repeal Health-Care Legislation,” Washington Post A4 (March 18, 2010)). Several states’ attorneys general have sued in federal court to have the excise tax on taxpayers without health insurance declared unconstitutional (see Florida v. Department of Health and Human Servs ., No. 3:10-CV-00091-RV-EMT (N.D. Fla., filed 3/23/10)), although the lack of enforcement mechanisms for that excise tax may indicate that no significant attempt will be made to enforce the tax. In addition, the tax on excess health benefits, which has already been deferred until 2018, seems likely to be eliminated or significantly reduced because of its extreme unpopularity with certain key constituencies that would be affected by it.
The Congressional Budget Office (CBO) has estimated that the health care legislation will reduce the federal deficit by $143 billion in the years 2010–2019, including various predicted cost savings plus new tax revenue. The tax revenues over that time are estimated to total $525 billion. However, given that most of the provisions are not effective until future years, no guidance has yet been issued on how various provisions will be implemented, and the ongoing opposition may lead to repeal or revision of various aspects of the legislation, it seems likely that the revenue raised will be far less than predicted by the CBO.
Patient Protection and Affordable Care Act, P.L. 111-148; Health Care and Education Reconciliation Act of 2010, P.L. 111-152