Tax Provisions in the Health Reconciliation Act

Late Thursday, Congress passed the Health Care and Education Reconciliation Act of 2010 (HR 4872). The bill now goes to the president for his signature. The Reconciliation Act amends various provisions of the Patient Protection and Affordable Care Act (PL 111-148), the large health care reform act that was enacted on Tuesday. The Reconciliation Act also adds some new provisions that were not included in the Patient Protection Act.

Premium Assistance Credit

The Patient Protection Act created refundable tax credits for eligible taxpayers to use to help cover the cost of health insurance premiums for individuals and families who purchase health insurance through a state health benefit exchange (which each state is required to establish). The Reconciliation Act slightly changes the amount of the credit, which equals the amount by which the taxpayer’s premiums exceed a specified threshold. That threshold ranges from 2% of income for those at 100% of the federal poverty level for the family size involved to 9.5% of income for those at 400% of the federal poverty level for the family size involved. The Reconciliation Act also provides for an inflation adjustment in the starting and ending percentages for years after 2014. The adjustment will be based on the rate of premium growth for the preceding calendar year over that year’s rate of income growth.

After 2018, the inflation adjustment will be based on the rate of premium growth for the preceding calendar year over that year’s consumer price index growth, but only if the aggregate amount of premium assistance tax credits and cost-sharing reductions under section 1402 of the Patient Protection Act for the preceding calendar year exceeds an amount equal to 0.504% of the gross domestic product for the preceding calendar year.

Excise Tax on Uninsured Individuals

New IRC § 5000A (created by the Patient Protection Act) is amended to change the amount of the penalty for U.S. citizens and legal residents who fail to maintain minimum amounts of health insurance coverage. Under the Reconciliation Act, individuals who fail to maintain minimum essential coverage will be subject to a penalty equal to the greater of: (1) 2.5% of household income in excess of the taxpayer’s household income for the tax year over the threshold amount of income required for income tax return filing under section 6012(a)(1); or (2) $695 per uninsured adult in the household. (Under the first act, the amount of the penalty was $750.) The penalty will be phased in from 2014–2016. For 2014, the penalty will be the greater of 1% of household income over the filing threshold or $95; for 2015, it will be the greater 2% of household income over the filing threshold or $325; and for 2016 it will be the full 2.5% or $695 amount.

Adult Dependent

The Reconciliation Act changes the definition of “dependent” for purposes of IRC § 105(b) (excluding from income amounts received under a health insurance plan) to include amounts expended for the medical care of any child of the taxpayer who has not yet reached age 27. The same change is made in section 162(l)(1) for purposes of the self-employed health insurance deduction, in section 501(c)(9) for purposes of benefits provided to members of a VEBA, and in section 401(h) for benefits for retirees.

Excise Tax on High Cost Employer-Sponsored Coverage

New IRC § 4980I (enacted by the Patient Protection Act) imposes a tax equal to 40% of any “excess benefit” associated with employer-sponsored health coverage. “Excess benefit” means the amount by which the aggregate cost of the coverage exceeds an annual limitation specified in the act. The Reconciliation Act pushes back the effective date of this provision, increases the annual limitation and eliminates a phase-in rule for the 17 states with the highest coverage costs.

Under the Reconciliation Act, for 2018, the annual limitation is $10,200 for self-only coverage or $27,500 for all other coverage. Retirees and employees in certain high-risk professions or who repair or install electrical or telecommunications lines have a higher limit. After 2018, the annual limitation is adjusted for inflation. This provision is effective for tax years beginning after Dec. 31, 2017.

Medicare Tax on Investment Income

The Reconciliation Act added a new IRC § 1411 that imposes a tax on individuals equal to 3.8% of the lesser of the individual’s net investment income for the year or the amount the individual’s modified adjusted gross income exceeds a threshold amount. For estates and trusts, the tax equals 3.8% of the lesser of undistributed net investment income or adjusted gross income over the dollar amount at which the highest trust and estate tax bracket begins.

For married individuals filing a joint return and surviving spouses, the threshold amount is $250,000; for married taxpayers filing separately, it is $125,000; and for other individuals it is $200,000.

Net investment income is defined as income from interest, dividends, annuities, royalties and rents, other than such income derived in the ordinary course of a trade or business (however, income from passive activities and from a trade or business of trading in financial instruments or commodities is included in the definition of net investment income).

This provision applies to tax years beginning after Dec. 31, 2012.

Economic Substance Doctrine

The Reconciliation Act codifies the economic substance doctrine in new IRC § 7701(o). The provision says that a transaction will be treated as having economic substance only if the transaction changes the taxpayer’s position in a meaningful way (apart from the tax benefits) and the taxpayer has a substantial purpose (apart from the tax benefits) for entering into the transaction.

The economic substance doctrine was created by the courts, and while they agree about the general definition and purpose, courts have applied different tests in determining whether a transaction has economic substance. The act codifies a two-part test and requires transactions to meet both prongs of the test.

The Reconciliation Act puts failure to meet the economic substance test within the list of transactions that are subject to penalty under IRC § 6662 and imposes an increased penalty amount for nondisclosed transactions that lack economic substance. The act also removes transactions that lack economic substance from the reasonable cause exception in IRC § 6664.