Changes in tax laws will affect physician practices

By Jeffrey B. Sansweet, Esq.

In July and August of 1996, legislation was passed covering such various areas as health insurance portability, welfare reform and the minimum wage. Although not as highly publicized, most likely because of the election and because tax rates were not reduced, the legislation contains numerous tax law and pension changes.

This article will summarize the tax law changes in the Small Business Job Protection Act of 1996, the Health Insurance Portability and Accountability Act of 1996, the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 and the Taxpayer Bill of Rights 2 (hereinafter referred to collectively as the “1996 Tax Act”) which are most likely to affect physicians and their practices. A separate article will discuss the pension law changes.

Many physician practices which have not been sold to health care systems may be structured as sole proprietorships, partnerships or S Corporations, as opposed to the more common C Corporations. For 1996, health insurance premiums paid for sole proprietors, partners and greater than 2 percent shareholders of S Corporations are only 30 percent deductible, whereas C Corporations can deduct 100 percent of such premiums. This deduction has been increased from 30 percent to 80 percent to be phased in as follows: 1997 – 40 percent, 1998-2002 – 45 percent, 2003 – 50 percent, 2004 – 60 percent, 2005 – 70 percent, 2006 and thereafter – 80 percent.

Since the health insurance deduction is on its way to being close to equalized for all types of taxpayers, we are generally advising start-up practices to elect S Corporation status so as to minimize year-end profit split calculations and to avoid double tax issues on a practice sale. One of the obstacles, however, in larger group practices that are becoming more prevalent is that the number of shareholders of an S Corporation has been limited to 35. Effective as of January 1, 1997, the 1996 Tax Act has increased the number of shareholders allowed for S Corporation to 75. In addition, qualified retirement plan trusts and tax-exempt 501(c)(3) organizations may now be S Corporation shareholders. Thus, a joint venture between a physician practice and a hospital or hospital affiliate may now be structured as an S Corporation. The 1996 Tax Act also extended the authority of the IRS to treat late-filed S Corporation elections as timely if there is reasonable cause justifying the late filing.

It is not uncommon for a physician to have a provision in his or her employment agreement or shareholders agreement which provides for a $5000 payment to his or her estate upon death. This has been popular because the first $5000 paid to an estate or beneficiary by or on behalf of an employer by reason of the employee’s death has been tax-free under Internal Revenue Code Section 101(b). The 1996 Tax Act has repealed Section 101(b) for decedents dying after August 20, 1996. Thus, a practice should consider deleting this benefit from the corporate agreements.

Several insurance-related changes in the 1996 Tax Act include the following:

• Interest expense deductions on loans procured to purchase key-person life insurance for employees of a corporation have been limited to the first $50,000 of debt with respect to such policies on each individual.
• Accelerated death benefits received under a life insurance contract on the life of an insured, terminally or chronically ill individual will generally be tax-free after 1996. Also, if a portion of a life insurance contract is assigned or sold to a viatical settlement provider, amounts received from the provider will not be taxed. However, the exclusion from tax is not applicable to any amounts paid to any person other than the insured if the person has an insurable interest with respect to the insured because the insured is an employee, officer or director of the person or because the insured has a financial interest in the person.
• Amounts received under a “qualified” long-term care insurance contract will generally, beginning January 1, 1997, be excluded from taxable income as amounts received for personal injuries and sickness. Also, premiums for long-term care insurance and related unreimbursed expenses will generally be treated the same as deductible medical expenses subject to the 7.5 percent of adjusted gross income floor.
• Beginning January 1, 1997, self-employed individuals and employers with no greater than 50 employees may establish medical savings accounts (MSAs). This “pilot” program will end December 31, 2000 and will be limited to the first 750,000 individuals covered nationally. Participation in the MSA program is conditioned upon coverage under a “high deductible” health insurance plan (i.e., a deductible between $1500 and $2250 for individual coverage and between $3000 and $4500 for family coverage). Contributions to the account by an individual are deductible from adjusted gross income, and contributions made by an employer are generally excluded from income. Distributions from the account for qualified medical expenses incurred for the benefit of the individual or his or her dependents are generally excluded from income.

There are several other changes that may impact physician practices. In general, medical and office furniture and equipment that is purchased cannot be expensed immediately, but rather is depreciated over time for tax purposes. Code Section 179 allows the practice to expense up to $17,500 of such purchases per year. The 1996 Tax Act increases the Section 179 deduction to $25,000 to be phased in as follows. For the tax tear beginning in 1997 the maximum expense deduction is $18,000. The deduction for successive years is as follows: 1998 – $18,500, 1999 – $19,000, 2000 – $20,000, 2001 or 2002 – $24,000, 2003 and thereafter – $25,000.

In addition, businesses that paid more than $50,000 in tax deposits in 1995 were to have begun making those deposits electronically by January 1, 1997. However, because there was a concern that the initial IRS mailing informing businesses of the requirements may have been confusing, the electronic payment requirement has been delayed until July 1, 1997.

Finally, Section 530 of the Revenue Act of 1978 has been amended in an attempt to provide more clarity on standards to be applied to the issue of employer-employee versus independent contractor status. Section 530 currently allows employers to escape employment tax liability if the employer has always treated the worker as an independent contractor and the employer had a reasonable basis for such treatment. A reasonable basis exists if such treatment was in reasonable reliance on judicial precedent, a past IRS audit in which no assessment was made on account of improper treatment of the worker, or a long-standing recognized practice of a significant segment of the industry in which the individual worked. The bad news in the 1996 Tax Act is that a taxpayer will no longer be able to rely on a previous audit unless such audit included an examination for employment tax purposes of whether the worker involved or a worker holding a similar position was properly classified. Included among the good news is that in determining whether an industry practice is long-standing enough for an employer to rely on in classifying workers, no fixed length of time will be required. Also, in determining whether the industry practice was followed by a significant segment of the industry, no fixed percentage must be shown. In no case, however, will an employer be required to show that the practice is followed by more than 25 percent of the industry.

There are several other changes that may impact physicians individually. The current luxury tax on automobiles was extended by 3 years, through December 31, 2002. However, the 10 percent rate of tax has been reduced by one percentage point per year beginning with sales after August 27, 1996. Therefore, the tax rate percentages are as follows: 1996 – 9 percent, 1997 – 8 percent, 1998 – 7 percent, 1999 – 6 percent, 2000 – 5 percent, 2001 – 4 percent, 2002 – 3 percent.

In addition, effective beginning in 1997, nonworking spouses will be allowed to contribute up to $2000 per year to a deductible IRA. Under prior law, if one spouse had no compensation, a married couple was allowed a maximum annual deductible IRA contribution of $2250. However, if the working spouse is an active participant in an employer-sponsored retirement plan and exceeds a certain income level, the deduction will either be reduced or eliminated altogether.

Finally, the 1996 Tax Act authorizes the IRS to impose penalty excise taxes when a 501(c)(3) organization engages in an “excess benefit transaction”. Excess benefit transactions, as defined in new Section 4958, include transactions in which a “disqualified person” engages in a non-fair-market-value transaction with an organization, receives unreasonable compensation or receives payment based on the organization’s income in a transaction that violates the private inurement prohibition. A disqualified person is defined as any individual who is in a position to exercise substantial authority over an organization’s affairs, regardless of the individual’s official title. A disqualified person who benefits from an excess benefit transaction is subject to a penalty equal to 25 percent of the excess benefit. Organization managers who participate in such a transaction knowing that it is improper are subject to a penalty tax of 10 percent of the amount of the excess benefit. If there is no correction of the excess benefit after a deficiency notice from the IRS, a second tax may be imposed equal to 200 percent of the amount of the excess benefit. I have already been involved in a situation where a hospital attempted to use these new provisions to reduce the salary of the Chief of Pathology.

In conclusion, physicians should be sure to contact their tax advisors to see how the 1996 Tax Act affects them and their practices.Jeffrey B. Sansweet, Esq., is a principal of the Wayne health care law firm of Kalogredis, Tsoules and Sweeney, Ltd.