There is little doubt that every physician in the U.S. has an opinion on the 2010 healthcare legislation and its impact on medical care in this country. We are sure you do. What is less clear is whether or not most physicians understand the tax ramifications of the new law. While some newly elected and re-elected members of Congress have pledged to do away with this legislation, President Obama seems equally as set on making sure the new law remains on the books. In this article, we will lay out the most significant tax provisions of the healthcare law and make some suggestions about ways to reduce the tax impact on you assuming the legislation stays intact.
1. Higher Medicare taxes on high-income taxpayers.
High-income taxpayers will be hit with a double whammy under the new law: a tax increase on wages and a new levy on investments.
Higher Medicare payroll tax on wages.
Under current law, wages are subject to a 2.9% Medicare payroll tax. Workers and employers pay 1.45% each. Self-employed people pay both halves of the tax (but are allowed to deduct half of this amount for income tax purposes). Unlike the payroll tax for Social Security, which applies to earnings up to an annual ceiling ($106,800 for 2010), the Medicare tax is levied on all of a worker’s wages without limit.
Under the provisions of the new law, which take effect in 2013, most taxpayers will continue to pay the 1.45% Medicare hospital insurance tax, but single people earning more than $200,0000 and married couples earning more than $250,000 will be taxed at an additional 0.9% (2.35% in total) on the excess over those base amounts. This includes nearly all physicians, obviously. Self-employed persons will pay 3.8% on earnings over the threshold. Married couples with combined incomes approaching $250,000 will have to keep tabs on their spouses’ pay to avoid an unexpected tax bill. It should also be noted that the $200,000/$250,000 thresholds are not indexed for inflation, so it is likely that more and more people will be subject to the higher taxes in coming years.
Medicare payroll tax extended to investments. Under current law, the Medicare payroll tax only applies to wages. Beginning in 2013, a Medicare tax will, for the first time, be applied to investment income. A new 3.8% tax will be imposed on net investment income of single taxpayers with AGI above $200,000 and joint filers over $250,000 (unindexed). Net investment income is interest, dividends, royalties, rents, gross income from a trade or business involving passive activities, and net gain from disposition of property (other than property held in a trade or business).
Because the new tax on investment income won’t take effect for three years, it leaves more time for Congress and the IRS to tinker with it. So we can expect lots of refinements and “clarifications” between now and when the tax is actually rolled out in 2013.
2. Planning opportunities
The following potential planning opportunities should be considered to reduce the tax bite these new rules might have on your practice and personal taxes:
· To reduce the impact of the increasing Medicare taxes on wages, physicians should strongly consider using multiple legal entities at their practice, so as to manage how they are paid income and how that income will be taxed.
· The 3.8% investment surtax does not apply to distributions from IRAs and other qualified retirement plans. Thus, taxpayers may wish to increase contributions to IRAs and 401(k), 403(b) and 457 plans. However, consideration should be given to the fact that we are facing periods of rising tax rates and distributions from such plans are subject to tax.
· The 3.8% investment surtax does not apply to distributions from Roth IRAs. Roth distributions also are not taxable, and taxpayers at any income level are able to convert traditional IRA’s to Roth IRA’s effective this year.
· Because income from tax exempt and tax deferred vehicles like municipal bonds, tax deferred non-qualified annuities, life insurance, and non-qualified deferred compensation are not included in investment income, investments in these vehicles should become more favorable relative to investments producing income subject to the tax.
· Charitable remainder trusts should become more appealing because they permit taxpayers to defer income over a period of time, enabling them to stay under the threshold amount.
· Charitable lead trusts will become more popular to shift investment income to a CLT which in turn will be offset by the “above the line” charitable deduction.
· Installment sales will be popular to even out income over a number of years.
· Roth IRA conversions will be considerably more favorable because they will generally lower future MAGI thereby avoiding the surtax.
Tax planning for investment income will become even more critical. Evaluating the tax drag on investments takes on a new meaning in light of the increased surtax on investment income. In addition, income streams which are non-taxable become even more valuable. Hybrid benefits plans and investments in cash value life insurance policies which can provide tax free income streams will help taxpayers avoid the surtax.
3. Floor on medical expenses deduction raised from 7.5% of adjusted gross income (AGI) to 10%. Under current law, taxpayers can take an itemized deduction for unreimbursed medical expenses for regular income tax purposes only to the extent that those expenses exceed 7.5% of the taxpayer’s AGI. The new law raises the floor beneath itemized medical expense deductions from 7.5% of AGI to 10%, effective for tax years beginning after Dec. 31, 2012. The AGI floor for individuals age 65 and older (and their spouses) will remain unchanged at 7.5% through 2016.
This change makes it even more important for business owners and professionals to consider health and medical related planning that often can be enhanced through the use of C-corporations – an under-utilized entity for medical practices.
4. Limit reimbursement of over-the-counter medications from HSAs, FSAs, and MSAs.The new law excludes the costs for over-the-counter drugs not prescribed by a doctor from being reimbursed through a health reimbursement account (HRA) or health flexible savings accounts (FSAs) and from being reimbursed on a tax-free basis through a health savings account (HSA) or Archer Medical Savings Account (MSA), effective for tax years beginning after Dec. 31, 2010.
5. Increased penalties on nonqualified distributions from HSAs and Archer MSAs. The new law increases the tax on distributions from a health savings account or an Archer MSA that are not used for qualified medical expenses to 20% (from 10% for HSAs and from 15% for Archer MSAs) of the disbursed amount, effective for distributions made after Dec. 31, 2010.
Conclusion: tax planning more important than ever
Above are just a few of the tax changes the healthcare law enacted. In addition, with tax rates due to rise as sunset provisions take effect along with the tax increases above, high income taxpayers – like physicians — can no longer afford to “sit back and do nothing” when it comes to entity structure planning, tax planning and retirement planning.
David B. Mandell, JD, MBA is an attorney, author of 5 books for doctors, and principal of the financial consulting firm O’Dell Jarvis Mandell LLC, where Carole C. Foos, CPA works as a CPA and tax consultant. They can be reached at Mandell@ojmgroup,com or (877) 656-4362.