Potential Tax Policy Consequences of H.R. 3, No Taxpayer Funding for Abortion Act

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1 TO: RE: FROM: Interested Persons Potential Tax Policy Consequences of H.R. 3, No Taxpayer Funding for Abortion Act ACLU Washington Legislative Office DATE: February 28, 2011 Introduction Rep. Chris Smith (R-NJ) has proposed H.R. 3, the No Taxpayer Funding for Abortion Act ( the Smith bill ). Included in the Smith bill are specific provisions that would alter the tax treatment associated with medical expenses and the purchase of health insurance, to the extent that the amounts spent are used to pay for an abortion procedure or an insurance policy that would provide coverage for such a procedure. This paper, prepared pro-bono at the request of the Washington Legislative Office of the American Civil Liberties Union 1 by tax attorneys at one of the nation s top law firms, will examine the specific, and often draconian, effects that the Smith bill would have on taxpayers were it to be passed into law. Medical Expenses and Ability to Pay Principles With a few notable exceptions discussed below, preferential tax treatment for medical expenses and insurance premiums comes in the form of a reduction to taxable income. While colloquially these reductions are referred to as tax benefits, there is a meaningful and serious debate as to the normative appropriateness of including amounts spent on medical needs within the tax base. 2 For instance, assume that a taxpayer has an income of $100. An emergency 1 2 For more information, contact Vania Leveille, Senior Legislative Counsel, at or vleveille@dcaclu.org. See, e.g., William Andrews, Personal Deductions in an Ideal Income Tax, 86 Harv. L. Rev. 309 at 314 (1972) ( Thus, in evaluating the medical expense deduction, the underlying question is whether the medical services (cont'd)

2 2 P age medical need arises, and the taxpayer is forced to spend $50 half of her income on medical care. Is it fair to say that the measure of this taxpayer s ability to pay tax should be based on her $100 income? Generally, our tax system says no. Rather, the accepted judgment is that a taxpayer s ability to pay taxes should be measured on the taxpayer s income after taking into account medical expenses. 3 Thus, rather than treating medical expenses as consumption (i.e., like buying a television) the tax code treats medical expenses as a factor that contributes to the baseline with which we measure the individual s ability to pay. Just as we deem an individual with a higher salary able to pay more tax than an individual with a lower salary, so too do we consider an individual with higher medical expenses less able to pay tax than an individual with lower medical expenses. Viewed in this light, legislation that would seek to deny certain tax benefits associated with medical care expenses and insurance costs is not simply scaling back the government dole, as its proponents might suggest. Rather, as the medical expenses of a taxpayer affect that taxpayer s ability to pay taxes, requiring a taxpayer to include such expenses in his or her income amounts to a penalty. In fact, Edward Kleinbard, the recent former Chief of Staff of the Joint Committee on Taxation, in a recent article that advocated for the repeal of some of the most well-entrenched tax benefits in the tax code (such as the home mortgage interest deduction and the charitable giving deduction) specifically excepted the deduction for medical expenses from his proposal, stating that it does relate to an individual s ability to pay tax. 4 In limited circumstances, tax provisions related to medical expenses and insurance costs serve to transfer wealth and provide incentives towards the attainment of health care. The Reconciliation Act of 2010, as amended and in combination with the new healthcare reform law, the Patient Protection and Affordable Care Act, instituted a refundable tax credit that is designed to create a subsidy for eligible individuals who purchase insurance on an exchange. 5 In this manner, the tax code is being used as a means of transferring wealth to income-eligible individuals who could not otherwise afford to purchase insurance at market price. The Affordable Care Act provides an additional tax credit for small business owners who subsidize (cont'd from previous page) should be included or excluded in the refined concept of personal consumption for tax purposes. For many purposes, of course, medical services are properly classed as personal consumption. But for purposes of interpersonal comparisons of taxable capacity, there are persuasive reasons for excluding medical services. ) The tax code removes health care consumption from an individual s tax base in many ways, including: health insurance premiums subsidized by employers are not included in taxable income, self-employed individuals are entitled to deduct the cost of their health insurance premiums from gross income, there is an itemized deduction for extraordinary medical expenses, and various savings accounts mechanisms allow medical expenses to be paid with pre-tax dollars. Edward D. Kleinbard, Sacred Tax Cows: It s Them Or Us at August 10, Sec. 1401(e), P.L , 3/23/2010.

3 3 P age their employees health insurance, which acts as an incentive for such owners to do so, when purchasing health insurance might otherwise be cost-prohibitive. 6 Who Does the Smith Bill Penalize? Bearing in mind the rationale underlying the tax code s treatment of medical expenses, as described above, a close examination of the Smith bill s tax provisions reveals that it serves to punish certain segments of the population. Women. It should go without saying that the effects of the Smith bill will disproportionately fall on women, as women are the ones who are most likely to spend funds on abortion procedures. However, the Smith bill does not punish women exclusively. Many men purchase insurance policies that cover their spouses and dependents, and many use the funds considered in the Smith bill to pay expenses for abortion procedures for their spouses and dependents. Low & Middle-Income People. The Smith bill would penalize low and middle income taxpayers. As described below, taxpayers who would be entitled to a subsidy for insurance purchased on an exchange would not be eligible for such a subsidy if the insurance plan offered on the exchange included coverage for abortion procedures. Thus, while wealthier taxpayers whose employers provide insurance premium subsidies would likely suffer no penalty to enroll in a plan that includes coverage for abortion procedures, taxpayers who must buy insurance on an exchange would lose a significant subsidy, and in all likelihood be effectively precluded from obtaining insurance with coverage for abortion procedures. Small Businesses. The Affordable Care Act provides for a tax credit for small businesses (businesses with 25 or fewer full-time employees) to encourage the provision of health insurance for their employees. 7 The Smith bill s provisions would deny small businesses this tax credit if they were to offer insurance policies that covered abortion procedures. In all likelihood, this would have the effect of eliminating coverage for abortion for employees of small businesses. Tax-Exempt Organizations. As described below, tax-exempt organizations are also eligible to receive the small business credit for the provision of health insurance (the credit is taken against employment tax payments). 8 At a time when individuals are scaling back on charitable giving, 9 small charities that would be eligible for the small business tax credit can use all the help they can get. The Smith bill would deny these organizations a crucial tax incentive, without which many of these charities would not likely be able to bear the cost of providing health insurance to their employees. Such a crucial incentive should not be dependent upon whether the organization provides insurance coverage that covers abortion procedures I.R.C. 45R. See fn. 5, supra. I.R.C. 45R(f). See Stephanie Strom, Charitable Giving Declines, A New Report Finds, New York Times, June 9, 2009.

4 4 P age Specific Effects of the Smith bill The Smith bill contains three separate provisions specifically related to taxation. Below we have reproduced those sections and outlined how that provision may affect taxpayers. 10 A. Smith bill, section 303 (1): No credit shall be allowed under the internal revenue laws with respect to amounts paid or incurred for an abortion or with respect to amounts paid or incurred for a health benefits plan (including premium assistance) that includes coverage of abortion The Health Coverage Tax Credit The health coverage tax credit ( HCTC ) is a refundable tax credit equal to 80 percent of the cost of qualified health care coverage paid by certain eligible individuals. 11 Individuals who are eligible for the credit are those individuals who are receiving trade adjustment assistance benefits, individuals eligible for the alternative trade adjustment assistance program, and individuals over the age of 55 who receive pension benefits from the Pension Benefit Guarantee Corporation ( PBGC ). 12 Qualified health coverage includes coverage purchased for a qualifying family member, which includes the individual s dependents. 13 While individuals who qualify for the HCTC under the PBGC feature are generally of the age range that do not require abortion coverage in their health insurance, many may have dependents for whom the coverage is an important insurance benefit. The Smith bill would prevent any eligible individual from a receiving a credit, of any amount, on the premiums paid for insurance that covered abortions. COBRA Continuation Coverage Premium Reduction The Consolidated Omnibus Reconciliation Act of 1985 ( COBRA ) 14 requires that a group health plan must offer continuation coverage to qualified beneficiaries in the case of loss of employment, and other qualifying events. Plans often require the payment of a premium in monthly installments for such coverage, which generally may not exceed 102 percent of the applicable premium Much of the description of current law has been drawn from The Joint Committee on Taxation, Tax Expenditures For Health Care, JCX-66-08, (July 30, 2008) and The Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the Reconciliation Act of 2010, as Amended, in Combination with the Patient Protection and Affordable Care Act, JCX-18-10, (March 21, 2010). I.R.C. 35. I.R.C. 35(c). I.R.C. 35(d). Pub.L. No

5 5 P age The American Recovery and Reinvestment Act ( ARRA ) 15 contained a provision that offered premium coverage assistance to eligible individuals (based on their adjusted gross income). 16 An eligible individual is required only to pay 35 percent of the premium; the group health plan must treat the individual as having paid the full premium required for COBRA additional coverage. The mechanism for delivering this subsidy requires that employers must pay the subsidized portion of the premium for the eligible individual, and offsets its employment tax liability by the amount of the subsidy. 17 If the employer s aggregate subsidies for a fiscal quarter exceed the employer s total employment tax liability, the Secretary of the Treasury is required to credit or refund the excess of this amount as if it were an overpayment of taxes. 18 The effect that the Smith bill will have on COBRA continuation coverage premium reductions is unclear. The ARRA does not specifically refer to the amount by which an employer is to reduce its employment taxes under this provision as a credit, although the reduction of employment taxes serves the same operation as a credit would. Additionally, the ARRA refers to the return of the excess amounts paid to the employer as a credit or refund, though in essence those two terms can be used interchangeably in this context. Thus, it remains unclear whether a taxpayer whose COBRA health plan provides abortion coverage will be able to receive the subsidy provided by the ARRA, although there is a substantial risk that this is the case. Premium Assistance Credit The Reconciliation Act of 2010, as amended and in combination with the Affordable Care Act, created a refundable tax credit for eligible individuals who purchase health insurance through an exchange. 19 Eligible individuals who purchase their insurance through an exchange report their income to the exchange. Based on the information provided, the individual receives a premium assistance credit, the amount of which is dependent upon the individual s income. 20 The individual s premium payments are reduced by the amount of the credit, and the Treasury Department pays the credit amount directly to the insurance plan in which the individual is enrolled. The Smith bill s specific inclusion of premium assistance is clearly meant to apply to this provision of the Affordable Care Act. Were the Smith bill to pass, low income individuals who need to purchase health insurance through an exchange would not be eligible for the tax credits associated with this purchase if the purchased insurance policy provided coverage for abortions Pub. L. No ARRA I.R.C. 6432(c). Id. See fn. 4, supra. I.R.C. 36B.

6 6 P age Small Business Tax Credit Under a provision of the Affordable Care Act, a general business tax credit is provided for qualified small employers for qualified nonelective contributions to purchase health insurance for its employees. 21 For purposes of this credit, employers with no more than 25 fulltime equivalent employees are eligible, whose employees must have average annual wages of no more than $50,000 ($25,000 in the case of employers with 10 or fewer full-time employees). 22 The credit is equal to the applicable percentage of the small business employer s contribution to the health insurance premium for each covered employee. For the first phase of the credit (i.e., through taxable years beginning in 2013), the applicable tax credit percentage is 35 percent. For years beginning thereafter, the applicable percentage is 50 percent. 23 The credit is reduced for employers who have more than 10 full time employees but fewer than 25, and is also reduced as the employees average wages rise from $25,000 to $50, Tax-exempt organizations that would otherwise qualify for the credit (i.e., based on the number of employees and their average wages) are also eligible for the credit. 25 However, for these organizations, rather than serving as a general business credit, the credit is a refundable tax credit limited to the amount of the payroll taxes of the employer during the calendar year. 26 To the extent that a small business employer were to make a qualified nonelective contribution to purchase a health insurance plan that included coverage for abortion procedures, that small business or tax-exempt organization could not receive a small business tax credit under this provision of the Smith bill. B. Smith bill, section 303(2): For purposes of determining any deduction for expenses paid for medical care of the taxpayer or the taxpayer's spouse or dependents, amounts paid or incurred for an abortion shall not be taken into account I.R.C. 45R. I.R.C. 45R(d). I.R.C. 45R(b); 45R(g). I.R.C. 45R(c). I.R.C. 45R(f). Id. 27 Section 303(2) of the Smith bill, as introduced on January 20, 2011, originally provided that for purposes of determining any deduction for expenses paid for medical care of the taxpayer or the taxpayer s spouse or dependents, amounts paid or incurred for an abortion or for a health benefits plan that includes coverage of abortion shall not be taken into account. This section was amended on February 28, 2011 and the phrase italicized above -- or for a health benefits plan that includes coverage of abortion -- was deleted. Under the original language, a selfemployed individual could not take a tax deduction for the cost of health insurance premiums if the insurance policy (cont'd)

7 7 P age Itemized Deduction for Health Care Individuals may claim an itemized deduction for unreimbursed medical expenses, but only to the extent that those medical expenses exceed 7.5 percent of the individual s adjusted gross income. 28 The provision applies both to insured and non-insured individuals, and an individual s non-subsidized health insurance premiums can be counted towards the 7.5 percent threshold. 29 This provision has the effect of providing a benefit only to those who have significant medical expenses, and whose itemized deductions are significant enough so as to outweigh taking the standard deduction. The Smith bill would eliminate the deduction for any expenses that are directly related to abortion procedures. C. Smith bill, Section 303(3): In the case of any tax-preferred trust or account the purpose of which is to pay medical expenses of the account beneficiary, any amount paid or distributed from such an account for an abortion shall be included in the gross income of such beneficiary." Health Savings Accounts Individuals with a high-deductible health plan (and no other health plan except those that provide permitted coverage) may establish and make tax deductible contributions to a health savings account ( HSA ). 30 Contributions made to an HSA by an individual are deductible for income tax purposes, regardless of whether the individual itemizes personal deductions. 31 Additionally, an individual can exclude from income contributions that the individual s employer (cont'd from previous page) included coverage of abortion (as many policies do). Additionally, as per the original language, an individual could not have included the cost of insurance premiums (if the plan included abortion coverage) when determining whether unreimbursed medical expenses above 7.5% of adjusted gross income could be itemized and deducted. Finally, under the original language, it was unclear whether the Smith bill would change current law and prevent employers from taking a deduction for compensation paid to employees in the form of healthcare premium subsidies. As a result of the change to section 302(2) it is now clearer that self-employed individuals may continue to deduct their premiums even if the policy includes abortion, individuals may include the cost of their insurance policy when itemizing unreimbursed medical expenses above 7.5% of adjusted gross income, and the employer deduction/employee exclusion for employer-sponsored health insurance remains intact even if the insurance plan provides coverage for abortion. However, this change does not alter or mitigate the bill s fundamental unfairness and its discriminatory treatment of a legal, medical procedure: abortion. All of these provisions constitute the worst kind of government interference in a woman s private medical decisions I.R.C I.R.C. 213(d)(1)(D). I.R.C I.R.C. 62(a)(19).

8 8 P age makes to the individual s HSA. 32 Earnings in an individual s HSA accumulate on a tax-free basis, and distributions from an HSA that are used for qualified medical expenses are excludable from the individual s gross income. 33 Distributions from an HSA that are not used for qualified medical expenses are not only included in the recipient s income, but are also subject to an additional tax of 10 percent (except if the distribution was made after death, disability, or the individual reached the age of Medicare eligibility). 34 This additional tax increases to 20 percent in The Smith bill would have the effect of requiring the inclusion in income of any amounts paid out of an HSA to the account holder, when those proceeds are used for expenses relating to an abortion. It is likely (although not entirely clear) that such a distribution would also be subject to the 10 percent surtax for distributions for non-qualified medical expenses. Health Flexible Spending Arrangements Health Flexible Spending Arrangements ( FSA ) are a common means by which an employee can pay for medical expenses on a pre-tax basis. Health FSAs are funded on a pre-tax basis under an employer s cafeteria plan. 35 Health FSAs are subject to the tax code s general requirement for cafeteria plans, including the requirement that amounts remaining in a health FSA as of the end of the plan year must be forfeited by the employee (the so-called use-it-orlose-it rule). 36 Reimbursements from the health FSA are not includible in the account holder s gross income. 37 The Smith bill would have the effect of requiring those who use funds from a health FSA for abortion procedures to include those funds into gross income for the taxable year. Health Reimbursement Arrangements Health Reimbursement Arrangements ( HRA ) operate in a manner similar to health FSAs, in that they are accounts maintained by employers that reimburse employees for medical expenses. 38 HRAs, however, must be funded by the employer (as opposed to health FSAs, which are funded on a salary-reduction basis), and the use-it-or-lose-it rules do not apply I.R.C. 106(d)(1). I.R.C. 223(f)(1). I.R.C. 223(f)(4)(A). I.R.C. 125; Prop. Treas. Reg (a). Prop. Treas. Reg (c). I.R.C. 125(a). Notice , Sec. I, IRB 93

9 9 P age Significantly, unlike an FSA, an HRA is permitted to reimburse an employee for health insurance premiums. 39 Under the Smith bill, amounts distributed to an employee from an HRA for purposes of reimbursing the employee for funds spent for abortion procedures are included in the employee s taxable income. 39 Notice , Sec. II, CB 93