Last month, both houses of Congress approved of landmark health care reform legislation. On March 21, 2010, the House first voted 219-212 in favor of the health care bill that passed the Senate in December, the Patient Protection and Affordable Care Act (H.R. 3590). Immediately thereafter, the House passed its "modifications" to H.R. 3590 by way of the Health Care and Education Reconciliation Act of 2010 (H.R. 4872) by a vote of 220-211. Senate approval followed shortly thereafter. The President signed H.R. 3590 (as amended) into law on March 23, 2010 and H.R. 4872 on March 30, 2010 (H.R. 3590 (as amended) and H.R. 4872 combined, the "Legislation") making President Obama's promise for sweeping health care reform a reality.
In order to partially fund the numerous changes to the health care system (projected to cost approximately $940 billion), the Legislation establishes a variety of new taxes and fees expected to generate about $428 billion of revenue. This Alert summarizes these principle new taxes and fees.
HEALTH CARE COVERAGE MANDATES -- TAX INCENTIVES/PENALTIES
The main goal of the mandate provisions is to increase the number of Americans covered by health insurance through the use of both tax incentives and penalties. A summary of the material tax changes are as follows:
- Excise Tax -- Beginning in 2014, individuals who do not maintain certain minimal health insurance coverage for themselves and their dependents will be subject to an additional annual excise tax. The excise tax will be the greater of (i) $695 per failure, or (ii) 2.5% of household income in excess of the threshold amount of income required for income tax filing. These amounts, however, cannot annually exceed (i) 300% of the per adult filing penalty (e.g., $695 x 3 in 2016), or (ii) the national average premium for the newly-created "bronze level" health plans. New information returns will be required to be filed by providers of health care in order to properly determine who is subject to this new tax. Exemptions will be allowed for (i) individuals below the income tax filing threshold, (ii) individuals whose lowest cost option is still greater than 8% of their adjusted gross income ("AGI"), (iii) members of recognized religious sects, (iv) de minimis lapses in coverage, (v) members of Indian tribes, and (vi) other hardship situations.
- Premium Assistance Tax Credits -- The Legislation provides for sliding scale refundable tax credits for individuals and families between 100-400% of the federal poverty level who purchase certain health insurance through a state exchange because either they were (i) not offered "minimum essential coverage," (ii) offered only "unaffordable" coverage by their employer, or (iii) offered coverage by their employer where the plan's share of the cost of the benefits provided is less than 60% of the total. The refundable tax credit generally will be based on the percentage of income the cost of the premium of the newly-created "silver plan" applicable to the taxpayer represents.
- Employer Fee -- While the Legislation does not require employers to provide health insurance coverage to its employees, if an employer (i) had more than 50 full-time employees ("FTEs") in the preceding tax year, and (ii) employs at least one person who receives a premium assistance tax credit or cost-sharing reduction for health insurance purchased from a state exchange, it will be required to pay an additional fee. If the above requirements are met and the employer does not offer health care coverage at all, the monthly fee is $166.67 ($2,000 per year) x number of FTEs in excess of 30. If the employer does offer health care coverage, but still has at least one employee who receives a premium tax credit or cost-sharing reduction from the government, the monthly fee is the lesser of (i) $250 ($3,000 per year) per employee receiving the credit/ reduction, or (ii) $166.67 ($2,000 per year) x number of FTEs in excess of 30. This additional tax will apply to months beginning after December 31, 2013.
- Small Business Tax Credits -- Employers with (i) average annual wages of $25,000 or less, and (ii) 10 or less FTEs generally will be eligible for a tax credit up to 35% of their contributions to their employees' health care premiums for the years 2010-2013. For years after 2013, the employer generally will be eligible for a tax credit of up to 50% of its contributions, but only for the first two years in which it purchases its health insurance coverage through its state exchange. (The credits will be available at a reduced rate for (i) employers with average annual wages between $25,000 and $50,000, and (ii) employers with between 10 and 25 FTEs.) The credit will be part of the general business tax credit. Organizations that are exempt from tax under Section 501(c) of the Internal Revenue Code (the "Code") also will be eligible for the credits (at reduced rates) which can be off-set against payroll taxes.
GENERAL REVENUE PROVISIONS
This next section summarizes selected additional material revenue raisers included in the Legislation. While some of the provisions described below are directly tied to health care reform, some are simply mechanisms included to raise the revenue needed to carry out the various other goals of the Legislation.
Excise Tax on High Cost Insurance -- Beginning in 2018, a 40% excise tax will be imposed on the cost of each employee's "employer-sponsored health coverage" that exceeds a threshold amount (generally $10,200 for individuals and $27,500 for families). Such tax will be imposed on the issuers of the health insurance, but there is no prohibition on insurers passing the tax on to consumers through increased cost. Employer-sponsored health coverage will generally include an employee's typical major medical coverage (excluding dental and vision coverage), but will also include other fairly new types of insurance such as flexible spending accounts and health savings accounts. The employer will be required to calculate the cost in excess of the threshold for each employee and then allocate such excess (subject to the excise tax) to each of the employee's insurers. Penalties will apply for reporting failures.
Increased Medicare Payroll Tax -- The employee (and, therefore, nondeductible) portion of the Medicare tax on wages is increased by 0.9% for wages in excess of $200,000 for individuals and wages in excess of 250,000 for joint filers. (This additional 0.9% Medicare tax and the threshold amounts also apply to self-employment income.) This increase will be effective for remuneration received after December 31, 2012.
New Medicare Tax on Unearned Income -- Beginning in 2013, individuals will be subject to a new 3.8% Medicare tax on the lesser of (i) net investment income, or (ii) modified adjusted gross income ("MAGI") in excess of a threshold amount. The threshold amount for single taxpayers is $200,000 while the threshold amount for joint filers is $250,000. Net investment income generally consists of interest, dividends, rents, royalties, annuities and net gains from passive activities. Estates and trusts (with certain exceptions) also will be subject to the tax using a slightly different formula.
Annual Fees -- The Bill imposes an annual fee, allocated by market share, on the following healthcare industries:
- Manufacturers and importers of branded drugs -- $2.5-4.1 billion (depending on year)
- Health insurance providers -- $8-14.3 billion (depending on year)
The annual fee for the branded drug industry begins in 2011 and the health insurance industry fee begins in 2014.
Excise Tax on Sales of Medical Devices -- Beginning in 2013, a 2.3% excise tax will be assessed on the sales price of any taxable medical device sold by a manufacturer, producer or importer. Exclusions will apply for devices generally sold to the public (e.g. contact lenses, hearing aids, etc.).
Economic Substance (Codification and New Penalties) -- The Legislation codifies the economic substance doctrine that currently exists only in the common law. It clarifies that to be protected from a re-characterization for federal tax purposes, a transaction must meet the following two requirements: (i) the transaction must change the taxpayer's economic position in a meaningful way (apart from federal, state and local tax effects), and (ii) the transaction must have a substantial purpose (apart from federal, state and local tax effects). Transactions lacking economic substance are added to the list of situations to which the Section 6662 20% underpayment penalty applies. They will also now be subject to an increased 40% underpayment penalty if the relevant facts affecting their tax treatment are not adequately disclosed. Reasonable cause defenses to the imposition of the penalty are not permitted. These provisions are effective for transactions entered into after the Legislation's date of enactment.
Change in Definition of "Medical Expenses" -- The definition of "medical expenses" in the context of what qualifies for (i) tax-free reimbursements through health reimbursement arrangements and flexible spending accounts, and also (ii) tax-free distributions through health savings accounts and Archer MSAs is revised to include expenses for drugs only if the drug is either (i) a prescription drug, (ii) insulin, or (iii) doctor-prescribed over-the-counter medicine. (This effectively eliminates the tax-free benefits associated with these arrangements for the purchase of non-doctor-prescribed over-the-counter drugs.) This new rule is effective for expenses incurred after December 31, 2010.
Increased Penalty (Non-Qualified Health Savings Account ("HSA") Distributions) -- The penalty for distributions from HSAs that are not made for "qualified medical expenses" is increased from 10% to 20% of the disbursed amount beginning in 2011.
Limitation on Flexible Spending Account ("FSA") Salary Reductions -- Elective salary reductions under a cafeteria plan for purposes of coverage under a Health FSA are limited to $2,500 per year starting in 2013.
Limitation on Itemized Deduction for Medical Expenses -- Beginning in 2013, the threshold for deducting unreimbursed medical expenses on Schedule A is increased to 10% of a taxpayer's AGI from 7.5%. (Through 2016, taxpayers over the age of 65 and their spouses are excepted from this change.)
Elimination of Deduction for Federal Prescription Drug Subsidies -- Sponsors of qualified retiree prescription drug plans that receive tax-free subsidy payments from the Secretary of Health and Human Services will be prohibited from deducting the costs reimbursed by such subsidy for federal income tax purposes beginning in 2013.
Increased Information Reporting for Payments to Corporations -- Persons who make payments to corporations of $600 per year or more in exchange for either property or services will now be required to file an information return with both the IRS and the corporation itself with the goal of increasing disclosure of potentially taxable payments. This increased reporting goes into effect for payments made in taxable years beginning after December 31, 2011.
Indoor Tanning Tax -- A tax equal to 10% of the amount paid for tanning services will be assessed on customers effective for services performed on or after July 1, 2010.
While debates concerning the wisdom of many of these changes continue, as well as actual legal challenges, the Health Care Reform package is currently law. Although some of the provisions became effective at passage, most have delayed effective dates. As a result, there may be opportunities for you to minimize the negative tax effects associated with this Legislation with some advance planning. There also will undoubtedly be continuing legislative efforts to make technical corrections to the Legislation, as well as the need for detailed implementing regulations.
An appendix to this Alert summarizes the effective dates of the key tax provisions.