Key Business and Individual Tax Provisions Included in Recently Enacted Health Care Reform
On March 23, 2010, President Obama signed into law H.R. 3590, the Patient Protection and Affordable Care Act (the “Health Care Act”), which effects a comprehensive overhaul of the health care system in the United States. H.R. 4872, the Health Care and Education Reconciliation Act of 2010 (the “Reconciliation Act” and together with the Health Care Act the “Act”), which was signed into law by President Obama on March 29, 2010, amends certain provisions of the Health Care Act and includes new laws that were not part of the earlier legislation. The discussion below is a summary of certain of the key business and individual tax provisions included in the Act.
Additional Tax on Wages of High-Income Taxpayers
Background. The Federal Insurance Contributions Act (“FICA”) imposes two taxes on wages – the Old Age, Survivors and Disability Insurance (“OASDI”) tax and the Medicare Hospital Insurance (“HI”) tax. These taxes finance Social Security and Medicare benefits, respectively, and are imposed on wages paid by an employer to an employee. The OASDI tax rate is 6.2% on wages up to a annual “wage base” ($106,800 for 2010), and the HI tax rate currently is 1.45% on all wages, regardless of amount. Each component of the FICA tax is imposed on the employer and also on the employee, and the employee portion of the FICA tax generally must be withheld and remitted to the Federal government by the employer.
Similarly to the taxes imposed by FICA, the Self-Employment Contributions Act (“SECA”) imposes the OASDI tax and the HI tax on self-employed taxpayers on a taxpayer’s “net earnings from self-employment”. As with the FICA taxes, for purposes of SECA, there is an annual “ceiling” limitation on the OASDI tax ($106,800 for 2010), and no limit on the HI tax. The OASDI tax rate is 12.4% and the HI tax rate currently is 2.9% on all of the taxpayer’s self-employment income. Self-employed taxpayers generally are allowed a deduction for one half of the SECA taxes paid.
New Provision. The Act increases the employee portion of the HI tax (currently 1.45%) by an additional tax of 0.9% on wages received in excess of a threshold amount. The threshold amount is $250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately and $200,000 for other individuals. Thus, for an employee who is not married, after the effective date of the rule, the employee’s portion of the HI tax would be imposed at a rate of 1.45% on the first $200,000 of wages and 2.35% on wages in excess of $200,000. The employer generally is required to withhold the additional 0.9% HI tax from the employee’s wages.
The Act similarly imposes an additional HI tax of 0.9% on a self-employed taxpayer’s on self-employment income in excess of the threshold amounts of $250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately, and $200,000 for other individuals. Thus, after the effective date of the rule, for a self-employed taxpayer who is not married, HI tax is imposed at a rate of 2.9% on the first $200,000 of wages and 3.8% on wages in excess of $200,000. Notably, the taxpayer is not allowed a deduction for the additional 0.9% HI tax.
Effective date. The foregoing rules apply to tax years beginning after December 31, 2012.
Higher Tax on Investment Income of High-Income Taxpayers
Background. As discussed above, Medicare benefits are currently financed primarily through the HI tax, which currently is imposed on wages as opposed to investment income.
New provision. The Act adds new Code Section 1411, which generally imposes an “Unearned Income Medicare Contribution” tax on certain investment income of individuals, estates, and trusts. With respect to individuals, the tax is equal to 3.8% of the lesser of (1) net investment income or (2) the excess of modified adjusted gross income over a threshold amount. Thus, effectively, the tax applies only to individual taxpayers who have net investment income as well as modified adjusted gross income over a threshold amount. A taxpayer’s modified adjusted gross income generally is the taxpayer’s adjusted gross income (“AGI”) adjusted by foreign earned income and deductions. The threshold amount is $250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately and $200,000 for other individuals.
With respect to trusts and estates, the tax is equal to 3.8% of the lesser of (1) undistributed net investment income or (2) the excess of AGI over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins (presently, $7,500). Thus, similarly to individual taxpayers, the tax effectively applies only to trust and estates that have undistributed net investment income and an AGI that exceeds the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.
For purposes of the tax, net investment income generally includes interest, dividends, annuities, royalties, and rents, gains from the sale of property (generally capital gains) excluding such types of income derived in the taxpayer’s ordinary course of a trade or business. For this purpose, income from a trade or business generally does not include income from a passive activity of the taxpayer or from a trade or business of trading securities or commodities. Importantly, distributions from qualified retirement plan are not included in the calculation of net investment income.
Effective date. The Unearned Income Medicare Contribution is effective for tax years beginning after December 31, 2012.
The table below generally summarizes (i) the tax rate under current law, (ii) what such tax rate is schedule to increase to absent new legislation in 2011 (which new legislation most are not expecting), and finally, what the rate would increase to in 2013 for taxpayers with modified adjusted gross income in excess of the threshold amounts described above:
Type of Income |
Currently |
2011 |
2013 |
Long-term capital gains |
15% |
20% |
23.8% |
Diviends (qualifying) |
15% |
39.6% |
43.40% |
Interest, rent, royalty, annuities |
35% |
39.6% |
43.4% |
Codification of Economic Substance Doctrine
Background. The economic substance doctrine is one of several judicially created doctrines that are used by courts to deny the tax benefits of a tax-motivated transaction, notwithstanding that the transaction may satisfy the literal requirements of a specific provision in the Internal Revenue Code. The doctrine generally disallows tax benefits if the transaction does not result in a meaningful change to the taxpayer’s economic position other than a purported reduction in Federal income tax.
There has been a lack of uniformity among courts regarding the proper test to determine whether a transaction has economic substance, as illustrated by the divergent application of the doctrine in the tax shelter litigation that has flooded the courts during the last decade. The Act attempts to address this lack of uniformity by adding Internal Revenue Code Section 7701(o), which codifies the economic substance doctrine.
New provision. New Section 7701(o) of the Internal Revenue Code provides that any transaction or series of transactions to which the economic substance doctrine “is relevant” is treated as having economic substance only if (1) the transaction changes, in a meaningful way, the taxpayer’s economic position, and (2) the taxpayer has a substantial purpose for entering into such transaction. The determination of whether the economic substance doctrine is relevant to a transaction is made in the same manner as if the provision codifying the doctrine had not been enacted. Further, under the new provision, in determining whether the two tests are met with respect to a transaction, a profit potential is taken into account only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits from the transaction. In calculating any pre-tax profit, fees and other transaction expenses must be taken into account as expenses. In addition, achieving a financial accounting benefit that originates from a reduction of federal income tax is not taken into account in determining whether the taxpayer meets the test described in (2) above. Federal, state or local income tax effects should be disregarded in applying the two tests descried above. Finally, the Act requires Treasury to issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profits in appropriate cases.
The economic substance provision applies to transactions entered into by individuals only if the transaction is entered into in connection with a trade or business or an activity engaged in for the production of income.
While the new provision codifies and makes uniform the test for determining when a transaction has economic substance, pursuant to its terms, the provision does not change the present law standards that courts use in determining when to apply the economic substance doctrine.
Importantly, the Act also creates a new “strict liability” penalty regime applicable to transactions lacking economic substance (or “failing to meet any similar rule of law”). A 20% “strict liability” penalty is imposed on any underpayment attributable to a transaction lacking economic substance, and the penalty is increased to 40% if the relevant facts of the transaction are not adequately disclosed on the taxpayer’s tax return. Similarly, any claim for refund that is excessive due to its lacking economic substance is subject to a 20% penalty. Notably, the reasonable cause and good faith exception and the reasonable basis exception do not apply in connection with these new penalties. Further, it is unclear what is encompassed by “similar rule of law,” the violation of which would also give rise to the strict liability penalty. It is possible that transactions that run afoul of doctrines such as “step-transaction,” “business purpose,” “substance over form,” and “sham transaction” would be subject to the penalties as well.
We would generally expect the new strict liability penalty to impact tax planning that companies and certain individuals engage in, as the costs of engaging in certain transaction, even with considerable planning, diligence and advice may be higher than before.
Effective date. The foregoing rules apply to transactions entered into after March 30, 2010.
Excise Tax on Insurance Company for “Cadillac Plans”
The Act added new Code Section 4980I, which imposes an excise tax on insurance providers equal to 40% of any “excess benefit” associated with an employer-sponsored health insurance plan. An excess benefit for this purpose generally is the amount by which the cost of the insurance exceeds a statutorily prescribed threshold amount. Pursuant to amendments made in the Act, for 2018, the threshold amount is $10,200 for individual coverage and $27,500 for family coverage, subject to a percentage adjustment tied to the cost of U.S. health care. The employer sponsoring the insurance plan generally is obligated to calculate the amounts subject to tax and issue the insurance provider an information return. The insurance company is responsible for paying the excise tax. Code Section 4980I is effective for tax years beginning after December 31, 2017.
Increased Threshold for Medical Expense Deductions
Background. Under present law, an individual taxpayer generally is allowed an itemized deduction for unreimbursed medical expenses, but only to the extent that such expenses exceed 7.5% of the taxpayer’s adjusted gross income (“AGI”). For purposes of the alternative minimum tax, medical expenses are deductible only to the extent that they exceed 10% of the taxpayer’s adjusted AGI.
New provision. The 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, 2014, 2015 and 2016, if either the taxpayer or the taxpayer’s spouse turns 65 before the end of the taxable year, the increased threshold does not apply and the threshold remains at 7.5% of AGI. The new provision does not change the AMT treatment of the itemized deduction for medical expenses. This provision is effective for taxable years beginning after December 31, 2012.
Corporate and Other Information Reporting
In general, a taxpayer is obligated to file an information return (e.g., an IRS Form 1099) if the taxpayer makes certain payments of $600 or more to a payee in the course of the taxpayer’s trade or business. Under current law, there is an exception for payments made to certain payees, such as corporations, exempt organizations, governmental entities, international organizations, or retirement plans. The Act eliminates this exception and obligates a taxpayer to file information returns to any person other than a tax-exempt corporation. In addition, the Act expands the types of reportable payments to include “amounts in consideration for property” and “gross proceeds”. These provisions are effective for payments made after December 31, 2011.
2014 Estimated Tax Calculation for Large Corporations Further Increased
Background. Corporations generally are required to make estimated income tax payments for each tax year in 4 installments that are due on the 15th day of the 4th, 6th, 9th, and 12th month of the tax year. Until recently, the four installments were equal in amount.
Under the 2009 Corporate Estimated Tax Shift Act, for a corporation with assets of at least $1 billion (determined as of the end of the previous tax year), the amount of any required installment of corporate estimated tax due in July, August, or September 2014 was increased by .25 percentage points to 100.25% of the payment otherwise due. Subsequent increases pursuant to the 2009 Assistance Act, the 2009 Preference Extension Act and the 2010 HIRE Act, were made so that amount of any required installment of corporate estimated tax otherwise due in July, August, or September 2014 was increased from 100.25% to 157.75% of the amount otherwise due.
New provision. Under the Act, in the case of a corporation with assets of at least $1 billion (determined as of the end of the previous tax year), the amount of any required installment of corporate estimated tax otherwise due in July, August, or September 2014 is further increased by 15.75 percentage points to 173.50% of the payment otherwise due. The amount of the required installment that is due after the increased installment is reduced to reflect the total amount of the increase (i.e., 73.5%).
Therefore, any corporate estimated tax due in July, August, or September 2014 is required to be 73.50% higher than it would have otherwise been, and the following corporate estimated tax is 73.50% lower than it would have otherwise been. The federal government’s fiscal year begins October 1 st, and the apparent purpose of this provision is to move revenues from one fiscal year to another to meet budgetary requirements. This provision is effective March 30, 2010.
Premium Assistance Credit for Individual Taxpayers
Section 36B of the Internal Revenue Code was created under the Act to provide a refundable tax credit for eligible individuals and families to subsidize the purchase of certain health insurance through a state exchange. Notably, under the Act, each state is required to establish an exchange to provide individuals and small businesses with access to affordable, quality health insurance. Under the Act, the amount of the credit generally equals the amount by which the taxpayer’s health insurance premiums exceed a threshold that is based on the federal poverty level. In general, the threshold ranges from 2% of income for taxpayers at 100% of the poverty level for and 9.5% of income for taxpayers at 400% of the poverty level. The credit is only available for taxpayers who are eligible for Medicaid, employer-sponsored insurance, or other acceptable coverage. The credit generally is available to taxpayers for tax years ending after December 31, 2013.
Tax Credits for Small Businesses Offering Employee Health Coverage
The Act adds a new Section 45R of the Internal Revenue Code, which provides a general business credit for qualified small businesses that make nonelective contributions on behalf of their employees for insurance premiums. A qualified small business for this purpose generally is an employer with no more than 25 employees and average wages of no more than $50,000. In general, 100% of the credit is available to an employer with 10 or fewer employees and with average wages from the employer of less than $25,000, and the credit is phased out up to the 25-employee limit. The credit generally is available for tax years beginning after December 31, 2009.