The Health Care Act of 2010 (Health Care Act) is perhaps the most far-reaching legislation in a generation. It was designed to reform fundamentally the entire U.S. health care system. Once this legislation is fully implemented, it will have a major impact on virtually every business and individual by requiring the majority of U.S. residents not covered by Medicaid or Medicare to obtain health care coverage either individually or through his or her employer. This article outlines important Federal tax changes contained in this recent legislation.
HIGHLIGHTS OF THE HEALTH CARE ACT
The centerpiece of the Health Care Act is a requirement that almost all Americans obtain a minimum level of health care coverage, or pay a penalty. It is anticipated that businesses will play a key role in this mandate because larger employers must provide employees with qualifying health coverage, or pay an additional tax. Qualifying smaller businesses will be exempt from this so-called play-or-pay tax. Individuals not covered by a qualifying employer health care plan and who do not maintain minimum health insurance coverage will be subject to a penalty tax. Lower and middle income individuals will get either a refundable tax credit or employer-paid voucher to help pay for their health insurance. No later than 2014, each state will be required to establish an American Health Benefit Exchange (“Health Insurance Exchange”) to help individuals and qualifying small employers in that state acquire qualified health care coverage. To help fund this new health care mandate, the Health Care Act imposes over $400 billion in new taxes and fees on employers and individuals. Perhaps the most controversial are the two new taxes on higher‑income taxpayers: an additional Medicare Surtax on earned income, and a separate Medicare Surtax on investment income.
Starting in 2013, the Health Care Act imposes a new .9% Medicare Surtax on the earned income and a 3.8% Medicare Surtax on the unearned income of higher-income taxpayers; increases the medical expense deduction threshold from 7.5% to 10% of AGI; caps employee contributions to health care flexible savings accounts at $2,500; eliminates the deduction for the subsidized portion of employers’ Medicare Part D payments to retirees; and places a $500,000 deduction cap on compensation paid by health insurance companies.
Starting in 2014, the Health Care Act begins implementing its health care coverage mandate with several new provisions, including: penalties for individuals who remain uninsured; tax incentives for low-income individuals to buy health insurance; penalties for larger employers that fail to provide adequate coverage for employees; a voucher system that will help certain lower-income employees obtain health insurance coverage; a host of new fees and taxes on various businesses within the health care industry; and a requirement that each state have a Health Insurance Exchange up and running.
Starting In 2018, a 40% excise tax will be imposed on so-called Cadillac health plans.
Small Employers Get New Credit For Providing Employee Health Insurance.One of the pleasant surprises coming from the Health Care Act is a new and immediate tax credit for “eligible small employers” that 1) offer health insurance to employees, and 2) pay at least 50% of the cost of insurance. For tax years beginning after 2009 and before 2014, the Health Care Act allows an eligible small employer to take a credit of up to 35% of the cost of qualifying employee health insurance purchased from state-licensed health insurance companies. For tax years beginning after 2013, the maximum credit is 50% of the employer’s cost of qualifying employee health coverage.
The credit is only available to an “eligible small employer” (ESE), whether formed as a regular “C” corporation, “S” corporation, partnership, LLC, or sole proprietorship. An ESE will generally receive no credit if it has 25 or more full-time equivalent employees (FTEs) during the year, or if its FTEs have average annual wages of $50,000 or more. To determine the number of FTEs, the new law generally requires an employer to divide total employee hours worked for the year (by all full-time and part-time employees)by 2,080 hours (i.e., the number of hours in a 52-week year based on a 40-hour work week). To determine the average annual FTE wages, an employer generally divides the employer’s aggregate wages for the year by the number of FTEs. For purposes of each formula, there is a host of special rules that may exclude hours worked by certain employees, or that may exclude the compensation paid to certain employees. For instance, the formulas exclude hours worked by and compensation paid to certain owners (and members of the owners’ families).
SELECTED PROVISIONS FIRST EFFECTIVE IN 2013
Additional .9% Medicare Surtax On Earned Income Of Higher-Income Taxpayers. Payroll taxes imposed on your W-2 earnings include both a Social Security tax and a separate Medicare tax. Under current law, the overall Medicare tax rate is 2.9% (1.45% imposed on the employee and an additional 1.45% imposed on the employer). If you are self employed, you must pay the entire 2.9% Medicare tax on your earned income. However, as a self-employed taxpayer, you are allowed to deduct one-half (1.45%) of your Medicare tax as an “above-the-line” deduction. Although the Health Care Act does not increase your Social Security taxes, it does increase the Medicare taxes for higher-income taxpayers. Generally, effective for wages and self-employed earnings received after 2012, the Health Care Act imposes an additional .9% Medicare Surtax. The surtax applies to the amount by which the sum of your W-2 wages and yourself-employed earnings exceeds $250,000 if you are married filing a joint return (exceeds $200,000 if you are single, $125,000 if you are married filing separately). Note! For married individuals filing a joint return, the W-2 earnings and the self-employed earnings of both husband and wife are aggregated in determining if the earnings exceed the $250,000 threshold.
New 3.8% Medicare Surtax On Investment Income. Since the inception of the Medicare program, the Medicare tax has only been imposed on an employee’s “wages” and a self-employed individual’s “earned income.” Starting in 2013, a new 3.8% Medicare Surtax will be imposed on all or a portion of the net investment income (e.g., interest, dividends, annuities, royalties, rents, and capital gains) of certain higher-income individuals. The tax will apply to married individuals filing jointly with modified adjusted gross income (MAGI) exceeding $250,000 (exceeding $200,000 if single, $125,000 if married filing separately). Trusts and estates that have net investment income in excess of certain threshold amounts will also be required to pay the 3.8% Medicare Surtax, unless the income is timely distributed to beneficiaries. However, if the income is timely distributed, the beneficiaries of the trust or estate may be subject to the Medicare Surtax.
What Is Included In Net Investment Income? Generally, net investment income includes (net of allocable deductions) interest, dividends, annuities, royalties, rents, gain from the sale of property (e.g., capital gains), and operating income from a business that trades in financial instruments or commodities. It also includes operating income from any other business which is a “passive activity” (unless the operating income constitutes self-employment income subject to the 2.9% Medicare tax on earned income).For this purpose, a “passive activity” is any business activity (other than an activity conducted through a C corporation) which is subject to the passive loss limitation rules because the owner does not materially participate in the business. For example, you are deemed to materially participate in a business and, therefore, the business is not passive if you spend more than 500 hours during the year working in the business.
Is Any Investment Income Exempt From The Surtax? Yes. For purposes of the 3.8% Medicare Surtax on investment income, “investment income” does not include: tax-exempt bond interest; gain on the sale of a principal residence otherwise excluded from income under the home-sale exclusion provisions; or distributions from qualified plans, IRAs, 403(b) annuities, etc. Planning Alert! Taxable distributions from qualified plans, traditional IRAs, etc., will increase your MAGI which could, in turn, push you over the $250,000 (joint return) or $200,000 (single return) thresholds, subjecting your net investment income to the 3.8% Medicare Surtax.
Observations And Planning Considerations. The following are a few observations and planning considerations relating to the new 3.8% Medicare Surtax on investment income:
• Tax-Exempt Income Becomes More Valuable. Investing in products that produce tax-exempt income will gain more importance. For example, tax exempt municipal bond interest will potentially provide higher income taxpayers with a double tax benefit: 1) the interest will not be included in the taxpayer’s MAGI thus reducing the chance that the taxpayer will exceed the income thresholds for the 3.8% Medicare Surtax, and 2) the tax-exempt interest itself is exempt from the Medicare Surtax.
• Additional Benefits For Contributions To Qualified Retirement Plans. By maximizing your deductible contributions to qualified retirement plans (e.g., traditional IRAs, §401(k)s, SEPs, etc.), you will potentially receive a double tax benefit: 1) your contributions will reduce your MAGI and reduce your chance of exceeding the income thresholds that would expose your current net investment income to the Medicare Surtax, and 2) the retirement plan distributions that you receive when you retire will be exempt from the Surtax.
SELECTED PROVISIONS FIRST EFFECTIVE IN 2014
Penalty For Failing To Carry Health Insurance. Beginning in 2014, the Health Care Act provides a penalty for individuals who do not have “minimum essential health coverage.” The penalty will be paid with an individual’s income tax return. Certain individuals may be granted an exemption from this penalty, such as: individuals having financial hardship or religious objections; American Indians; those without coverage for less than three months; aliens not lawfully present in the U.S.; incarcerated individuals; those for whom the lowest cost plan option exceeds 8% of household income; individuals with incomes below the tax filing threshold; and individuals residing outside of the U.S. Tax Tip. Starting in 2014, the Health Care Act also provides for a refundable health insurance premium assistance credit to encourage low and middle income individuals to purchase health insurance.
New Penalty For Larger Employers That Fail To Provide Adequate Employee Health Coverage. The Health Care Act, starting in 2014, will generally require certain larger employers to either offer and contribute to their employees’ qualified health insurance coverage, or pay a penalty. This penalty will generally not apply to any employer that employed on average less than 50 full‑time employees during the preceding calendar year. Planning Alert! This new so-called play-or-pay penalty contains a host of technical provisions, which are far too lengthy to address in this letter. Please call our firm if you would like additional information.