Tax Provisions of the Medicare Prescription Drug, Improvement and Modernization Act of 2003
Editor's Note: As you are aware, Congress has just enacted The Medicare Prescription Drug, Improvement and Modernization Act of 2003, providing for the first time a prescription drug benefit through Medicare. In addition to the alterations to the Medicare program, the Act contains a number of significant tax/employee benefits provisions which are discussed below. Crowell & Moring will soon have available its analysis of the entire Act for your use. In the meantime, here are the highlights of the employee benefits/tax provisions of the legislation.
A. Health Savings Accounts
1. In General
Continuing the trend toward consumer-driven health care, effective for tax years beginning after December 31, 2003, the Act creates a new type of tax-favored defined contribution health care vehicle, known as the Health Savings Account ("HSA"). HSAs are trust accounts or custodial arrangements that provide tax-favored treatment for the payment of current medical expenses as well as the ability to save on a tax-favored basis for future medical expenses. They can be used to pay medical expenses of the account holder and his or her spouse and dependents and can be funded by pre-tax salary reduction contributions through a cafeteria plan. Like an IRA, they are the account holder's property and they are portable.
2. Tax Advantages
Within limits, contributions to HSAs are deductible if made by an eligible individual and are excludable for income and employment tax purposes if made by an eligible individual's employer. In addition, distributions to pay for qualified medical expenses are not included in the recipient's income. Distributions that are not for qualified medical expenses are includible in income and subject to an additional 10% tax. The additional tax, however, does not apply after death, disability, or the individual becoming eligible for Medicare.
3. Eligible Individuals
"Eligible individuals" are individuals who are covered by an employer-sponsored "high deductible health plan" and self-employed individuals covered by high deductible health plans. The employee or self-employed individual must not be covered under any other health plan that is not also a high deductible health plan. Individuals who are eligible for Medicare benefits and those who can be claimed as a dependent on someone else's tax return, however, cannot contribute to an HSA.
4. High Deductible Health Plan
A "high deductible health plan" is a health plan with a deductible of at least $1,000 for individual coverage or $2,000 for family coverage and an out-of-pocket expense limit that does not exceed $5,000 for individual coverage or $10,000 for family coverage. These figures are indexed for inflation. The $5,000 and $10,000 limits are applied to plans using a network of providers based upon the limits for in-network services.
5. Tax Treatment of and Limits on Contributions
HSA contributions are deductible (within limits) for federal income tax purposes "above the line." In addition, employer contributions (including salary reduction contributions under through a cafeteria plan-which are now permitted under the Act) are excludable for income and employment tax purposes to the extent the contribution would be deductible if made by the employee. An individual also can deduct contributions made by family members on his or her behalf.
The maximum annual contribution that can be made to an HSA is the lesser of (1) 100% of the annual deductible under the high deductible plan, or (2) the maximum deductible permitted under an Archer MSA high deductible health plan under present law, as adjusted for inflation. For 2004, the maximum high deductible is estimated to be $2,600 for individual coverage and $5,150 for family coverage. In addition, individuals who will reach age 55 by the end of the tax year can make "catch-up" contributions over and above the otherwise applicable limit. The limit on catch-ups is $500 in 2004. It increases in $100 annual increments until it reaches $1,000 in 2009 and thereafter. Contributions, including catch-up contributions, however, cannot be made once an individual becomes eligible for Medicare.
Contributions that exceed the above limits are subject to a 6% excise tax unless distributed to the contributor.
6. Comparability Rule
An employer that contributes to employees' HSAs, must make comparable contributions (i.e., same dollar amount or same percentage of the deductible under the high-deductible health plan) on behalf of all employees with comparable coverage during the same period. An employer that violates this rule is subject to an excise tax equal to 35% of the amount contributed to HSAs by the employer for the relevant period. The IRS can waive part or all of this tax.
Unlike Archer MSAs, under which contributions can come from employer contributions or employee contributions, but not both, contributions to an HAS can come from both sources. Also, HSAs are not subject to a "use it or lose it" rule (health flexible spending accounts-"FSAs"-are subject to such a rule). Even if an employee leaves a particular employer, he can take his account balance with him. Amounts can be rolled over tax-free into an HSA from an Archer MSA, a health FSA or another HSA. Such rollovers do not count against the annual contribution limits.
8. Taxation of Distributions
Distributions from an HSA for qualified medical expenses of the individual and his or her spouse or dependents are completely tax-free. Distributions that are not used to pay qualified medical expenses are subject to income tax as well as an additional 10% tax unless made after death, disability, or after the individual becomes eligible for Medicare.
B. Exclusion from Income of Federal Subsidies for Prescription Drug Plans
Beginning in 2006, the Act excludes from an individual's gross income the 28% employer subsidy for retiree prescription drugs enacted by the Act. In addition, a taxpayer can deduct prescription drug expenses incurred even though the taxpayer also received an excludible subsidy related to the same expenses. The provision is effective for taxable years ending after the Act's enactment date.
C. Exception to Information Reporting Requirements for Certain Health Arrangements
In general, a person in a trade or business who makes certain payments to another person totaling $600 or more in a year, must provide an information report to the IRS on Form 1099. Treasury regulations specify that fees for professional services, including the services of physicians, must be reported. The regulations exempt payments made to corporations, unless the corporation is "engaged in providing medical and health care services" or if the payment is made to a hospital that is tax-exempt or that is owned and operated by a governmental entity. Revenue Ruling 2003-43, 2003-21 I.R.B. 935, provides that payments made to medical service providers through the use of debit, credit, and stored value cards must be reported by the employer on Form 1099-MISC.
The Act exempts from these reporting rules payments medical care made under either: (1) a flexible spending account ("FSA"), or (2) a health reimbursement arrangement ("HRA") that is treated as employer-provided coverage. The provision applies to payments made after December 31, 2002.
D. Erie County Language in Conference Report
Although a provision was deleted from the Act that would have overturned the U.S. Court of Appeals for the Third Circuit's decision in Erie County Retirees Ass'n v. County of Erie , 220 F.3d 193, (3d Cir. 2000), cert. denied, 532 U.S. 913, (2001), the Conference Report clarifies Congress' intent to permit employers to provide retiree medical benefits that are reduced or eliminated once a retiree becomes eligible for Medicare, without violating the Age Discrimination in Employment Act ("ADEA") (i.e., by discriminating in favor of younger retirees against older retirees). The Conference Report supports the EEOC's current position that employers can design their retiree medical plans to take Medicare into account.
For more information, please contact the professional(s) listed below, or your regular Crowell & Moring contact.