Dealing with Health Care Reform's New Tax Laws: The Health Care and Education Reconciliation Act of 2010

Now that Congress has passed landmark health care reform package, much work needs to be done in dealing with new requirements. While the end result of the legislative process is necessarily health care related, the tax law plays a major role in its implementation. From the tax credits and subsidies used to expand health coverage, to the many penalties, fees and surtaxes designed to pay for it, the Tax Code is front and center.

Two new laws

Health care reform is actually made up of two new laws: the Patient Protection and Affordable Care Act of 2010 and the Health Care and Education Reconciliation Act of 2010. The Patient Protection Act was crafted largely in the Senate and sets out the general framework of health care reform. The Reconciliation Act was prepared in the House to modify the Patient Protection Act, especially in the areas of tax credits and cost sharing for individuals to help make coverage more affordable. Common features to both laws are delayed effective dates for many of the provisions, which make strategic planning all that more important.

New taxes and penalties

Viewing the historic health care reform package from the context of the Tax Code, many new taxes and penalties stand out immediately above the rest. Initially, we would advise taking particular note of the following highlights:

• Individuals who earn more than $200,000 for the year ($250,000 for married couples) will be paying an additional 0.9 percent in Hospital Insurance (Medicare) tax, starting in 2013;
• Individuals whose adjusted gross income for the year exceeds $200,000 ($250,000 for joint filers), whether from wages or otherwise, will also be paying an additional 3.8 percent Medicare tax on net investment income, starting in 2013;
• Employers with 50 or more employees generally will be required to provide a minimum level of health insurance for their employees or pay a penalty per employee, starting in 2014;
• Small employers with no more than 25 employees are entitled to up to a 35 percent tax credit on the cost of providing health insurance for employees, starting immediately in 2010;
• Most individuals will be required to obtain health insurance or be subject to a penalty tax starting in 2014;
• Tax credits to subsidize the cost of health insurance premiums will be available to individuals earning up to 400 percent of the poverty level, starting in 2014;
• Health flexible savings arrangement (FSA) dollars will be limited to prescription medications with some exceptions after 2010, along with placing a $2,500 annual cap on expenses covered under health FSAs, starting in 2013;
• A 40 percent excise tax will be imposed on high-cost, "Cadillac" employer-sponsored health coverage, starting in 2018;
• Fees will be imposed on the pharmaceutical industry and health insurance providers , starting in 2011 and 2014, respectively;
• An excise tax will be imposed on medical device manufacturers after 2012; and
• Limits on tax-subsidized medical expenses will be imposed by raising the itemized medical expense deduction floor for regular tax purposes from 7.5 percent to 10 percent, generally starting in 2013.

Tax incentives

Among a handful of tax incentives provided under the new health-care reform package, two are particularly notable at this time: (1) the ability of parents to cover adult children up to age 27 under their tax-qualified employer-provided health plans, starting immediately on or after March 23, 2010; and (2) the unveiling of a simplified cafeteria plan specifically tailored to small businesses, starting in 2011.

Exchanges

The health care reform package requires each state to establish an exchange by 2014 to help individuals and qualified employers obtain coverage. Coverage will be offered at various levels. Qualified individuals may be eligible for premium assistance tax credits, cost-sharing or vouchers to help pay for coverage through an insurance exchange. An individual's income whether or not coverage is provided by his or her employer will all be taken into account when determining if the individual qualifies for a premium assistance tax credit, cost-sharing or voucher.

IRS guidance

Over the course of the next few months, the IRS and other federal agencies will be filling in details on how to comply with all the provisions under the massive health care reform package. The IRS is expected to issue guidance soon on the provisions with effective dates in 2010 and 2011. This office will be staying on top of all developments, with an eye toward how to best maximize results under the new law for our clients. We are prepared to advise our clients on all compliance rules and tax-reduction opportunities that undoubtedly will arise. In the meantime, if you have any questions about the new law, please do not hesitate to call our office.

 First Quarter 2010 Federal Tax Developments

The first quarter of 2010 brought many tax developments from Congress, the IRS and the courts. We have highlighted some of these important federal tax developments below.

Health care reform. In March, President Obama signed comprehensive health care reform legislation (the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act). The health care reform package does not mandate employer-provided coverage but beginning in 2014 large employers that do not offer coverage will pay a penalty. Large employers that offer coverage but the coverage fails to meet minimum essential standards will also pay a penalty. Tax credits for small employers are available immediately for 2010 tax years. Individuals must obtain minimum essential coverage after 2013 unless they are treated as exempt; otherwise they will pay a penalty. Starting in 2013, the new law broadens the Medicare tax base for higher income taxpayers, including amounts paid on investment income, and, after 2017, imposes an excise tax on high-dollar health insurance plans.

HIRE Act. President Obama signed the Hiring Incentives to Restore Employment (HIRE) Act in March, providing businesses with payroll tax relief, a worker retention tax credit and enhanced Code Sec. 179 expensing. Payroll tax forgiveness applies to wages paid to covered workers who are on the employer's payroll after March 18, 2010 and before January 1, 2011. The covered employee must begin employment after February 3, 2010 and before January 1, 2011. The HIRE Act also allows employers to claim a worker retention credit for qualified employees.

Estate tax. The federal estate tax does not apply to decedents dying after December 31, 2009 and before January 1, 2011. Also, beginning in 2010, the stepped up basis at death rules are replaced with modified carryover basis at death rules applicable to estates holding assets with unrealized capital gains of more than $1.3 million. In December 2009, the House passed the Permanent Estate Tax Relief Act, which would permanently extend the top federal estate tax rate of 45 percent with a $3.5 million exclusion ($7 million for married couples). The Senate, however, has failed to take up the House bill. Some action this year is expected.

Individual tax rates. President Obama urged Congress in his Fiscal Year (FY) 2011 federal budget proposals to extend the individual marginal rate cuts enacted in 2001 but allow the top two individual marginal income tax rates to revert to 36 percent and 39.6 percent respectively after 2010. Higher income individuals also would pay 20 percent tax on qualified dividends and capital gains after 2010 under the president's proposal. Congress is expected to take up the individual marginal rate cuts and the dividend/capital gains tax rates over the summer of 2010.

Homebuyer credit. In January, the IRS issued an updated version of Form 5405, First-Time Homebuyer Credit and Repayment of the Credit. Because of documentation requirements for claiming the credit, taxpayers who claim the credit on their 2009 return must file a paper return and attach Form 5405 and a properly executed copy of a settlement statement used to complete the purchase. The IRS noted that settlement documents can vary from one location to another. For a newly constructed home where a settlement statement is unavailable, a copy of the certificate of occupancy generally will be accepted, the IRS advised.

Audit rates. IRS statistics released in March indicate that the examination rate for individual taxpayers between FY 2008 and FY 2009 remained generally static at an overall audit rate of one percent for individuals. The audit rate was 1.86 percent for taxpayers with adjusted gross incomes (AGIs) between $200,000 and $500,000 and 5.35 percent for taxpayers with AGI between $1 million and $5 million.

Maximum fair market values. The IRS released in January the maximum fair market values (FMVs) for business automobiles, trucks and vans first placed into service in 2010 and for which the vehicle cents-per-mile rule and the fleet-average valuation rule may apply. The maximum FMVs for use of the vehicle cents-per-mile valuation rule in 2010 are $15,300 for a passenger automobile and $16,000 for a truck or van, which includes automobiles built on a truck chassis, such as minivans and sport-utility vehicles (SUVs) built on a truck chassis.

Vehicle depreciation. Depreciation limits for business automobiles, trucks and vans first placed in service in 2010 as well as the annual income inclusion amounts for vehicles first leased in 2010 were released by the IRS in February. The maximum depreciation limits for passenger automobiles first placed in service during the 2010 calendar year are $3,060 for the first tax year; $4,900 for the second tax year; $2,950 for the third tax year; and $1,775 for each tax year thereafter. The amounts for trucks and vans first placed in service during the 2010 calendar year are $3,160 for the first tax year; $5,100 for the second tax year; $3,050 for the third tax year; and $1,875 for each tax year thereafter. If Congress decides to extend bonus depreciation for another year into 2010, first year amount will increase by $8,000, as was the case in 2009.

Uncertain tax positions. In February, the IRS announced a controversial proposal to require certain businesses to report directly on their annual income tax returns any uncertain tax positions determined under financial accounting standards. The IRS is developing a new schedule to implement the reporting requirement. The new reporting requirement will not take effect immediately and will not apply to tax returns filed in 2010 for the 2009 tax year.

409A correction program. Because of the complex and detailed requirements for plans to comply with Code Sec. 409A and the severe consequences for violations, employers urged the IRS to develop a document correction program. In January, the IRS announced a document correction program for Code Sec. 409A nonqualified deferred compensation plans. The program is a follow-up to the 409A correction program for operational failures.

Passive activity losses. After a number of court losses, IRS acquiesced "in result only" to a 2009 decision by the Court of Federal Claim's decision ( Thompson v. U.S. ) holding that a member's interest in a limited liability company taxed as a partnership is not a limited partnership interest for passive activity loss (PAL) purposes under Code Sec. 469. The IRS also indicated that it will issue more guidance and amend existing regulations.

Tax shelter penalties. The IRS has extended until June 1, 2010 its moratorium on collecting penalties under Code Sec. 6707A for undisclosed tax shelter transactions. Additionally, the agency also will continue to delay until June 1, 2010 filing new notices of federal tax lien for collecting amounts due solely to Code Sec. 6707A penalties. Both the House and Senate have passed bills ameliorating the penalty for small businesses.

Retirement plan payments. A taxpayer who received early distributions from two individual retirement annuities was liable for the Code Sec. 72(t) 10 percent additional tax, the U.S. Tax Court held in February ( Prough v. Commissioner ). The taxpayer failed to establish the distributions met the substantially equal periodic payments exception. The Obama administration is reportedly studying the annuitization of retirement plan payments.

Housing allowances. The IRS issued its table of adjusted limitations in March on housing expenses for 2010, adding new foreign locations and slightly raising the housing allowance for most locations. Code Sec. 911 allows U.S. taxpayers living abroad to exclude their foreign earned income and housing costs from gross income. The Tax Increase Prevention and Reconciliation Act of 2005 allows the IRS to adjust the standard formula limitation for determining the amount of employer-paid housing excluded from foreign earned income, based on geographic differences in housing costs relative to housing costs in the U.S.

Like-kind exchanges. In March, the IRS unveiled a much-anticipated safe harbor for participants in multiple-party like-kind exchanges under Code Sec. 1031 that have experienced hardship because of the default of qualified intermediaries (QIs) during the economic downturn. The safe harbor for reporting gain or loss is available to taxpayers that initiated deferred like-kind exchanges but failed to complete the exchange due to a QI's default on its obligation to timely acquire and transfer replacement property when its assets are frozen in bankruptcy or receivership.

Royalties. In March, the Court of Appeals for the Second Circuit found that a taxpayer can deduct royalties paid to license trademarks for selling the products. The Second Circuit's decision is significant because it is the first to address the treatment of intellectual property royalties under the uniform capitalization rules of Code Sec. 263A.

Student FICA exception. In a major concession, the IRS agreed in March to accept claims that medical residents qualify under the student FICA exception and are entitled to refunds for FICA (Social Security) taxes. The new IRS policy, however, does not apply to current payments but only to tax periods ending before April 1, 2005. Generally, courts have held that medical residents were not subject to FICA taxes because their services were incident to and for the purpose of pursuing an educational course of study.

Return preparers. The IRS announced in January the results of a study of its oversight of tax return preparers. All paid signing preparers will be required to register with the IRS. Unenrolled preparers (practitioners who are not CPAs, attorneys, enrolled agents and, in some cases, licensed public accountants) will be required to successfully complete continuing education classes and competency testing.

Before 2010, only individuals with modified adjusted gross incomes (AGI) of $100,000 or less could convert amounts in their traditional IRA to a Roth IRA. Moreover, married taxpayers filing separate returns have also been prohibited from converting their traditional IRA to a Roth IRA as well. However, beginning in 2010, the $100,000 AGI limit on conversions of traditional IRAs to Roth IRAs is eliminated completely. This special treatment gives everyone regardless of his or her income level the opportunity to convert a traditional IRA to a Roth IRA. Additionally, filing status restrictions are also lifted, allowing married taxpayers filing a separate return to convert a traditional IRA to a Roth IRA.

It is important to understand that an IRA conversion is treated as a taxable distribution, taxed as ordinary income at your marginal tax rate. This in effect accelerates the taxable income that you would eventually pay on distributions from a traditional IRA once you retire, but does so in exchange for never taxing any future appreciation in the value of your account from what it is today. That is often a significant tax advantage. You should also note that unlike a withdrawal from an IRA, a conversion does not trigger any 10 percent early withdrawal penalty.

Although conversion to a Roth IRA does trigger immediate taxable income, Congress provided a special incentive in 2010 to jumpstart Roth conversions under the new rules: In 2010 (and 2010 only), individuals will have the choice of recognizing their conversion income in 2010 or averaging it over 2011 and 2012. You must elect one option. This allows you to pay taxes on the converted amount ratably over two years, instead of recognizing it all as income in one year. You will be taxed at the rates in effect for 2011 and 2012.

For some taxpayers, their tax rate may rise after 2010 even if their income does not. President Obama has proposed, and Congress is expected to enact, legislation to restore the top two pre-2001 marginal income tax rates after 2010. This means that the top two brackets will be 39.6 percent and 36 percent after 2010. Consequently, if you do not want to take the chance that your income tax rate will be higher in 2011 and 2012 than in 2010, you may want to elect to pay the full tax on the Roth conversion in your 2010 income tax return, at 2010 income tax rates.

Higher-income individuals who plan to pay the entire conversion tax in 2010 instead of ratably in 2011 and 2012 because of the anticipated increase in the top marginal tax rates, may want to avoid, for year-end 2009, the traditional year-end-planning techniques of accelerating deductions and deferring income. Alternatively, consider doing the opposite this year to avoid being pushed into the highest brackets by a large IRA-to-Roth-IRA conversion.

Taxpayers are expected to convert their traditional IRAs to Roth IRAs for a variety of reasons. Roth IRAs have two major advantages over traditional IRAs:

• Roth IRA distributions are tax-free if they are qualified distributions. To be qualified, they must be made after a five-year holding period has passed and after the accountholder reaches age 59 1/2, or on account of death, disability, or the qualified purchase of a first home.
• Roth IRAs are not subject to the required minimum distribution (RMD) rules that apply to traditional IRAs (as well as individual qualified plans). Therefore, a Roth IRA accountholder who reaches age 70 1/2 does not need to begin taking distributions; instead, the funds can continue to grow tax free until they are needed or are passed on heirs.

The tax-free nature of qualified Roth IRA distributions may prevent individuals from being taxed in a higher tax bracket that would otherwise apply if he or she were withdrawing taxable distributions from a traditional IRA. Moreover, these distributions --unlike those from traditional IRAs-- do not effect the calculation of tax owed on Social Security payments and do not affect AGI-based deductions.

An IRA to Roth IRA conversion should be considered by individuals who:

• Can afford the tax on the converted amounts;
• Anticipate being in a higher tax bracket in the future than they are currently in; and
• Have a significant amount of time before reaching retirement to allow assets to grow tax-free and recoup dollars that may have been lost due to the conversion tax.

If you are planning on taking advantage of the Roth IRA conversion opportunity next year, consider some of the following strategies this year:

• Because of the economic slowdown, many individuals are postponing retirement. Roth IRAs, unlike traditional IRAs, generally have no age limitation on contributions from earned income or on mandatory payouts. This is an advantage for individuals who are extending their careers beyond traditional retirement age.
• If you are able to make deductible IRA contributions this year, do so. This can help you reduce your 2009 tax bill and, if you convert to a Roth IRA in 2010, you will not have to pay back the tax savings until 2011 and 2012, if you elect to ratably pay the tax over the two-year period.
• Additionally, you may want to consider making nondeductible IRA contributions this year since you can later roll over the amounts into Roth IRAs next year at no tax cost.

If you anticipate being below the $100,000 AGI level this year, consider converting to a Roth IRA right away while your traditional IRA account balance is still low because of stock market declines. If your situation is different from what you anticipate before you file your 2009 return, you might consider "recharacterizing" your 2009 Roth conversion back to a traditional IRA and then converting to a Roth IRA in 2010 instead.

Note. For 2010, the AGI limits for maximum Roth IRA contributions is $167,000 for married joint filers (up from $166,000 in 2009), and will remain at $105,000 for other filing statuses, including married individuals filing separately and single taxpayers. While the $100,000 AGI limit for rollovers has been lifted, the AGI limit for annual contributions has remained.

There are a significant number of tax and financial considerations that come into play when determining whether to convert your traditional IRA to a Roth. If you have any questions about traditional IRA to Roth IRA conversions and the new 2010 planning opportunity, please contact our office.  

Bonus depreciation. Bonus depreciation is back for 2009. The 2009 Recovery Act extends the 50 percent bonus depreciation authorized by the Economic Stimulus Act of 2008, which generally expired at the end of 2008. Businesses can take advantage of bonus depreciation throughout 2009 (and longer for certain types of property). Bonus depreciation is taken on top of regular depreciation. Keep in mind that a large current depreciation deduction results in smaller future deductions so careful planning is an absolute must. To allow vehicles to continue to be depreciated at a higher level, the 2009 Recovery Act also adds $8,000 to the "caps" ordinarily placed on such deductions. Especially useful to businesses with accumulated AMT and research tax credits on their tax books, the 2009 Recovery Act also allows eligible businesses to monetize these credits in lieu of taking bonus depreciation for 2009.

Code Sec. 179 expensing. Increased Code Sec. 179 expensing is also back for 2009. The Economic Stimulus Act of 2008 increased Code Sec. 179 expensing for 2008 to $250,000 and the threshold for reducing the deduction to $800,000. However, the enhanced provision expired at the end of 2008. The 2009 Recovery Act revives it for 2009. Unless Congress intervenes, Code Sec. 179 expensing will return to pre-2008 indexed levels of $134,000, with a cost of equipment level of $530,000 for 2010. In 2011, it is scheduled to drop even lower, to a pre-2001 indexed level of $25,000, with an equipment cap of only $200,000.

Net operating losses. Many taxpayers expected Congress to extend the carryback period for net operating losses (NOLs) to five years. The 2009 Recovery Act does so, but limits this important relief for qualified small businesses (businesses with average gross receipts of $15 million or less). The treatment is also temporary and only applies to NOLs for any tax year beginning or ending in 2008. Qualified businesses can choose to carry back NOLs three, four or five years. Immediate refunds are available to businesses that qualify. Taxpayers that previously elected to forego the two-year carryback for 2008 NOLs can revoke that election and make a new election to claim the extended carryback under the new law. However, the revocation had to have been made by April 17, 2009.

Cancellation of indebtedness. Many taxpayers also expected Congress to provide tax relief for companies that purchase their own or related party debt at a discount. The 2009 Recovery Act addresses cancellation of indebtedness but not as generously as many taxpayers had hoped. Eligible businesses will be able to recognize cancellation of certain indebtedness over five years, beginning in 2014, under the new law. This treatment applies to specified types of business debt repurchased or forgiven by the business after December 31, 2008 and before January 1, 2011.

Work Opportunity Tax Credit. Congress has taken a special interest in the Work Opportunity Tax Credit (WOTC) as a mechanism to encourage employers to hire individuals who are economically-challenged. The 2009 Recovery Act modifies the definitions of eligible veterans and disconnected youth to bring more individuals under the WOTC. This treatment is temporary.

S corporations. A built-in gains tax applies to corporations that make an S corporation election. The tax is computed by applying the highest corporate tax rate to the net recognized built-in gain of the S corporation for the tax year. The 2009 Recovery Act reduces the recognition period for assets subject to the built-in gains tax from 10 to seven years, for dispositions in tax years beginning in 2009 and 2010.

Small business stock. Generally, an investor other than an entity doing business as a C corporation, may exclude 50 percent of the gain from the sale or exchange of "qualified small business stock." The 2009 Recovery Act new law raises the 50 percent exclusion to 75 percent. However, the increase is temporary and applies to stock acquired after the date of enactment and before January 1, 2011. Holding period rules also apply.

Executive compensation. The economic slowdown cast a spotlight on the executive compensation practices of Wall Street firms and many lawmakers are unhappy with what they see as "excessive" compensation. The 2009 Recovery Act reflects the changing mood in Congress. Lawmakers especially singled-out expenditures for luxury items by companies receiving financial assistance from the government's Troubled Asset Relief Program (TARP) for more regulation. Congress also directed the Treasury Secretary to review bonuses, awards and other incentives paid to senior executives at these firms and determine if the payments were contrary to public interest.

COBRA. Individuals who are involuntarily separated from employment between September 1, 2008 and January 1, 2010 can elect to pay 35 percent of their premiums for COBRA coverage and will be treated under the new law as paying the full amount. The former employer will pay the remaining 65 percent of the premium. In return, the employer will be able to credit its share of this temporary COBRA subsidy against wage withholdings and payroll taxes. The COBRA subsidy is generally only available for nine months. The Department of Labor has issued model notices that employers can send to former employees who are eligible for the COBRA subsidy. The IRS has also issued guidance on what qualifies as involuntary termination for purposes of the COBRA subsidy.

Energy incentives. Producers of alternative and renewable energy are definite winners under the 2009 Recovery Act. Congress has rewarded them with significant increases in energy tax incentives. Among the incentives are an enhanced renewable electricity production tax credit, an expanded energy investment tax credit, an increased alternative fuel pump tax credit, and an investment credit election. The incentives are temporary.

First-time homebuyer credit. While the first-time homebuyer credit is thought of as being targeted to individuals, it will impact businesses, especially home construction. The U.S. housing market is in one of its steepest slumps in recent memory. The 2009 Recovery Act extends the first-time homebuyer tax credit to include purchases made before December 1, 2009. The 2009 Recovery Act also raises the credit to $8,000 and eliminates the repayment requirement. Home builders, sellers and others in the housing industry need to market this credit aggressively.

More incentives. The 2009 Recovery Act also prospectively revokes a controversial IRS notice affecting NOL limitations on banks and expands the health coverage tax credit for eligible taxpayers. The new law also increases the New Markets Tax Credit program, modifies the low income housing credit, decreases estimated tax payments for certain individuals whose incomes come from small businesses and delays withholding on government contractors. For the auto industry and consumers alike, the new law allows the sales tax paid on a new vehicle purchase from February 17, 2009 through December 31, 2009 as a deduction whether or not an individual itemizes deductions. Congress also enhanced many tax-exempt and tax-credit bond rules to help states and local governments generate revenue.