On March 23, 2010, President Obama signed into law the “Patient Protection and Affordable Care Act” (H.R. 3590).  One week later, on March 30, 2010, the President signed into law the “Health Care and Education Affordability Reconciliation Act” (H.R. 4872), which modified key provisions of H.R. 3590.  The two Acts together will significantly change the nation’s health care system.  To pay for these changes, a number of new taxes and fees are imposed on businesses and individuals, with staggered effective dates over the next eight years.  This Client Alert provides a summary of the most significant tax-related changes of this landmark health care reform legislation.  Future Client Alerts will cover other aspects of this legislation and related regulatory guidance, including a forthcoming Alert dealing with Employee Benefit Plans.

Increased Taxes on Individuals with Higher Incomes

1. New 0.9 Percent Medicare Surtax

The employee’s share of the Medicare payroll tax (the so-called “hospital insurance” payroll tax) is increased by 0.9 percentage points (from 1.45% to 2.35%) for an individual taxpayer earning over $200,000 ($250,000 for married couples filing jointly).  As a result, employees subject to the surtax will owe a 2.35% Medicare tax on their wages in excess of the base amounts. Corresponding changes are made to the self-employment tax, so that self-employed individuals will pay 3.8% on their earnings above the thresholds (2.9% plus 0.9%). The earnings threshold amounts are not indexed for inflation. Effective date: January 1, 2013.

2. New 3.8 Percent Medicare Surtax on Unearned Income

A new “unearned income Medicare contribution tax” is imposed on the net investment income of an individual taxpayer with adjusted gross income (AGI) over $200,000 ($250,000 for a joint return). Net investment income is interest, dividends, royalties, rents, gross income from a trade or business involving passive activities, and net gain from disposition of property (other than property held in a trade or business). Net investment income is reduced by properly allocable deductions to such income.  The new tax applies to the lesser of net investment income or AGI in excess of the thresholds – so if a couple earns $200,000 in wages and $100,000 in capital gains, $50,000 will be subject to the 3.8% surtax. The AGI threshold amounts are not indexed for inflation. The new tax also applies in a modified fashion to trusts and estates. Effective date: January 1, 2013.

Tax Changes Relating to “Universal” Health Coverage

1. Employer Requirements

Providing Insurance

• Penalties applicable to large employers (50+ employees) that do not provide coverage. Large employers are generally required to offer and contribute to their workers’ health insurance or pay a penalty.  This “play or pay” requirement is tied to the new premium assistance tax credits provided to low and middle income individuals who purchase insurance through a state exchange (see below). More specifically, a large employer that does not offer “qualified” coverage must pay a penalty if at least one employee purchasing health insurance through a state exchange is eligible to receive the premium assistance tax credit or cost-sharing reduction.  The penalty for failing to provide coverage is $2,000 for each full-time employee, with an exemption for the first 30 employees.  For example, if an eligible employer has 100 full-time employees and fails to offer coverage, it will be subject to a $140,000 penalty ($2,000 X 70 (100-30)), payable monthly in 1/12 increments.
• Penalties applicable to large employers (50+ employees) that do not provide coverage. Large employers are generally required to offer and contribute to their workers’ health insurance or pay a penalty.  This “play or pay” requirement is tied to the new premium assistance tax credits provided to low and middle income individuals who purchase insurance through a state exchange (see below). More specifically, a large employer that does not offer “qualified” coverage must pay a penalty if at least one employee purchasing health insurance through a state exchange is eligible to receive the premium assistance tax credit or cost-sharing reduction.  The penalty for failing to provide coverage is $2,000 for each full-time employee, with an exemption for the first 30 employees.  For example, if an eligible employer has 100 full-time employees and fails to offer coverage, it will be subject to a $140,000 penalty ($2,000 X 70 (100-30)), payable monthly in 1/12 increments.
• Defining “Full-Time Employee”.  All employees that work on average 30 hours per week in a month qualify as full-time employees.  This definition is applicable only to these penalty provisions.
• Small Employers.  Employers with less than 50 full-time employees are not subject to the insurance penalties listed above. 
• Effective Date:  January 1, 2014.

Vouchers

• All employers that provide insurance must provide “qualified employees” with the option of receiving a voucher that the employees can apply against insurance they purchase on their own, in lieu of participating in the employer-sponsored program.   An employee is a “qualified employee” if that person earns less than 400% of the federal poverty line and the employee’s contribution is between 8% and 9.5% of the employee’s household income.  The amount of the voucher is equal to the amount the employer would have contributed towards its health coverage.  Employers providing the vouchers will not be subject to penalties for employees that receive a voucher.
• Effective date: January 1, 2014.

2. Tax Credits for Small Employers Offering Health Coverage

Small employers may receive a tax credit for a portion of the employer’s contribution.  Employers are only eligible if they have 25 or fewer full-time employees and average wages of $50,000 or less.  For 2010 through 2013, small employers will be eligible for a 35% tax credit for the amount contributed to an employee’s health insurance premium, if the employer pays at least 50% of the premium cost.  For 2014 and beyond, for a maximum of two years, employers will be eligible for 50% of premiums paid for health insurance through a state exchange, if the employer pays at least 50% of the premium cost.  Only employers with 10 or fewer full-time employees and average wages less than $25,000 can receive the full benefit of the credit.  The credit is phased out as the number of employees or their average wages increase.  Employers may only deduct the amount of premium payments that are not reimbursed through a tax credit.

3. Penalty on Individuals Who Fail to Maintain Coverage

A new tax code section requires most individuals to obtain and maintain minimum essential health care coverage.  Medicare and Medicare establish the minimum coverage for their respective participants.  For others, minimum coverage is determined under an available employer plan, the individual market or a state exchange plan.  Failure to maintain minimum coverage will expose the individual to a penalty per insured individual in the household of $95 in 2014, $325 in 2015 and $695 in 2016, or 2½ percent of excess household income for the year, if that is greater than the fixed amount.  Excess household income is the difference between actual household income and that individual’s tax return filing threshold.  There are a few exceptions for individuals with religious conscience limitations, illegal aliens and people in jail.  The penalty will not apply if the premium would exceed 8% of that individual’s actual household income for the month.  Effective date:  January 1, 2014.

4. Premium Assistance for Low and Middle Income Taxpayers

A new tax code section establishes a refundable tax credit for taxpayers whose household income is between 100% and 400% of the federal poverty line and who are not covered by an employer plan.  This new credit – called the premium assistance tax credit – is the lesser of (i) the monthly premium paid by the taxpayer for insurance through a state exchange plan, or (ii) a complex formula intended to charge a higher portion of the premium to the taxpayer as the taxpayer’s income goes up the scale from 100% to 400% of the poverty line.  A new non-tax code provision provides that the credit is paid directly by the federal government to the exchange plan in which the taxpayer is enrolled, to be credited against the taxpayer’s premium under that plan.  These direct payments are to be made under a program to be established by the Secretary of Health and Human Services (in consultation with Treasury).  Effective date:  January 1, 2014.

5. Extension of Dependent Coverage

The Public Health Service Act is amended to require that group health plans and health insurers offering health coverage must continue to provide coverage for unmarried adult children of a covered individual or family until the child turns 26.  Effective date:  Plan years beginning on or after September 23, 2010.

Other Health-Related Revenue Raisers – Individuals

1. Increased AGI Threshold for Claiming Medical Expense Deductions

The AGI threshold for claiming the itemized deduction for medical expenses is increased from 7.5 percent of AGI to 10 percent of AGI for regular tax purposes (alternative minimum tax AGI threshold remains at 10 percent). Effective date:  January 1, 2013 (but individuals age 65 and older may claim the itemized deduction for medical expenses at 7.5 percent of AGI through 2016).

2. New $2,500 Contribution/Reimbursement Limit for Health FSAs

The amount of tax-free contributions to (and reimbursements from) health flexible spending accounts (FSAs) under cafeteria plans is limited to $2,500 per year. The dollar amount is indexed for inflation after 2013.  Effective date: January 1, 2013.

3. Prohibition on Using FSA, HRA, HSA or MSA Funds for Nonprescription Medications

The legislation provides that the cost of over-the-counter medicine (other than insulin or doctor-prescribed medicine) may not be reimbursed with excludible income through a health FSA, health reimbursement account (HRA), health savings account (HSA) or Archer medical savings account (Archer MSA).  This prohibition is accomplished by conforming the definition of “qualified medical expenses” for purposes of employer-provided health coverage (including health FSAs and HRAs), HSAs and Archer MSAs to the definition used for the medical expense itemized deduction.  Effective date:  January 1, 2011.

4. Increased Penalty for Nonqualified Withdrawals from HSAs and MSAs

The legislation increases the additional tax for HSA withdrawals prior to age 65 that are used for purposes other than qualified medical expenses from 10 percent to 20 percent, and increases the additional tax for Archer MSA withdrawals from 15 percent to 20 percent. Effective date:  January 1, 2011.

Other Health-Related Revenue Raisers – Businesses

1. 40 Percent Excise Tax on High-Cost Employer-Sponsored Health Coverage

An excise tax of 40 percent is levied on insurance companies and plan administrators for any health coverage plan with an annual premium that is above the threshold of $10,200 for single coverage and $27,500 for family coverage. The tax applies to the amount of the premium in excess of the dollar threshold. An additional $1,650 single coverage threshold amount (to $11,850) and an additional $3,450 family coverage threshold amount (to $30,950) applies for retired individuals age 55 and older and for plans that cover employees engaged in high risk professions.  Employers with age and gender demographics that result in higher premiums are allowed to value the coverage provided to employees using the rates that would apply using a national risk pool.  The excise tax applies to self-insured plans and plans sold in the group market, but does not apply to plans sold in the individual market (except for coverage eligible for the deduction for self-employed individuals). Stand-alone dental and vision plans are disregarded in applying the tax. The dollar amount thresholds are automatically increased if the inflation rate for group medical premiums between 2010 and 2018 is higher than the Congressional Budget Office estimates in 2010. Beginning in 2019, the dollar thresholds are indexed to inflation.  Employers will be required to compute the aggregate health insurance coverage value in excess of the dollar thresholds, and issue information returns for insurers indicating the amount subject to the excise tax.  Effective date:  January 1, 2018.

2. 10 Percent Excise Tax on Indoor Tanning Services

A ten percent excise tax is imposed on indoor tanning services. Effective date:  for services provided on or after July 1, 2010.

3. 2.3 Percent Excise Tax on Medical Devices 

An excise tax is imposed on the sale of a medical device by a manufacturer, producer or importer at a rate of 2.3 percent. Exempted from the tax are eyeglasses, contact lenses, hearing aids, and any other medical device determined by the IRS to be of a type that is generally purchased by the public at retail for individual use. Effective date:  January 1, 2013.

4. Deduction for Employer Part D Eliminated 

The legislation eliminates the deduction for the subsidy for employers who maintain prescription drug plans for their Medicare Part D eligible retirees. Effective date:  January 1, 2013.

5. Annual Fee on Health Insurance Providers Based on Market Share

The legislation imposes an annual flat fee on the health insurance sector beginning in 2014 allocated across the industry according to market share. The schedule for the flat fee is: $8 billion for 2014; $11.3 billion for 2015 and 2016; $13.9 billion for 2017; and $14.3 billion for 2018. For years after 2018, the fee is indexed to the rate of premium growth.  The fee does not apply to companies whose net premiums written are $25 million or less.

6. Annual Fee on Pharmaceutical Manufacturers Based on Market Share

The legislation imposes an annual flat fee on the pharmaceutical manufacturing sector beginning in 2011 allocated across the industry according to market share. The schedule for the flat fee is: $2.5 billion for 2011; $2.8 billion for 2012 and 2013; $3 billion for 2014 to 2016; $4 billion for 2017; $4.1 billion for 2018; and $2.8 billion for 2019 and thereafter. The fee does not apply to companies with sales of branded pharmaceuticals of $5 million or less.

7. Executive Compensation Deduction Limited for Insurance Providers

The deductibility of executive compensation for insurance providers is limited if at least 25 percent of the insurance provider’s gross premium income is derived from health insurance plans that meet the minimum essential coverage requirements in the legislation (“covered health insurance provider”). The deduction for remuneration paid to an “applicable individual” is limited to $500,000 per taxable year.  “Applicable individuals” broadly include all officers, employees, directors, and other workers or service providers (such as consultants) performing services for or on behalf of a covered health insurance provider. Effective date:  January 1, 2013.

8. New Exemption Requirements and Excise Tax for 501(c)(3) Hospitals

Hospitals that are tax-exempt under Section 501(c)(3) of the tax code are subject to the following new exemption requirements: complete a community needs assessment once every three years; adopt and publicize a financial assistance policy; do not charge patients who qualify for financial assistance more than patients with insurance coverage; and determine if a patient qualifies for financial assistance before taking “extraordinary collections actions.” A hospital that fails to complete the community needs assessment is subject to a new excise tax of $50,000.  Effective date:  January 1, 2011, except that the community needs assessment requirement is effective in 2013.

Other Health-Related Tax Changes

1. Increases in Adoption Tax Credit and Adoption Assistance Exclusion

The legislation increases the adoption tax credit and adoption assistance exclusion by $1,000, makes the credit refundable, and extends the credit through 2011. Effective date:  January 1, 2010.

2. W-2 Reporting of Value of Health Benefits

An employer is required to disclose on each employee’s annual Form W-2 the value of the employee’s health insurance coverage sponsored by the employer.  For example, if an employee enrolls in employer-sponsored health insurance coverage under a major medical plan, a dental plan, and a vision plan, the employer is required to report the total value of the combination of all of these health-related insurance policies.  Effective date:  January 1, 2011.

3. New Tax Credit for New Therapies

The legislation enacts a two-year temporary “qualifying therapeutic discovery project” tax credit of $1 billion to be divided among qualifying small companies whose therapeutic discovery project has been certified by the Secretary of Health and Human Services (HHS).  A small company is one with 250 or fewer employees.  Effective date: costs paid or incurred in 2009 and 2010 for a therapeutic discovery project that has been certified by HHS.

4. New Exclusion for Health Professionals with State Loan Repayment Relief

Excluded from gross income are payments made under any state loan repayment or loan forgiveness program that is intended to provide for the increased availability of health care services in underserved or health professional shortage areas. Effective date: effective retroactively for amounts received by an individual in taxable years beginning after December 31, 2008.

Non-Health Related Tax Changes

1. Form 1099 Reporting for Corporate Payees

Prior law generally exempted payments to corporations from the Form 1099 reporting requirements.  The legislation deletes this exemption by providing that businesses that pay an amount greater than $600 to corporate providers of property and services must file a Form 1099 information report with each provider and the IRS.  Effective date:  January 1, 2012.

2. Codification of Economic Substance Doctrine and Penalties

The economic substance doctrine is a judicial doctrine that has been used by the courts to deny tax benefits when the transaction generating these tax benefits lacks economic substance. The courts have not applied the economic substance doctrine uniformly. The legislation clarifies the manner in which the economic substance doctrine should be applied by the courts and imposes a penalty on understatements attributable to a transaction lacking economic substance. Effective date: Transactions entered into after March 30, 2010.