Tax Implications of Healthcare Reform for Small Businesses

Small business owners who want to maximize after-tax profits and capital investment should have a working knowledge of how recent federal laws affect small businesses. In March 2010, President Barack Obama signed into law the Patient Protection and Affordable Care Act, followed closely by the Health Care and Education Reconciliation Act, which amended the Affordable Care Act (collectively referred to as the ACA).

In addition to many nontax items, these major pieces of legislation contain several new or modified tax provisions and amendments to the Internal Revenue Code (IRC). Several of these provisions directly or indirectly affect small businesses and, thus, have implications for their owners and advisors. Small business owners are likely to look closely at the ACA to seek ways to minimize the negative tax consequences. To determine the particular effect that each provision will have on a particular business, individuals should consult with their tax and business advisors. With some careful tax planning, the impact of the changes can be minimized.

Penalty on Employers that Don't Provide Coverage

Beginning in 2014, the ACA imposes a penalty on employers with 50 or more fiilltime employees that do not offer coverage or offer coverage that pays less than 60% of health-related expenses (IRC section 4980H). Persons who work 30 or more hours each week count as full-time employees for the purposes of this threshold. The hours of part-time employees (for a month) are aggregated and divided by 120 to determine full-time equivalent employees. This computation is solely for purposes of assessing the penalty.

For example, if an employer has 10 parttime employees who work 21 hours each week for one month, 5 employees who work 30 hours each week for one month, and 40 employees who work 40 or more hours per week for one month, the employer has 52 fiill-time equivalent employees for that month, computed as follows:

21 hours x 4 weeks x 10 employees = 840 hours per month -=-120 hours = 7 fulltime equivalent employees + 5 employees who work 30 hours per week + 40 full-time employees = 52 full-time equivalent employees.

A penalty is imposed on any employer with 50 or more equivalent full-time employees if it fails to offer health insurance coverage to its full-time employees and their dependents and at least one fulltime employee has enrolled in health insurance coverage through a state exchange for which a premium tax credit or cost-sharing reduction is allowed. The penalty for having one employee enrolled in a subsidized program is $ 167 per month for every full-time equivalent employee above 30 employees; the maximum penalty per year is $2,000 per full-time equivalent employee above 30 employees. For example, if the aforementioned company employed 52 full-time equivalent employees and offered no health insurance coverage at all for the year, the penalty would be $44,000 ([52 - 30] x $2,000). Employers may not deduct this penalty as an expense.

A penalty is imposed on any employer with 50 or more equivalent full-time employees if it offers health insurance coverage that pays less than 60% of healthcare costs, and if at least one full-time employee has enrolled in health insurance coverage purchased through a state exchange for which a premium tax credit or cost-sharing reduction is allowed. In this case, the penalty is not based on all employees, but rather on all employees who qualify for subsidized health insurance coverage and actually receive the credit or cost-sharing reduction mentioned above. The penalty is $250 per month for each subsidized employee; the maximum penalty per year is $3,000 per full-time equivalent employee above 30 employees. For example, if an employer has 52 full-time equivalent employees, and four of them work all year but qualify for subsidized health insurance, the employer would pay a penalty of $12,000 (4 x $3,000). Again, employers may not deduct the penalty amount. These penalties are adjusted for inflation each year.

Tax planning tips. Because this change is not effective until 2015, employers have some time to engage in tax reduction strategies. For example, the 50employee threshold discussed above does not include seasonal workers (i.e., those who work 120 or fewer days per year); therefore, a company that uses 49 workers most of the year but also uses seasonal workers will not be subject to the above penalties.

Excise Tax on High-Cost Employer Plans

The ACA amended IRC section 49801 to add a new excise tax on high-cost employer plans. The tax applies when an employee is covered under applicable employersponsored coverage at any time during the taxable year and there is any excess benefit with respect to the coverage. It is calculated by using the total cost of insurance and insurance-related coverage, whether paid by the employee or the employer. This includes the insurance premiums paid by the employer, the insurance premiums paid by the employee, the money paid into flexible spending accounts, the money paid into health savings accounts, and the money paid into medical savings accounts. If the aggregate amount exceeds $10,200 ($27,500 for family or spousal coverage), the excess benefit is subject to an excise tax equal to 40% of the excess benefit. The threshold amounts are increased by $1,650 for certain older employees (qualified retirees) and by $3,450 for employees in high-risk occupations (e.g., mining, law enforcement). Employers must compute this excise tax. It may be levied on the employer directly or on the insurance provider, depending upon the circumstances and the insurance policy. The excise tax applies to tax years beginning in 2018, and the threshold amounts are indexed for inflation thereafter.

Tax planning tips. Most employers do not need to worry about this excise tax, because it does not take effect for several more years and is designed to penalize unusually expensive "Cadillac plans." Although no one knows what will happen to healthcare costs over the next several years, they are likely to rise above current levels. If future costs rise near these threshold levels, employers should proceed with caution as they select healthcare plans for their employees.

Small Business Tax Credit

The ACA amended IRC section 45R, to add a credit for "employee health insurance expenses of small employers." For these purposes, an eligible small employer is defined as having 25 or fewer full-time equivalent employees with average annual wages of $50,000 or less (i.e., where complete phaseout occurs). Qualifying employers are eligible for a credit of up to 50% of the amount they contribute toward their employees' health insurance premiums. Employers with 10 or fewer employees and average annual wages of $25,000 or less are eligible for a credit of up to 100%. The credit is phased out for employers with more than 25 employees with average annual wages greater than $50,000; the credit is phased in over time from 2010 to 2013. During this period, the maximum credit is 35% of the employer's eligible health insurance premium expense. Beginning in 2014, the füll 50% credit will be available. Employers will not be allowed to take both an expense deduction and the credit for the same dollars (J. Beavers, "Health Care Reform Adds New Taxes," The Tax Adviser, Tax Trends, May 2010, pp. 359-364).

Example. This example illustrates the computation of the credit and the phaseout. Consider a business that employs 15 full-time employees with average annual wages of $40,000. The employer pays $300 per employee per month for health insurance premiums throughout the year.

The credit is determined as follows:

* Health insurance premiums paid: $300 x 12 months x 15 employees = $54,000

* Initial credit: $54,000 x 50% (2014 credit percentage) = $27,000

The following is the determination of the phaseout:

* Number of employees: (15 - 10) 15 x $54,000 - $18,000

* Average annual wages: ($40,000 - $25,000) - $25,000 x $54,000 - $32,400

* Phaseout amount: ($18,000 + $32,400) = $50,400

* Credit allowed: (initial credit of $54,000 - phaseout of $50,400) = $3,600

Tax planning tips. The small business in the example above could double the credit from $3,600 to $7,200 by reducing its number of full-time equivalent employees from 15 to 14. The simplest way to accomplish this is by using seasonal employees because their wages and hours are not counted (full-time equivalent employees equals total hours worked during the year, divided by 2,080 hours). A small business could also consider reducing its workforce by one or two employees and utilizing overtime hours, because hours in excess of2,080 for the year are not counted. Small businesses should keep in mind that a 5% owner and a 2% owner/employee of an S corporation do not count as employees. Finally, it is worth remembering that the $25,000 wage amount is indexed for inflation beginning in 2014.

Tax on Net Investment Income

Starting in 2013, a Medicare tax of 3.8% is applicable to individual taxpayers (as well as to estates and trusts) that have certain types of net investment income higher than a prescribed amount. Net investment income is defined as the sum of gross income from rents, royalties, interest, dividends, and annuities, minus deductions properly allocable to that income. Net investment income also includes a trade or business that is a passive activity and a trade or business involving the buying and selling of financial instruments or commodities. Finally, net investment income includes net gains from the disposition of property other than that which is held in a trade or business (i.e., net capital gains).

The 3.8% tax is imposed on the lesser of the individual's net investment income for the year or the amount of the individual's modified adjusted gross income (AGI) that exceeds a threshold amount ($250,000 for a married taxpayer filing a joint return, $125,000 for a married taxpayer filing a separate return, and $200,000 for all other individuals). The new Medicare tax is also imposed on estates and trusts on the lesser of their undistributed net investment income or their AGI exceeding these threshold amounts. This provision will particularly impact real estate investors.

Tax planning tips. These taxes must be included in a taxpayer's estimated tax payments and are not deductible for federal income tax purposes. Taxpayers with businesses that are primarily passive in nature but almost meet the appropriate threshold to be reclassified as active should consider altering income-producing activities in order to classify the trade or business as active. Taxpayers should also consider investing in tax-exempt bonds.

Other Tax Provisions

Many changes have been made to the federal tax law, effective beginning in 2013. Certain tax law changes resulted from the ACA, but other important changes are also discussed in the following sections.

Additional Medicare tax. Starting in 2013, an additional Medicare tax of 0.9% may be applicable to a taxpayer making more than a prescribed amount and satisfying certain other conditions. The relevant amount subject to such tax depends upon the taxpayer's filing status and earnings. Pursuant to the ACA, the threshold amounts are $250,000 for a married couple filing jointly, $125,000 for a married individual filing separately, and $200,000 for singles and all other taxpayers.

Healthcare flexible plans. Starting in 2013, healthcare spending plans are limited to a maximum of $2,500. This amount is adjusted for inflation in 2014 and later years.

Long-term capital gains and qualified dividends. For 2013, the maximum marginal income tax rate on long-term capital gains and qualified dividends is scheduled to be 20%. The maximum marginal ordinary income tax rate for tax years beginning on or after January 1, 2013, has increased to 39.6% (previously 35%). In general, this tax rate is applicable to the extent of taxable income above $450,000 (married filing jointly taxpayers and qualified surviving spouses), $425,000 (heads of household), $400,000 (single taxpayers), or $225,000 (married filing separately).

Itemized deduction phaseout. Beginning in 2013, the itemized deduction phaseout will be reinstated for taxpayers above the applicable threshold amount prescribed in the American Taxpayer Relief Act of 2012 (ATRA), signed into law on January 2, 2013. The phaseout reduces itemized deductions by the lesser of 3% of the amount of AGI above the threshold or 80% of the otherwise allocable itemized deductions. The AGI threshold amounts are $250,000 for single taxpayers and $300,000 for married taxpayers filing jointly ($ 150,000 for married filing separately). For taxpayers below these amounts, the permanently eliminates the phaseout of itemized deductions.

Depreciable property. The ATRA extends the limitation on the amount that can be expensed under IRC section 179 for certain depreciable property. The act extended IRC section 179 rules that were in effect for tax years beginning in 2010 and 2011 to tax years beginning in 2012 and 2013 as well. These mies include 1) an expense cap of $500,000, 2) a $2 million phaseout threshold, and 3) the ability of taxpayers to apply $250,000 of the $500,000 expense cap to qualified real property. The amount under IRC section 179 for expensing certain depreciable property will revert to $25,000 for tax years beginning after 2013 (http:// wwwJcpmg.com/US/en/IssuesAndInsights/ ArticlesPublications/taxnewsflash/Pages/ clarification-expensing-certain-depreciableproperty-in-20 12-2013 .aspx). Therefore, businesses that plan to purchase IRC section 179 qualified property in early 2014 should move those purchases to late 2013 in order to qualify for a larger deduction.

Additional Provisions

The ACA and ATRA have a broad and wide tax impact. Although this discussion has highlighted certain relevant provisions, taxpayers and their advisors should also examine additional provisions, such as those pertaining to medical devices, health insurance premium credits, individual share responsibility provisions, tax-exempt hospitals, group health plans, Medicare Part D Coverage, and the alternative minimum tax.

The ACA appears to be an attempt to bolster access to, and improve the efficacy and efficiency of, healthcare; however, the act itself is intricate. As evidenced by recent developments, it has stirred controversy, argument, and debate. Only time will reveal the success or failure of its provisions. ?

Taxpayers with businesses that are primarily passive in nature but almost meet the appropriate threshold should consider altering income-producing activities in order to classify the trade or business as active.

Portions of this article have been adapted from a similar article that appeared in Real Estate Issues, vol. 35, no. 3, 2010/2011.

James R. Hardin, PhD, CPA, is a professor and chair of the department of accounting in the Mitchell College of Business at the University of South Alabama, Mobile, Ala.Mark Segal, JD, MLT, CPA, is a professor of accounting, also at the University of South Alabama.