The new Patient Protection and Affordable Care Act adds tax provisions to the Internal Revenue Code that may have a significant effect on your bottom line. They include:
- a 3.8% surtax on certain unearned income;
- an increase in the Medicare portion of the FICA tax;
- an excise tax on "Cadillac" health plans;
- an excise tax on uninsured individuals;
- a premium assistance credit;
- expansion of the definition of "dependent" for purposes of the Internal Revenue Code §105 medical reimbursement exclusion; and
- codification of the economic substance doctrine.
Below is a brief description of how these provisions may impact you.
1. Medicare Tax
Beginning on January 1, 2013, the Act will impose a new 3.8% surtax on the lesser of:
- net investment income; or
- the excess of modified adjusted gross income ("MAGI") over a threshold amount.
Net Investment Income
Net investment income is the excess of gross investment income over certain investment expenses. Investment income includes items such as interest, dividends, capital gains, annuities, rents, royalties and passive activity income, but does not include:
- active trade or business income;
- distributions from IRAs or other qualified plans;
- any income taken into account for self-employment tax purposes; or
- gain on the sale of an active interest in a partnership or S corporation.
Modified Adjusted Gross Income
Generally, MAGI is the sum of adjusted gross income (i.e., IRS Form 1040, Line 37) plus certain exclusions from gross income.
The "threshold amount" is:
- $250,000 for married taxpayers filing jointly;
- $125,000 for married taxpayers filing separately;
- $200,000 for single taxpayers; and
- approximately $12,000 for trusts.
Bottom Line Effect
The examples below illustrate how the "lesser of" rule works.
Example 1. Joe, a single taxpayer, has $50,000 of salary and $50,000 of net investment income for MAGI of $100,000. The 3.8% surtax would not apply because his MAGI is less than $200,000.
Example 2. Jane, another single taxpayer, has $250,000 of net investment income and no other source of income. The 3.8% surtax would apply to $50,000 of income (the lesser of investment income of $250,000 or the excess of $250,000 MAGI over $200,000 threshold amount).
Example 3. John & Mary, married and filing jointly, have $400,000 of salaries and no net investment income. The 3.8% surtax would not apply because they have no investment income.
You should consider the following potential planning opportunities:
- The 3.8% surtax does not apply to distributions from IRAs and other qualified retirement plans. You may wish to increase contributions to IRAs and 401(k), 403(b) and 457 plans.
- Investments in tax exempt and tax deferred vehicles like municipal bonds and life insurance are recommended because the income they produce is not included in investment income (although they are included in MAGI income).
- Installment sales may be used to defer income over time so that you may reduce your income each year below the MAGI threshold, thereby reducing your exposure to the 3.8% surtax.
2. Increase in Medicare Portion of FICA
Currently, there is a 1.45% FICA tax on both employers and employees. The Act will add 0.9% to the employee portion for individuals earning more than $200,000 per year and married couples earning more than $250,000 per year, thereby increasing their FICA contribution to Medicare to 2.35%. The increase in the Medicare portion of FICA to 2.35% is effective with tax years beginning after December 31, 2012.
The FICA increase may encourage taxpayers to form S-corporations rather than limited liability companies and partnerships since the FICA tax is imposed only with respect to employee wages and not on distributive shares of shareholders.
3. "Cadillac" Excise Tax
The Act will also impose a 40% tax on any "excess benefit" under employer-sponsored health coverage. Excess benefit is the cost of the health coverage above certain annual limitation amounts—$10,200 for individual-only plans and $27,500 for all other plans. The excise tax on Cadillac plans is effective with tax years beginning after December 31, 2017.
4. Excise Tax on Uninsured Individuals
New Internal Revenue Code section 5000A will impose a penalty on U.S. citizens who fail to maintain minimum health insurance coverage. The penalty amounts are phased-in according to the following schedule:
- 2014—the greater of 1% of the household income above a certain threshold, or $95
- 2015—the greater of 2% of income above the threshold amount, or $325
- 2016 and subsequent years—the greater of 2.5% of income over the threshold amount, or $695
The current threshold amounts are $9,500 for single filers, $18,700 for married taxpayers filing joint returns, $3,650 for married taxpayers filing separately and $12,000 for head of household status.
5. Premium Assistance Credit
The Act requires states to establish health benefit exchanges and provides a refundable credit for taxpayers who purchase health insurance from the state. The credit is the amount by which a taxpayer's premiums exceed certain threshold amounts. The credit will ensure that qualified individuals would not spend more than a specific percentage of their income on medical insurance premiums.
The threshold begins at 2% of income for taxpayers at 100% of the federal poverty level and increases to 9.5% for taxpayers at 400% of the federal poverty level. The federal poverty level is determined based on family size. The amount of the credit will be based on the percentage of income the cost of the premiums represents.
Example 1. Assume that the federal poverty level for a family of one individual in 2014 is $10,000. John's income in 2014 is $10,000, i.e., income of 100% of federal poverty level. He will be eligible for a premium assistance credit, with certain limitations, to the extent the health premiums exceed $200 (2% of $10,000) for tax year 2014.
Example 2. Assume again that the federal poverty level for a family of one individual in 2014 is $10,000. Jane's income in 2014 is $40,000, i.e., 400% of the federal poverty level. Jane will be eligible for a premium assistance credit, with certain limitations, to the extent the health premiums exceed $3,800 (9.5% of $40,000) for tax year 2014.
These amounts will be indexed for inflation beginning in 2014. The premium assistance credit is effective with tax years ending after 2013.
6. Adult Dependents
Internal Revenue Code section 105(b) generally excludes from income amounts reimbursed to a taxpayer for medical care expenditures made for the benefit of the taxpayer, his spouse and dependents. The Act changes the definition of dependent to include children up to 26 years of age (previously 23). The adult dependents provision is effective as of March 30, 2010, however many taxpayers will have to wait for the next plan year.
7. Economic Substance Doctrine
Generally, in determining whether the form of a transaction should be respected for tax purposes, courts have made two inquiries:
- Whether the transaction had economic substance beyond the tax benefits (objective test); and
- Whether the taxpayer had a non-tax business purpose for entering into the transaction (subjective test).
Courts have disagreed on the application of these tests. Some courts have respected a transaction if only one test was satisfied, while other courts have respected a transaction only if both tests were satisfied. The Act adds Internal Revenue Code Section 7701(o), which codifies the economic substance doctrine and requires both objective and subjective substance for a transaction to be valid for tax purposes.
The general impact is that taxpayers will now be required to demonstrate the substantial non-tax purpose in engaging in a transaction before it will be respected for federal income tax purposes.
Transactions lacking economic substance are subject to various penalties. The economic substance provision is effective as of March 30, 2010.