The U.S. Supreme Court declared the individual mandate in the Patient Protection and Affordable Care Act of 2010 (“Affordable Care Act”) to be constitutional (NFIB v. Sebelius, S.Ct., 6/28/12). This provision, which is set to take effect in 2014, is the linchpin for the entire law. As a result, several tax rules became effective in 2012 or are set to become effective in 2013. These rules affect both individuals and businesses. While political changes from the November 2012 election may disrupt the schedule, here are the rules as they now stand.
Additional Medicare taxes
Starting in 2013, two new—additional—Medicare taxes are set to take effect; one impacts earned income while the other affects unearned income.
Additional Medicare tax on earned income. A tax of 0.9% applies to earnings from wages (including tips and taxable fringe benefits) or self-employment over a threshold amount (Code Secs. 1401(b)(2); 3102(f)). The tax applies to earnings over:
- $200,000 for singles and heads of households
- $250,000 for married filing jointly
- $125,000 for married filing separately
Employers must withhold the tax from wages when earnings exceed the threshold. The IRS has guidance (www.irs.gov/businesses/small/article/0,,id=258201,00.html) on withholding rules for employers in question and answer format. For example, if an employee receives a year-end bonus that pushes her over the threshold, the additional Medicare tax is not withheld until the bonus is paid and then only to the extent of the bonus that puts total compensation for the year over the threshold. The additional Medicare tax is on top of the basic Medicare tax of 1.45% for the employee and 1.45% for the employer. There is no employer matching of this additional Medicare tax as there is for the basic Medicare tax. The IRS has said it will revise Form 941, Employer’s Quarterly Federal Tax Return, to reflect the new tax.
Self-employed individuals will have to take this additional tax into account in figuring estimated taxes. For purposes of deducting a portion of self-employment tax from gross income, special computations will be necessary because only the so-called employer portion of the tax is deductible; there is no employer matching for the additional Medicare tax (viewed as the employee portion of the tax).
Additional Medicare tax on net investment income. A tax of 3.8% applies to net investment income (investment income in excess of investment expenses) (Code Sec. 1411). The tax applies to all such income once the taxpayer’s modified adjusted gross income (AGI without the foreign earned income exclusion or housing exclusion) exceeds the applicable threshold amount:
- $200,000 for singles and heads of households
- $250,000 for married filing jointly
- $125,000 for married filing separately
Investment income includes interest, dividends, annuities, royalties, rents, and capital gains. For example, when a taxpayer sells a personal residence, the home sale exclusion continues to apply (Code Sec. 121). However, if there is any gain in excess of the applicable exclusion limit ($250,000 for singles; $500,000 for joint filers), the excess is treated as investment income for purposes of the 3.8% tax. Investment income also includes passive income from an S corporation, partnership, or limited liability company.
Investment income does not include income from these entities if the owner participates in the business. It does not include distributions from IRAs and qualified retirement plans, tax-exempt interest, and nontaxable veteran’s benefits.
There is no withholding for this additional tax. Taxpayers will have to take the additional tax into account when figuring withholding from wages or estimated taxes.
FSA limits
Another rule that takes effect in 2013 is the new federal law cap on the annual salary reduction contribution to a flexible spending account (FSA); it will be set at no more than $2,500 (Code Sec. 125(i)). Previously the annual cap was fixed by the employer, many of which had a substantially higher annual limit. After 2013, the $2,500 will be adjusted for inflation.
Recent IRS guidance (Notice 2012-40, IRB 2012-26, 1046) provides some clarifications on medical FSA rules for 2013. Here are some key points:
- Limit applies per employee. If spouses work for the same employer, each is eligible to contribute up to $2,500 to the company’s medical FSA).
- Employee not barred from multiple contributions. If an employee works for two companies and is eligible to participate in each company’s medical FSA, he or she can contribute up to the limit in each plan. Thus, such worker could contribute up to $5,000 (if each plan allows the maximum federal contribution amount).
- Employer contributions do not limit employee contributions. If the company adds money to an employee’s FSA (not a typical situation), the employee can still contribute up to $2,500.
- Cap limited to medical FSAs. It does not apply to employee contributions to health savings accounts (HSAs), dependent care FSAs, or cafeteria plan contributions.
- Plan amendments. Plans must be amended to reflect the $2,500 cap no later than December 31, 2014. However, they must be operated in conformance with the cap in 2013, even though an amendment has not yet been made.
Itemized medical deduction
Also starting in 2013, the adjusted gross income threshold for itemizing medical deductions increases to 10%; currently it is 7.5% (Code Sec. 213(a)). However, those who are 65 or older can continue to use the 7.5% threshold until 2017 (Code Sec. 213(f)).
The same limit applies for purposes of the alternative minimum tax (Code Sec. 56(b)(1)(B)).
This limitation, combined with the restriction on medical FSAs, means that more individuals will pay out-of-pocket for medical costs without any tax relief. From a tax-planning perspective, consumers may want to spend on discretionary medical costs, such as extra glasses or prescription sunglasses, before the end of 2012 to maximize the current medical deduction if they do not expect to be able to itemize medical costs in 2013.
Medical Loss Ratio
One rule that has already become effective concerns a new concept for many consumers called the medical loss ratio. Policyholders may receive rebates from insurance companies in 2012 because of the insurers’ failure to meet the medical loss ratio. The medical loss ratio is the percentage of premiums that federal law requires insurers to spend on medical care and other health activities as opposed to salaries, advertising, and other administrative costs. More specifically, the medical loss ratio is figured by dividing health care claims and quality improvement expenses by the insurers’ premium income minus taxes and regulatory fees (with certain additional adjustments). Insurers that spend less than the required ratio on medical care must give rebates to policyholders.
Federal law sets the ratio at 80%/20% for individual health insurance policies and groups (“small groups”) with fewer than 50 employees (unless a state elects to use a limit of 100). Starting in 2016, the small group limit is 100.
The ratio for large groups (groups larger than the small group limit) is 85%/15%. Some states already had ratios in place prior to the Affordable Care Act, and they can retain their ratios if they obtain an exemption from federal rules. States are allowed to adopt their own stricter rules, requiring insurers to spend a greater percentage of premiums on medical claims and activities.
Rebates by insurers must be made with respect to their activities in 2011. Policyholders must receive rebate checks or be given premium adjustments no later than August 1, 2012. The Kaiser Family Foundation estimates (www.kff.org/healthreform/upload/8305.pdf) that rebates will total $1.3 billion this year.
The IRS has provided guidance on the tax treatment of rebates resulting from the medical loss ratio in FAQs (www.irs.gov/newsroom/article/0,,id=256167,00.html). Generally, the tax treatment of the rebates is no different from any other recovery under the tax benefit rule (Code Sec. 111). For consumers with individual policies, if deductions were taken for premiums in 2011—as itemized deductions or, for self-employed individuals, as deductions from gross income—then rebates are taxable to the extent of any tax benefit. The fact that rebates are paid in cash or used to reduce current premiums has no impact on the tax treatment. Consumers who receive rebates in 2012 but claimed the standard deduction in 2011 are not taxed on the rebates.
Employees who paid some or all of the premiums for group health insurance through salary reduction arrangements (i.e., with pre-tax dollars) and who receive rebates are treated as having additional wages. They are not only taxable, but also subject to payroll taxes. Employees who paid for coverage with after-tax dollars are treated in the same way as consumers—they are taxable if they received a tax benefit in 2011 for the premiums.
Conclusion
Many of the new tax rules arising under the Affordable Care Act have yet to be fleshed out. The IRS has promised more guidance in the future (presumably it was waiting until the Supreme Court’s decision before investing considerable resources in implementing the law).
Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He probably is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.
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