U.S. Tax: House health care reconciliation package includes new Medicare tax on unearned income

House Democratic leaders on March 18 unveiled a health care reconciliation package that, as expected, includes a new Medicare tax on unearned income proposed by the White House, as well as modified proposals from existing House- andSenate-approved health care legislation to impose an excise tax on so-called "Cadillac" plans, impose new fees on selected industries, codify the economic substance doctrine, and make "black liquor" ineligible for the cellulosic biofuel producer credit.

The reconciliation bill was negotiated as a set of "fixes" to a comprehensive Senate-approved health bill that is awaiting consideration in the House. The proposed modifications are aimed at winning over House Democrats who have been reluctant to support the larger Senate legislation.

The House is currently set to consider the reconciliation bill and the underlying Senate-passed measure this coming Sunday, March 21.


Medicare tax on unearned income

The reconciliation bill includes a proposal offered by President Obama last month for a Medicare tax on income from interest, dividends, capital gains, annuities, royalties, and rents, other than income that is derived in the ordinary course of a trade or business and not treated as a passive activity, but would raise the rate to 3.8 percent (from 2.9 percent in the president's plan). The tax would be applied against the lesser of the taxpayer's net investment income or modified adjusted gross income (AGI) in excess of the threshold amounts. These thresholds are set at $200,000 for singles and $250,000 for joint filers.

Net investment income from a passive activity as well as income from a trade or business of trading financial instruments or commodities as defined by existing mark-to-market tax rules for dealers of commodities would be subject to tax. Income on an investment of working capital would also be taxed. Generally, a taxpayer could reduce net investment income by any deductions properly allocable to taxed income.

Some types of income would be exempt from the tax, including income from the disposition of certain active partnerships and S corporations, distributions from qualified plans, and any item taken into account in determining self-employment income. The tax would not apply to nonresident aliens or trusts for which all of the unexpired interests are devoted to charitable purposes.

The proposal defines modified adjusted gross income as AGI increased by any income excluded by the foreign earned income exclusion over the deductions and exclusions disallowed with respect to that income.

The new tax would be subject to general estimated tax rules for individuals.

For estates and trusts, the tax would apply on the lesser of the undistributed net investment income or the excess of adjusted gross income over the dollar amounts at which the 39.6 percent tax bracket for estates and trusts begins. The proposal clarifies the thresholds that would apply under the Medicare tax increase on wages for married taxpayers filing separately. In this case, it would be one-half of the amount for married filing joint filers. The proposal also clarifies that the Medicare tax on wages would also be subject to estimated tax payment rules.

The revenues from the tax on unearned income would be credited to the Supplemental Medical Insurance trust fund. If the unearned income tax – and other proposed tax hikes on high-income individuals included in the president's recently released FY 2011 budget – were to become law, a high-income taxpayer could expect an effective tax rate on capital gains and qualified dividends of 23.8 percent. Significantly, however, the effective tax rate on nonqualified dividends would be 43.4 percent.

The new unearned income tax would apply to taxable years beginning after December 31, 2012. The Joint Committee on Taxation (JCT) staff estimates that this provision would raise $210.2 billion over 10 years.


Excise tax on 'Cadillac' health plans

The reconciliation bill would revise and delay implementation of the excise tax on "Cadillac" health plans, currently the most significant revenue raiser in the Senate health care legislation. Under the bill, the excise tax would apply to employerprovided health plans with annual premiums exceeding $27,500 for families and $10,200 for individuals. The premium thresholds for retirees and employees in high-risk professions would be set at $30,950 for families and $11,850 for individuals. The thresholds would be indexed for general inflation. The premium thresholds would be further increased in 2018 if Congressional Budget Office projections regarding premium inflation between 2010 and 2018 underestimate cost growth. (The premium thresholds in the Senate-passed bill are $23,000 for families and $8,500 for individuals.) Dental and vision plans would not be included when calculating the total benefit value. The proposal retains exceptions in the Senate legislation for policies covering persons employed in certain high-risk occupations.

Additionally, the reconciliation language would delay the implementation date until 2018. (The Senate provision is effective for tax years beginning after December 31, 2012.)

The proposed changes reduce significantly the $148.9 billion in estimated revenue generated by the Senate-passed provision. The revised provision would raise $32 billion over 10 years.


Industry fees

The proposal would modify the three industry fee provisions contained in the Senate-passed health reform legislation by:

- Increasing the fee on manufacturers of brand-name pharmaceuticals by $4.8 billion over 10 years, and delaying the effective date of the provision by one year (until 2011). The fee would equal $2.5 billion for 2011, $3 billion for 2012 through 2016, $3.5 billion for 2017, $4.2 billion for 2018 and $2.8 billion a year thereafter. The provision would also add joint and several liability, where, with respect to a single covered entity liable for such fee, if more than one person is liable for payment of the fee, all such persons would be held liable. (The Joint Committee on Taxation 10-year revenue estimate: $27 billion.)

- Converting the fee on medical device manufacturers to an excise tax of 2.9 percent of the price for which the medical device is sold and delaying the effective date until 2013 (from 2011). The tax would not apply to Class I devices or to eyeglasses, contact lenses, hearing aids, and any other device deemed by the Secretary to be of the type available for regular retail purposes. (The Joint Committee on Taxation 10-year revenue estimate: $20 billion.)

- Delaying the effective date of the fee imposed on health insurance providers by three years (until 2014). The proposal would also create limited exceptions for plans that serve a critical purpose, including plans serving a high percentage of seniors and disabled individuals. For tax-exempt service providers, only 50 percent of net premiums written would be taken into account. The fee would equal $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 would be the amount applicable for the preceding year, increased by the rate of premium growth as calculated for the premium tax credits included in the Senate bill. (The Joint Committee on Taxation 10-year revenue estimate: $60.1 billion.)


Business revenue raisers

The reconciliation bill adopts two general business revenue raisers present in the House-passed bill: provisions to codify the economic substance doctrine and to make "black liquor" ineligible for the cellulosic biofuels producer credit.

Economic substance codification – The reconciliation agreement would codify the economic substance doctrine. It would require a conjunctive analysis of economic substance under which taxpayers would have to show both that (1) a transaction changed their economic position in a meaningful way apart from the federal income tax effects, and (2) they had a substantial purpose apart from federal income tax effects for entering into the transaction. A 40 percent strict liability penalty would apply to tax understatements attributable to undisclosed noneconomic substance transactions. The penalty would be 20 percent if a transaction is adequately disclosed. Provisions in the health care reform bill approved by the Houselast November that would have limited the ability of large corporations and publicly traded companies to obtain relief from accuracy-related penalties under the reasonable-cause exception were not included in this bill.

The Joint Committee on Taxation estimates that this provision would raise $4.5 billion over 10 years.


Black liquor – The reconciliation agreement would modify the cellulosic biofuel producer credit under section 40(b) topreclude black liquor – the wood pulp byproduct that paper companies use to power their mills – from eligibility.

This provision is intended to resolve a debate over the tax treatment of black liquor that has continued since 2007. When section 6426(d)(2)(G) was clarified in 2007 to apply to "liquid fuel derived from biomass," paper mills became eligible to claim the refundable alternative fuel mixture credit under section 6426(e) by adding a small amount of diesel fuel to their black liquor. The alternative fuel mixture credit expired on December 31, 2009. If Congress decides to extend the section 6426(e) credit, it is generally expected to add a provision that will make black liquor ineligible.

But a new issue in the debate emerged recently when the IRS held in an internal legal memorandum (ILM 200941011) that black liquor also may be eligible for the nonrefundable cellulosic biofuel producer credit under section 40(b)(6), which is not scheduled to expire until December 31, 2012.

To address this, the reconciliation bill would modify section 40(b)(6) (which allows taxpayers to claim a $1.01-per-gallon nonrefundable credit for certain liquid fuels produced) to provide that a fuel is ineligible for the cellulosic biofuel producercredit if:
- Its combined water-and-sediment content is greater than 4 percent (determined by weight) or
- Its ash content exceeds 1 percent (determined by weight).

The effect of this statutory change is that black liquor will not qualify for a nonrefundable credit under section 40(b)(6).

The provision would be effective for fuels sold or used after January 1, 2010 (the House bill provided that the provision would be effective after the date of enactment.) The JCT estimates that this provision would raise $23.6 billion over 10 years.

Corporate estimated taxes – In addition to these provisions, the reconciliation bill proposes a one-time increase of 14.5 percentage points to estimated taxes corporations with assets of at least $1 billion for payments made during calendar year 2014.


Individual mandate

The reconciliation bill modifies the mandate penalty assessed against individuals who chose to remain uninsured. The Senate-approved provision calls for a phased-in excise tax based on the greater of a flat-dollar amount or a percentage of household income. The reconciliation bill would exempt income below the filing threshold, lower the flat payments required from $495 to $325 in 2015 and from $750 to $695 in 2016, and would increase the percent-of-income thresholds.

The bill also would extend the exclusion from gross income for employer-provided health coverage for adult children up to age 26.


Employer responsibility

Like the Senate bill, the reconciliation bill does not provide for an employer mandate but would charge a fee to larger businesses that do not provide insurance for their employees. Under the Senate bill, the fee will apply to employers with 50 or more employees and would be calculated based on the number of full-time employees. However, the reconciliation bill modifies the Senate provision by dropping the first 30 employees from the payment calculation. It also changes the applicable payment amount for firms with more than 50 employees that do not offer coverage to $2,000 per full-time employee. The reconciliation bill would eliminate the assessment for workers in a waiting period, while maintaining the 90-day limit on the length of any waiting period beginning in 2014.


Other revenue provisions

The reconciliation bill includes several other revenue-raising provisions that are variations on existing Senate proposals. These include:

- Limiting annual contributions to cafeteria plan Flexible Spending Accounts to $2,500 per taxable year, indexed to the Consumer Price Index for Urban Consumers after 2013. The provision would be effective for years beginning after December 31, 2012 – two years after the Senate bill's effective date (JCT 10-year revenue estimate: $13 billion).

- Eliminating the deduction for employer subsidies for retiree drug coverage under Medicare Part D starting in 2013 – two years after the Senate bill's effective date (JCT 10-year revenue estimate: $4.5 billion).

The reconciliation bill also stipulates that, if necessary, funds will be transferred to the Social Security Trust Funds to ensure that they are held harmless by the proposal.


Medicare 'donut hole' fix

The reconciliation bill would fill the Medicare prescription drug "donut hole" partly by providing a $250 rebate to Medicare beneficiaries who hit the donut hole in 2010. The bill also builds on pharmaceutical manufacturers' 50 percent discount on brand-name drugs beginning in 2011 to completely close the donut hole with 75 percent discounts on brand-name and generic drugs by 2020.


Next Steps

Currently, congressional leaders are still considering a process that would involve the House passing the comprehensive legislation that cleared the Senate last December 24, as well as this latest supplemental reconciliation bill.

Under one scenario being considered, the House Rules Committee would package the Senate bill and the reconciliation measure together under the same rule. To appease House Democrats who are reluctant to take a political hit by voting directly on the Senate bill, the Rules Committee may draft the terms of consideration in a way that deems the Senate bill to be automatically passed once either the rule or the reconciliation measure is approved.

The Rules panel is expected to meet on March 20, with floor consideration to follow the next day. Consideration of the bill may spill over into March 22. If this process plays out as Democratic leaders hope, the Senate bill would be sent to the White House for President Obama's signature and the reconciliation bill would be sent to the Senate for its consideration.

Because the bill will be moved under reconciliation procedures, debate is limited and only a simple majority vote will be required for passage. Senate leaders hope to finish consideration and send the reconciliation bill to the president by the start of their spring recess, which begins on March 29.