Passage of the Health Care and Education Reconciliation Act of 2010 (“Reconciliation Act”) amending the Patient Protection and Affordable Care Act of 2010 (together the “Health Care Reform Package”), which President Obama signed on March 23 created many tax changes. Many of these tax changes are discussed below.
Additional Medicare Payroll Tax
Beginning in the 2013 taxable year, the Reconciliation Act imposes a 3.8 percent “unearned income Medicare contribution” tax on the lesser of the taxpayer’s net investment income or modified adjusted gross income (“AGI”) in excess of $200,000 for singles and $250,000 for joint filers.
Net investment income includes interests, dividends, annuities, royalties, rents, gain from disposing of property from a passive activity, income earned from a trade or business that is a passive activity, and income earned from a trade or business of trading financial instruments of commodities as defined by existing mark-to-market tax rules for dealers of commodities. Income on an investment of working capital is also taxed. In determining net investment income, investment income is reduced by deductions properly allocable to that income. Some income is exempt from the tax, including income from the disposition of certain active partnerships and S corporations, distributions from qualified retirement plans, and any item taken into account in determining self-employment income. The tax does not apply to nonresident aliens or trusts for which all of the unexpired interests are devoted to charitable purposes.
The provision defines modified adjusted gross income as AGI increased by any income excluded by the foreign earned income exclusion over the amount of any deductions and exclusions disallowed with respect to that income.
Estates and trusts are also subject to a 3.8 percent unearned income Medicare contribution tax on the lesser of the undistributed net investment income for the tax year or the excess of adjusted gross income over the dollar amount at which the 39.6 percent tax bracket for trusts and estates begin.
Small Business Tax Credit
Beginning in 2010, many small businesses and tax-exempt organizations that provide health insurance coverage to their employees now qualify for a special tax credit.
The credit is designed to encourage small employers to offer health coverage for the first time or to maintain health coverage they already have.
An employer generally qualifies for this credit if the business has no more than 25 full-time equivalent (“FTE”) employees paying wages averaging less than $50,000 per employee per year. Because the eligibility formula is based in part on the number of FTEs, not the number of employees, many businesses will qualify even if they employ more than 25 individual workers. The qualified small employer must contribute at least one-half of the cost of health insurance premiums for coverage of its participating employees.
In 2010 through 2013, qualified small employers may qualify for a tax credit of up to 35 percent of their contribution toward the employee’s health insurance premium. After 2013, small employers that purchase coverage through an insurance exchange may qualify for a credit for two years of up to 50 percent of their contribution and 35 percent of premiums paid by eligible employers that are tax-exempt organizations.
The maximum credit goes to smaller employers with 10 or fewer FTEs paying annual average wages of $25,000 or less.
Eligible small businesses can claim the credit as part the general business credit starting with the 2010 income tax return they file in 2011. The IRS will provide further information on how to claim the credit for tax-exempt employers.
Excise Tax on “Cadillac” Health Plans
Beginning in 2018, the Health Care Reform Package will impose a 40 percent nondeductible tax on insurance companies or plan administrators for any health insurance plan with an annual premium in excess of an inflation-adjusted $10,200 for individuals and an inflation-adjusted $27,500 for families. There is a higher premium level for employers in certain high-risk professions: $11,850 for individual coverage and $30,950 for family coverage. Non-Medicare retirees age 55 and older are also eligible for higher thresholds.
Dental and vision plans are not included when calculating the total benefit value.
Corporate Estimated Taxes
The Reconciliation Act includes a one-time increase of 15.75 percentage points for estimated taxes of corporations with assets of at least $1 billion dollars for payments made during July, August, and September of 2014. Payments will be decreased by a corresponding amount during the following quarter.
Pursuant to the Health Care Reform Package most individuals who fail to maintain essential minimum universal coverage are liable for penalties. The penalty is based on the greater of a flat-dollar amount or a percentage of household income. The Reconciliation Act exempts income below the filing threshold, lowers the flat payments required from $495 to $325 in 2015 and from $750 to $695 in 2016 and increases the percent-of-income thresholds.
The employer-provided health coverage gross income exclusion extends to coverage for adult children up to age 26 as of the end of the tax year. Self-employed individuals are allowed a deduction for the premiums paid on the dependent care coverage for adult children up to age 26.
The Health Care Reform Package generally does not require employers to provide health insurance coverage. However, beginning in 2014, a fee is imposed on firms with 50 or more employees that do not provide coverage. The fee is calculated based on the number of full-time employees.
The Reconciliation Act modifies that provision by excluding the first 30 employees from the payment calculation.
Indoor Tanning Tax
The Health Care Reform Package imposes a 10 percent tax on qualified indoor tanning services effective for services provide on or after July 1, 2010.
Codification of the Economic Substance
The Reconciliation Act adds a revenue raiser that codifies the economic substance doctrine. Economic substance is a common law doctrine under which the tax benefits of a transaction are not permitted if the transaction does not have economic substance or lacks a business purpose. The provision in the Reconciliation Act requires a conjunctive analysis of economic substance under which taxpayers must show that (1) the transaction changes in a meaningful way their economic position apart from federal income tax effects and (2) they had a substantial purpose apart from federal income tax effects for entering into the transaction.
A 40 percent penalty applies to tax understatements attributable to undisclosed noneconomic substance transactions. The penalty is 20 percent if the transaction is adequately disclosed. The Reconciliation Act also renders the ability to obtain relief from accuracy-related penalties under the reasonable-cause exception inapplicable to noneconomic substance transactions.
The Joint Committee on Taxation projects that this provision will generate $4.5 billion over 10 years.
The courts have relied on the economic substance doctrine to distinguish abusive transactions from legitimate ones. The application of the doctrine is heavily dependent upon the facts and circumstances of a particular transaction. The codification of the economic substance doctrine adds some clarity but what remains to be seen is whether the codification will be more or less favorable to a transaction than the doctrine as historically applied
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