BILL ANALYSIS
SENATE REVENUE & TAXATION COMMITTEE --- REVISED
Senator Lois Wolk, Chair
AB 1178 - Portantino
Amended: August 5, 2010
Hearing: August 11, 2010 Tax Levy Fiscal: Yes
SUMMARY: Conforms California Law to Certain Provisions of
the Patient Protection and Affordable Care Act
(PPACA) (Public Law 111-148, March 23, 21010) and
the Health Care and Education Reconciliation Act
of 2010 (HCERA) (Public Law 111-152, March 30,
2010). Additionally, Conforms California Law to
the Federal Treatment of Health Savings Accounts
(HSAs).
Children Under 27 Years Old Allowed as Qualified Dependents
for Health Care Benefits
EXISTING FEDERAL LAW generally provides that employees
are not taxed on (that is, may "exclude" from gross
income") the value of the employer-provided health coverage
under an accident or health plan. This exclusion applies to
coverage for personal injuries or sickness for employees
(including retirees), their spouses and their dependents.
In addition, any reimbursements under an accident or health
plan for medical care expenses for employees (including
retirees), their spouses and their dependents generally are
excluded from gross income. Internal Revenue Code (IRC)
Section 152 defines a dependent as a qualifying child or
qualifying relative.
THIS BILL conforms to the federal change under the
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HCERA that extends the general exclusion for reimbursements
for medical care expenses under an employer-provided
accident or health plan to any child of an employee who has
not attained age 27 as of the end of the taxable year.
The California exclusion would apply in the same
manner and to the same periods as the exclusion applies for
federal purposes; that is, it would apply to payments made
on or after March 30, 2010.
Cafeteria Plans for Small Businesses
EXISTING FEDERAL LAW provides that Cafeteria plans
and certain qualified benefits are suject to
nondescrimination requirements to prevent descrimination in
favor of highly-compensated individuals as to elgibility
for benefits and to actual contributions and benefits
provided. There are also rules to prevent the provision of
disporportionate benefits to key employees.
THIS BILL conforms to the federal change under the
PPACA to provide small employers a safe harbor from the
nondiscrimination requirements of a cafeteria plan. The
safe harbor would apply to taxable years beginning on or
after January 1, 2011.
EXISTING FEDERAL LAW provides that qualified benefits
under a cafeteria plan are generally employer-provided
benefits that are not included in gross income under an
express provision of the IRC. In order to be excludable,
any qualified benefit elected under a cafeteria plan must
independently satisfy any requirements under the IRC
section that provides the exclusion.
THIS BILL conforms to the federal change that
limits the maximum amount available for reimbursement of
medical expenses under a cafeteria-plan flexible spending
arrangement to $2,500 per year, beginning on or after
January 1, 2013.
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EXISTING FEDERAL LAW generally does not allow benefits
offered under the new "American Health Benefit Exchanges"
to be part of a cafeteria plan. However, there is an
exception for small businesses.
THIS BILL conforms to the federal exception that
allows benefits offered under a Small Business Health
Options Program to be part of a cafeteria plan beginning on
or after January 1, 2014.
New Limitations on FSA/HRA/HSA/MSA Distributions
EXISTING FEDERAL LAW, effective January 1, 2011, does
not permit the cost of over-the-counter (OTC) medicines to
be reimbursed with excludible income through a Health
Flexible Spending Arrangement (FSA), Health Reimbursement
Account (HRA), Health Savings Account (HSA), or Archer
Medical Savings Account (Archer MSA or MSA), unless the
medicine is prescribed by a physician.
EXISTING STATE LAW permits OTC medicines to be
reimbursed with excludible income through a FSA, HRA or
MSA.
THIS BILL conforms to the new federal limitation under
the PPACA on excludable FSA, HRA, and MSA distributions for
non-prescribed OTC medicines. In general, California does
not conform to any of the federal HSA provisions. However,
if passed in its current form, this bill would adhere to
federal HSA provisions including this one. (See Comment H
below) The limitation would apply to taxable years
beginning on or after January 1, 2011.
Increase in Additional Tax on Nonqualified MSA/HSA
Distributions
EXISTING FEDERAL LAW applies an additional 20% tax on
distributions from an Archer MSA or a HSA that are not used
for qualified medical expenses effective January 1, 2011.
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IRS Publication 969 defines qualified medical expenses as
those expenses that would generally qualify for the medical
and dental expenses deduction. A partial list of medical
expenses can be found in IRS Publication 502. To be an
expense for medical care, the expense has to be primarily
for the prevention or alleviation of a physical or mental
defect or illness.
THIS BILL conforms, with modifications, to the
federally imposed additional tax on distributions from an
Archer MSA not used for qualified medical expenses by
levying a 10% additional tax on nonqualified distributions.
Presently, California does not conform to any of the
federal HSA provisions. (See Comment H below) The
additional tax would apply to disbursements made during tax
years beginning on or after January 1, 2011.
Codification of Economic Substance Doctrine
EXISTING LAW developed in case law, denies the tax
benefits of tax-motivated transactions that lack economic
substance, known as the "economic substance doctrine," most
notably in Gregory v. Helvering, 293 U.S. 465 (1935). The
Internal Revenue Service (IRS) denies claimed tax benefits
of transactions that technically comply with the Internal
Revenue Code but do not result in a meaningful change to
the taxpayer's economic position based on this doctrine.
The transaction must have economic substance apart from the
economic benefit achieved by the tax reduction to ensure
that IRS does not deny it, known as the objective test.
Additionally, the IRS does not deny the transaction when
the taxpayer intended the transaction to serve some useful
non-tax purpose, known as the subjective test. According
to the FTB, courts have not uniformly applied the doctrine;
some apply both tests, while others apply one or the other,
or use it as part of the analysis. Courts have also not
applied a consistent definition of the type of "non-tax
economic benefit" a taxpayer must establish in order to
demonstrate economic substance.
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EXISTING FEDERAL LAW codifies the economic substance
doctrine, allowing the IRS to deny transactions that do not
meet either the objective or subjective tests as it applies
to the federal income tax. Congress added this measure to
the Health Care and Education Reconciliation Act of 2010,
and it applies to transactions entered into on or after
March 30, 2010.
EXISTING FEDERAL LAW applies a new strict-liability
20% penalty (or 40% penalty for undisclosed transactions)
for underpayments attributable to transactions that lack
economic substance, or failing to meet requirements of any
similar rule of law. The penalty does not apply to a
transaction that the IRS applies a fraud penalty upon.
EXISTING STATE LAW codifies the economic substance
doctrine, allowing the FTB to deny transactions that lack a
non-tax California business purpose (the subjective test).
State law codified the doctrine in 2003.
EXISTING STATE LAW applies the strict-liability
Non-Economic Substance Transaction (NEST) penalty of 20%
(or 40% for non-disclosed transactions) for understatements
that lack a non-tax California business purpose. The
penalty does not apply to a transaction that the FTB
applies a fraud penalty upon.
EXISTING FEDERAL AND STATE LAW apply a separate
penalty to "listed transactions," and to any other
"reportable transaction," that is not a listed transaction
if the taxpayer enters into the transaction for the purpose
of avoiding the income tax. Reportable transactions are
those which the Treasury Secretary determines must be
disclosed because of its potential for tax avoidance or
evasion, while a listed transaction is the same as or
substantially similar to a transaction identified by the
Secretary as a tax avoidance transaction. Penalty amounts
and defenses depend on the level of the taxpayer's
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disclosure of the transaction, and taxpayers that are
publicly owned corporations must disclose the penalties to
the Securities and Exchange Commission.
THIS BILL conforms state law to federal law for
purpose of applying the economic substance doctrine to
federal adjustments. The measure allows the FTB to impose
the NEST penalty on transactions that the IRS determines do
not meet either the subjective or the objective test, where
current law only allows the FTB to apply the penalty on
transactions failing to meet the subjective test (i.e., a
non-tax California business purpose).
Denial of Deduction of Annual Fee on Branded Prescription
Pharmaceutical Manufacturers and Importers
EXISTING FEDERAL LAW effective January 1, 2011,
imposes an annual fee (treated as an excise tax) on
entities in the business of manufacturing or importing
branded prescription drugs for sale to any specified
government program or pursuant to coverage under any such
program. Fees collected under the provision are credited
to the Medicare Part B trust fund. The aggregate annual
fee for all covered entities is the applicable amount; the
applicable amount for calendar year 2011 is $2.5 billion.
The aggregate fee is apportioned among the covered entities
each year based on such entity's relative share of branded
prescription drug sales taken into account during the
previous calendar year. The fees imposed are not
deductible for US income tax purposes.
THIS BILL conforms state law to federal law in
recognizing that the annual fee on branded prescription
pharmaceutical manufacturers and importers is considered a
nondeductible tax.
Increased Threshold for Unreimbursed Medical Expense
Deduction
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EXISTING FEDERAL LAW effective January 1, 2012,
increased the floor that allows taxpayers to deduct
unreimbursed medical expenses, regardless of whether the
taxpayer has health insurance or not. Before the change,
taxpayers could take an itemized deduction when expenses
exceeded 7.5% of adjusted gross income (AGI) now increased
to 10%. However, if either the taxpayer or the taxpayer's
spouse turns 65 before the end of the 2013, 2014, 2015, or
2016 taxable year, the threshold increase is cancelled, and
he or she may deduct expenses that exceed 7.5% of AGI.
Under the alternative minimum tax (AMT), taxpayers may only
deduct expenses that exceed 10% of AGI, which Congress did
not change.
EXISTING STATE LAW allows taxpayers to deduct medical
expenses that exceed 7.5% of AGI.
THIS BILL conforms state law to federal law to the new
federal threshold by increasing the AGI threshold from 7.5%
to 10%, effective in the 2013 tax year with identical
allowance for senior citizens.
Free Choice Vouchers
EXISTING FEDERAL LAW, effective December 31, 2013,
requires employers offering minimum essential coverage
through an employer-sponsored plan to offer employees who
choose not to participate in the employer's health plan
with vouchers that can be used to purchase health plans on
the exchange. Only employees who must contribute more than
8% of income for the minimum employer-sponsored plan, and
whose total household income does not exceed 400% of the
poverty line are eligible for free choice vouchers. The
value of the voucher is equal to the employer's
contribution to its health plan.
EXISTING FEDERAL AND STATE LAW excludes from income
employer's contributions for employee's health care, and
allows employers to deduct the contributions. Congress
enacted added free choice vouchers into the laws allowing
the exclusion and the deduction.
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THIS BILL conforms state law to the recent federal
change to exclude the value of free choice vouchers from an
employee's income, and allows employers to deduct the
contributions from income.
Exclusion of Grants Provided in lieu of Therapeutic
Discovery Project Credits
EXISTING FEDERAL LAW establishes a 50 percent
nonrefundable investment tax credit for qualified
investments in qualifying therapeutic discoveries.
Companies can apply to have their research projects
certified as eligible for the credit or grant-in lieu of
the credit-which can be excluded from the taxpayer's gross
income. A "qualifying therapeutic discovery project" is a
project which is designed to develop a product, process, or
therapy to diagnose, treat or prevent diseases and
afflictions, as specified. This provision allocates $1
billion during 2009 and 2010 for the program. The credit
is available only to companies with 250 or fewer employees.
THIS BILL conforms to the federal income exclusion
for grants received in lieu of a tax credit for a
therapeutic discovery project. Similar to federal law, this
provision would exclude from income any grant received
under this federal provision.
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Other Provisions
EXISTING LAW provides modified conformity of
California's Revenue and Taxation Code to the Internal
Revenue Code and specified public laws. Currently,
California conforms to specified federal laws as of the
"specified date" of January 1, 2009 for federal laws
enacted after January 1, 2005 and before January 1, 2009
(SB 401, Wolk, 2010).
THIS BILL conforms to the following provisions in the
Patient Protection and Affordable Care Act (PPACA) (Public
Law 111-148):
Denial of Deduction for Additional
Hospital Insurance Tax on High-Income Taxpayers
for taxable years beginning on or after January
1, 2013 (PPACA Section 9015)
The additional hospital insurance tax is not
deductible under current California law and accordingly,
there is no impact to conforming to the new federal rule.
Exclusion of Tribal Government Health
Benefits (PPACA Section 9021)
Federal law generally provides that gross income
includes all income from whatever source derived.
Exclusions from income are provided, however, for certain
health care benefits. Additionally, under the general
welfare exclusion doctrine, certain payments made to
individuals are excluded from gross income. New federal
law (IRC Section 139D) allows an exclusion from gross
income for the value of specified Indian tribe health care
benefits provided after March 23, 2010.
California currently exempts from income tax income
received by an Indian tribal member who lives in that
tribe's Indian country and such income is sourced in the
tribal member's Indian country. In general, California
conforms to the general welfare doctrine and the exclusion
of certain health care benefits from gross income.
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Exclusion of Student Loan Forgiveness of
Certain Health Professionals (PPACA Section
10908)
Gross income generally includes the discharge of
indebtedness of the taxpayer. Under an exception to this
general rule, gross income does not include any amount from
the forgiveness of certain student loans, provided that the
forgiveness is contingent on the student's working for a
certain period of time in certain professions for any of a
broad class of employers. The new federal law (under IRC
Section 108) modifies the gross income exclusion for
amounts received under the National Health Service Corps
loan repayment program or certain state loan repayment
programs to include any amount received by an individual
under any state loan repayment or loan forgiveness program
that is intended to provide for the increased availability
of health care services in underserved or health
professional shortage areas (as determined by the state).
California conforms to this federal change for taxable
years beginning on or after January 1, 2010.
Increase to the Adoptions Assistance
Exclusion (PPACA 10909)
Consistent with federal law, California provides an
exclusion from the gross income of an employee for
qualified adoption expenses paid or reimbursed by an
employer under an adoption assistance program. For taxable
years beginning on or after January 1, 2010, the maximum
exclusion is increased to $13,170 per eligible child.
California does not conform to the federal adoption credit;
instead California provides its own credit for adoption
costs.
Health Savings Accounts
EXISTING FEDERAL LAW provides for health savings
accounts (HSAs) which are trusts created in the United
States that are used exclusively for the purpose of paying
the qualified medical expenses of the account beneficiary.
HSAs are available to individuals who are covered under a
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high-deductible plan (HDHP) and are not covered under any
other health plan, which is not a high deductible plan. A
HDHP for 2010 is defined as a health plan with an annual
deductible of at least $1,200 for individual coverage
($2,400 for family coverage) and maximum out-of-pocket
expenses of $5,950 for individual coverage ($11,900 for
family coverage.)
THIS BILL conforms to federal law by allowing
taxpayers to deduct contributions to HSAs from income and
allows employers to exclude from an employee's gross income
employer HSA contributions, effective for taxable years
beginning on or after January 1, 2013.
THIS BILL reduces the disqualified distribution
penalty applicable to HSAs from the current federal
percentage of 10% to 2.5% for state purposes, consistent
with state law regarding Individual Retirement Accounts
(IRAs). This measure also allows tax-free rollovers from
MSAs to HSAs as well as rollovers from one HSA to another.
Furthermore, this measure imposes a penalty on a trustee of
an HSA and a person who provides an individual with a HDHP
for each failure to file a report at the time and in the
manner required under IRC Section 223(h).
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FISCAL EFFECT:
---------------------------------------------------------------------------
| |
| |
| AB 1178 AS AMENDED 08/05/2010 |
|---------------------------------------------------------------------------|
| CONFORMITY TO: |
|---------------------------------------------------------------------------|
| HEALTH SAVINGS ACCOUNTS |
|---------------------------------------------------------------------------|
| PATIENT PROTECTION AND AFFORDABLE CARE ACT (Public Law 111-148, March 23, |
| 2010) |
|---------------------------------------------------------------------------|
| HEALTH CARE AND EDUCATION RECONCILIATION ACT OF 2010 (Public Law 111-152, |
| March 30, 2010) |
|---------------------------------------------------------------------------|
| Assumed Enactment Date By 9/30/10 |
---------------------------------------------------------------------------
-----------------------------------------------------------------------------
|Year|Sectio| Title |2010-11|2011-12|2012-13|2013-14|2014-15|
| | n # | | | | | | |
|----+------+-------------------------+-------+-------+-------+-------+-------|
|2013| |Health Savings Accounts | $0 | $0 |-$40,00|-$80,00|-$100,0|
| | | | | | 0,000 | 0,000 |00,000 |
-----------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------
| 2009 | PPACA 9023 |Exclusion |-$1,100,000 |-$1,400,000 | -$800,000 | -$500,000 | -$200,000 |
| | |of grants | | | | | |
| | |provided in | | | | | |
| | |lieu of | | | | | |
| | |therapeutic | | | | | |
| | |discovery | | | | | |
| | |project | | | | | |
| | |credits | | | | | |
|------------+------------+------------+------------+------------+------------+------------+------------|
| |PPACA 10908 |Exclusion | -$600,000 | -$350,000 | -$350,000 | -$350,000 | -$350,000 |
| | |for | | | | | |
| | |assistance | | | | | |
AB 1178 - Portantino
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| | |provided to | | | | | |
| | |participants| | | | | |
| | | in state | | | | | |
| | |student | | | | | |
| | |loan | | | | | |
| | |repayment | | | | | |
| | |programs | | | | | |
| | |for certain | | | | | |
| | |health | | | | | |
| | |professional| | | | | |
| | |s | | | | | |
-------------------------------------------------------------------------------------------------------
|----+------+-------------------------+-------+-------+-------+-------+-------|
|2010|PPACA |Expansion of adoption |-$2,700|-$2,200|-$800,0|-$200,0|-$200,0|
| |10909 |assistance programs | ,000 | ,000 | 00 | 00 | 00 |
-----------------------------------------------------------------------------
| |PPACA |Exclusion of health | $0 | $0 | $0 | $0 | $0 |
| | 9021 |benefits provided by | | | | | |
| | |indian tribal | | | | | |
| | |governments | | | | | |
-----------------------------------------------------------------------------
| |HCERA |Benefits for children |-$15,00|-$16,00|-$19,00|-$20,00|-$22,00|
| | 1004 |under age of 27 | 0,000 | 0,000 | 0,000 | 0,000 | 0,000 |
-----------------------------------------------------------------------------
| |HCERA |Codification of economic |Baselin|Baselin|Baselin|Baselin|Baselin|
| | 1409 |substance | e | e | e | e | e |
-----------------------------------------------------------------------------
|2011|PPACA |Distributions for |Baselin|Baselin|Baselin|Baselin|Baselin|
| | 9003 |medicine qualified only | e | e | e | e | e |
| | |if for prescribed drug | | | | | |
| | |or insulin | | | | | |
-----------------------------------------------------------------------------
| |PPACA |Increase in additional |$150,00|$300,00|$400,00|$500,00|$500,00|
| | 9004 |tax on distributions | 0 | 0 | 0 | 0 | 0 |
| | |from Archer MSAs not | | | | | |
| | |used for qualified | | | | | |
| | |medical expenses (to | | | | | |
| | |12.5%) | | | | | |
-----------------------------------------------------------------------------
| |PPACA |Denial of deduction of |$3,800,|$12,000|$14,000|$13,000|$14,000|
| | 9008 |annual fee on branded | 000 | ,000 | ,000 | ,000 | ,000 |
| | |prescription | | | | | |
| | |pharmaceutical | | | | | |
| | |manufacturers and | | | | | |
AB 1178 - Portantino
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| | |importers | | | | | |
-----------------------------------------------------------------------------
| |PPACA |Establishment of simple | $0 | $0 | $0 | $0 | $0 |
| | 9022 |cafeteria plans for | | | | | |
| | |small businesses (safe | | | | | |
| | |harbor) | | | | | |
-----------------------------------------------------------------------------
|2013|PPACA |Limitation on health |Baselin|Baselin|Baselin|Baselin|Baselin|
| |9005, |flexible spending | e | e | e | e | e |
| |10902 |arrangements under | | | | | |
| | & |cafeteria plans | | | | | |
| |HCERA | | | | | | |
| | 1403 | | | | | | |
-----------------------------------------------------------------------------
| |PPACA |Increased AGI Threshold | $0 | $0 |$4,600,|$46,000|$48,000|
| | 9013 |to Itemize Deductions | | | 000 | ,000 | ,000 |
| | |for Medical Expenses | | | | | |
|----+------+-------------------------+-------+-------+-------+-------+-------|
| |PPACA |Exclusion of additional | $0 | $0 |$2,400,|$4,400,|$4,900,|
| | 9015 |hospital insurance tax | | | 000 | 000 | 000 |
-----------------------------------------------------------------------------
----------------------------------------------------------------------------
|2014|PPACA |Small Business Health | Included in estimate of section 9022 |
| | 1515 |Options program | (see above) |
----------------------------------------------------------------------------
-----------------------------------------------------------------------------
| |PPACA |Exclusion of free choice | $0 | $0 | $0 |-$9,000|-$16,00|
| |10108 |vouchers | | | | ,000 | 0,000 |
|----+------+-------------------------+-------+-------+-------+-------+-------|
|Tota| | |-$15,45|-$7,650|-$39,55|-$46,15|-$71,35|
|l | | | 0,000 | ,000 | 0,000 | 0,000 |0,000 |
-----------------------------------------------------------------------------
AB 1178 - Portantino
Page 10
COMMENTS:
A. Purpose of the Bill
AB 1178 makes changes to California's Revenue and
Taxation Code that conform with recent federal changes to
the Internal Revenue Code necessary to implement recent
federal health care reform legislation.
B. Background: Health Care Reform
President Obama's sweeping health care reform
legislation, the Patient Protection and Affordable Care Act
(H.R. 3590), was enacted March 23, 2010 and amended by the
Health Care and Education Reconciliation Act of 2010 (H.R.
4872) enacted March 30, 2010. The White House touts this
legislation as the vehicle that will make health care more
affordable, make health insurers more accountable, expand
health coverage to all Americans, and make the health
system sustainable, stabilizing family budgets, the Federal
budget, and the economy. Implementation of this
legislation starts this year and continues through 2014 and
beyond.
When changes are made to the federal income tax law,
California does not automatically adopt such provisions.
Instead, state legislation is needed to conform to most of
those changes. Conformity legislation is introduced either
as individual tax bills to conform to specific federal
changes or as one omnibus bill to conform to the federal
law as of a certain date with specified exceptions. While
state conformity to federal income tax provisions offers
certain advantages and reduces tax compliance costs, it can
also significantly impact state revenues. Thus, it is
difficult to achieve complete conformity with federal
income tax rules.
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C. Health Care Benefits for Older Children
Under federal health care reform, health coverage for
an employee's children under 27 years of age is now
generally tax-free to the employee. This expanded health
care tax benefit applies to various work place and retiree
health plans. Specifically, the new federal law extends the
general exclusion from gross income for reimbursements for
medical care under an employer-provided accident or health
plan to any employee's child who has not attained age 27 as
of the end of the taxable year. This expanded health care
tax benefit applies to various workplace, retiree health
plans, and self-employed individuals who qualify for the
self-employed health insurance deduction on their federal
income tax return. AB 1178 would provide the California
exclusion and apply it in the same manner and to the same
periods as the exclusion applies for federal purposes.
D. Cafeteria Plans and Small Businesses
A cafeteria plan is a type of employee benefit plan
offered pursuant to Internal Revenue Code (IRC) Section
125. Its name comes from the earliest such plans that
allowed employees to choose between different types of
benefits, similar to a cafeteria. More specifically, a
cafeteria plan is a separate written plan under which all
participants are employees, and participants are permitted
to choose among at least one permitted taxable benefit (for
example, current cash compensation) and at at least one
qualified benefit. Finally, a cafeteria plan must not
provide for deferral of compensation, except as permitted
in IRC Section 125, as specified.
Qualified benefits under a cafeteria plan are
generally employer-provided benefits that are not included
in gross income under an express provision of the IRC.
Examples of qualified benefits include employer-provided
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health insurance coverage, group term life insurance
coverage not in excess of $50,000, and benefits under a
dependent care assistance program. In order to be
excludable, any qualified benefit elected under a cafeteria
plan must independently satisfy any requirements under the
IRC section that provides the exclusion. However, some
employer provided benefits that are not included in gross
income under an express provision of the IRC are explicitly
not allowed in a cafeteria plan. These benefits are
generally referred to as nonqualified benefits. Examples of
nonqualified benefits include scholarships,
employer-provided meals and lodging, and educational
assistance.
Employees can also elect a qualified benefit through
salary reduction by electing to forego salary and instead
receive a benefit that is excludible from gross income
because it is provided by employer contributions. IRC
section 125 provides that the employee is treated as
receiving the qualified benefit in lieu of the taxable
benefit. For example, active employess participating in a
cafeteria plan may be able to pay their share of premiums
for employer-provided health insurance on a pre-tax basis
through salary reduction.
Nondiscrimination Requirements. Cafeteria plans and
certain qualified benefits are suject to nondiscrimination
requirements to prevent discrimination in favor of
highly-compensated individuals as to elgibility for
benefits and to actual contributions and benefits provided.
There are also rules to prevent the provision of
disporportionate benefits to key employees.
New Federal law (IRC Section 125). Under the new
federal law, in years beginning after Dec. 31, 2010,
certain small employers' cafeteria plans can qualify as
simple cafeteria plans and thus avoid the nondiscrimination
requirements of a classic cafeteria plan under IRC Sec.
125. Under this provision, an eligible small employer is
provided with a safe harbor from the nondiscrimination
requirements for cafeteria plans as well as from the
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nondiscrimination requirements for specified qualified
benefits offered under a cafeteria plan, including group
term life insurance, benefits under a self-insured medical
expense reimbursement plan, and benefits under a dependent
care assistance program.
An employer eligible to establish a simple cafeteria
plan is any employer that, during either of the two
preceding years, employed an average of 100 or fewer
employees on business days. If an employer has 100 or fewer
employees for any year and establishes a simple cafeteria
plan for that year, then it can be treated as meeting the
requirement for any subsequent year even if the employer
employs more than 100 employees in the subsequent year.
However, this exception does not apply if the employer
employs an average of 200 or more employees during the
subsequent year.
These provisions allow small but growing employers to
continue to offer simple cafeteria plan benefits to
employees without the concern of having to meet the
discrimination requirements of a classic cafeteria plan.
Without this exception, the establishment of simple
cafeteria plans could create a disincentive to increased
hiring.
AB 1178 conforms California law to these federal
changes.
E. FSA/HRA/MSA/HSA
An employer may agree to reimburse expenses for
medical care of its employees (and their spouses and
dependents), not covered by a health insurance plan,
through a FSA which allows reimbursement for medical
expenses not in excess of a specified dollar amount. Such
amount is either elected by an employee under a cafeteria
plan or otherwise specified by the employer under a HRA at
the beginning of the plan year. Reimbursements under these
arrangements are excludible from gross income as
employer-provided health coverage. An employee may also
contribute money before taxes, through a salary reduction
AB 1178 - Portantino
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agreement with the employer, to a FSA. Any monies not used
during the year for reimbursement of qualified medical
expenses are forfeited. Alternatively, a HRA must be
solely funded by the employer. Also, left-over dollar
amounts in a HRA can continue to be used year after year.
Archer MSAs were created to help self-employed
individuals and employees of certain small employers meet
the medical care costs of the account holder, the account
holder's spouse, or the account holder's dependents. An
Archer MSA is a tax-exempt trust or custodial account
established with a US financial institution in which money
is saved exclusively for future medical expenses. To be
eligible for an Archer MSA, one must be covered under a
high-deductible health plan, similar to a HSA. (See Comment
H below) MSAs also provide tax benefits similar to HSAs.
However, MSAs are generally not as favorable as HSAs.
Additionally, after 2007, no new contributions can be made
to Archer MSAs except by or on behalf of individuals who
previously had made Archer MSA contributions and employees
who are employed by a participating employer.
New Federal Law (IRC Sections 106, 220, and 223).
Under the new federal law, as of January 1, 2011, the
definition of medical expenses for purposes of
employer-provided health coverage under a HRA, FSA, MSA or
HSA is the same as the definition of medical expenses for
purposes of the Schedule A itemized deduction, i.e.,
medicine is restricted to prescribed drugs and insulin. AB
1178 conforms California law to the federal change that
provides the cost of non-prescribed OTC medicines may not
be reimbursed with excludible income through a HRA, FSA,
MSA or HSA.
New Federal Law (IRC Sections 220 and 223).
Currently, federal law imposes an additional 15% tax on
nonqualified MSA distributions and an additional 10% tax on
nonqualified HSA distributions. For tax years beginning on
or after January 1, 2011, the additional tax on
distributions from a MSA or HSA not used for qualified
medical expenses will be 20%. California currently imposes
a 10% additional tax on nonqualified MSA distributions.
For tax years beginning on or after January 1, 2011,
California will assess a 12.5% additional tax. California
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does not currently conform to the federal HSA provisions.
If the Legislature passes AB 1178 in its current form,
California will impose a 2.5% additional tax on
nonqualified HSA distributions.
F. Codification of Economic Substance
The most significant non-tax element enacted by
Congress as part of Health Care reform is the codification
of the economic substance doctrine, a common law standard
that limits a taxpayer's ability to enter into tax-reducing
transactions that comply with the Internal Revenue Code but
serve no other economic purpose other than tax reduction.
Codifying the doctrine in federal law provides clear
direction to the Courts that the IRS can deny transactions
that fail either the subjective or objective tests of the
doctrine. The Joint Committee on Taxation estimates that
the codification of the doctrine results in $3.5 billion
over the next ten years.
For state purposes, the effect of codification is less
significant. FTB currently applies the penalty to
taxpayers failing the subjective test, and will see an
uptick in revenue when the IRS applies the penalty to any
new transactions not previously disallowed by case law that
result in income and tax adjustments. FTB does not expect
that it will issue any more penalties to transactions as a
result of inserting the federal definition of economic
substance into its penalty statutes, as almost all
penalties that fail the objective test will likely fail the
subjective one too. Failing to conform to this item will
only allow taxpayers using questionable transactions to
argue that a transaction used for state purposes disallowed
by the IRS should be allowed because it met the objective
but not the subjective test. The California Taxpayers'
Association disagrees, stating that AB 1178's changes are
litigation prone and create compliance difficulties.
Cal-Tax also objects to AB 1178's provision that allows FTB
to impose the NEST penalty whenever the IRS does because
strict liability penalties are unfair and undermine the
taxpayer/tax agency relationship.
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G. Increase to the AGI Threshold of the Schedule A Medical
Expense Deduction
Congress limited taxpayers from claiming unreimbursed
medical expense deductions by allowing taxpayers to claim
only those expenses that exceed 10% of AGI, instead of the
current threshold of 7.5%. While many argue that health
care is overused, and the tax deduction may provide some
incentive to purchase more care than necessary, most
observers state that this change was made largely for
revenue reasons, garnering $15.2 billion in federal
revenues between 2010-2019. The Committee may wish to
consider deleting this item due to its revenue increases,
which total almost $46 million annually when fully
implemented, unless a compelling policy reason exists for
its inclusion.
H. Health Savings Accounts
HSAs are private accounts in which individuals can
make tax deductible contributions with a maximum amount for
each year. The funds in these accounts are designed to be
used at the discretion of the enrollee for basic medical
needs and to provide savings for the future. HSA enrollees
are also enrolled in HDHPs which provide low premiums with
relatively high deductibles and maximum out-of-pocket
limit. Many HDHPs also cover preventative services.
HSAs are the only savings account with both
tax-deductible deposits and tax-free withdrawals, provided
those withdrawals are for qualified medical expenses.
Additionally, HSAs have no income limits. Comparatively, a
traditional IRA generally allows contributions to be tax
deductible, but treats withdrawals as income subject to
tax. Contributions to a Roth IRA are taxable but qualified
withdrawals are tax-free and Roth IRAs have income limits
restricting eligibility.
Proponents of HSAs maintain that they can reduce
overall spending on health care by giving consumers more
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control over their health care costs. HSAs were
established beginning with tax year 2004. At the time,
President Bush's Council of Economic Advisors stated
"health insurance in the United States has now also become
a vehicle for financing relatively low-cost, routine
expenditures" and "has important consequences: (1) It
encourages consumers to overuse certain types of health
care. (2) It gives little incentive for consumers to search
for the lowest-price providers. (3) It distorts incentives
for technological change."
This concept of providing consumers with more control
over healthcare costs is central to the argument of how
HSAs may reduce healthcare costs over time. President
Bush's Council of Economic Advisors stated, "As more
consumers shift into high-deductible plans, there is
greater potential for slowing price growth and increases in
cost-reducing technology, which could benefit even
consumers in traditional insurance plans." Furthermore,
proponents state that a high deductible forces consumers to
be more aware of the cost of routine medical procedures and
that this increased price awareness and sensitivity will in
turn control health care costs.
In August 2006, the United States Government
Accountability Office issued a report titled,
"Consumer-Directed Health Plans: Early Enrollee Experiences
with Health Savings Accounts and Eligible Health Plans."
The report stated that the median income of tax filers
reporting an HSA contribution in 2004 was $133,000.
Additionally, 51 percent of those tax filers contributing
to an HSA had an income of $75,000 or more. According to
the report, "HSA-eligible plan enrollees had higher incomes
than comparison groups."
The report also stated that, "In addition to using
HSAs to pay for medical and other expenses, account holders
appear to use their HSAs as a savings vehicle. About 55
percent of those reporting HSA contributions to the IRS in
2004 did not withdraw any funds from their account in 2004.
We could not determine whether HSA-eligible plan enrollees
accumulated balances because they did not need to use their
account (that is, they paid for care from out-of-pocket
sources or did not need health care during the year) or
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because they reduced their health care spending as a result
of financial incentives associated with the HSA-eligible
plan. However, many focus group participants reported
using their HSAs as a tax-advantaged savings vehicle,
accumulating their HSA funds for future use."
Opponents cite this report as further evidence of the
fact that HSAs are generally used by wealthier individuals
and are not accessible to lower income people.
Additionally, in the past, opponents of HSAs were concerned
that employers might no longer offer low deductible health
plans, opting for high deductible plans instead, and
shifting the costs to employees. The opponents further
stated that "high deductible health plans and savings
accounts hurt poor people who simply cannot afford to buy
high deductibles and are barely making ends meet."
Opponents further argued that HSAs are an example of
adverse selection where one healthy group of people is more
likely to use the high deductible programs than a less
healthy group of people that cannot afford the deductibles.
The recent federal health care reform legislation
will require most citizens and legal residents of the US to
have health insurance by January 1, 2014. The legislation
outlines the minimum coverage and essential health benefits
that need to be provided for a plan to qualify for the
mandated coverage; ultimately, these requirements could
limit the types of plans offered to individuals. For
example, all insurance policies will be required to provide
first dollar coverage for preventive care services. While
HSAs are currently allowed to provide such coverage, in the
future, all plans will be required to do so.
HSA Bank further summarizes on its website the
impacts this legislation has on HSAs as follows: All
insurance policies will be required to provide a minimum
actuarial value of at least 60% for the benefits covered.
However, it is not clear whether a plan's actuarial value
would include employer or individual contributions made to
the individual's HSA. Including the contributions in the
calculation of a plan's actuarial value would make it
easier for more HSA-compatible health plans to meet the
minimum actuarial value requirement. If contributions are
not included, many plans could no longer be sold.
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Clarity must still be provided regarding the
definition of "actuarial value" and what constitutes
"preventive care" under the new provisions, among other
requirements. It's a matter of time before we know the
final outcome but some experts feel the "considerable
uncertainties" surrounding HSA offerings may be enough to
drive them out of business.
The Legislature has considered 18 similar HSA bills
in the last seven years. The status of three HSA bills in
the current session is as follows:
SB 353 (Dutton) This bill was placed on
Committee suspense file May 13, 2009.
SB 1262 (Aanestad) This bill failed
passage in Senate Public Employment and
Retirement Committee on April 12, 2010.
SBX6 13 (Dutton) This bill was placed on
Committee suspense file May 13, 2010.
Because significant uncertainty exists regarding the
future treatment of HSAs under federal health care reform,
previous policy objections to HSAs have not yet been
overcome. Additionally, when legislators introduce
individual bills to conform state tax laws to federal ones,
broader conformity bills generally do not contain the item.
HSA conformity also results in foregone revenue to the
state of between $55 million and $6 million annually to the
benefit of higher-income taxpayers who do not participate
in group health care. The Committee may wish to consider
deleting this item.
Support and Opposition
Support:None received.
Oppose:California Taxpayers' Association
---------------------------------
Consultants: Mary Beth Faulkner, Meg Svoboda, Gayle Miller
and Colin Grinnell
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