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IRS Guidance Attempts to Resolve Circular Relationship Between Code Sections 36B and 162(l). (Parker Tax Publishing August 7, 2014)

The Affordable Care Act (ACA) is proving to be a challenge for tax return preparers, not only because of the complexity of the rules involved but also for the many unresolved questions the law presents. One of the bigger issues confronting preparers is how to calculate the premium tax credit under Code Sec. 36B that is available to taxpayers who purchase their own health insurance on a state or federal Exchange.

The issue for practitioners is how to calculate the premium tax credit for a taxpayer who is taking a deduction under Code Sec. 162(l) for health insurance premiums, because the credit is based in part on the taxpayer's modified adjusted gross income which is calculated after the deduction under Code Sec. 162(l). Thus, because the Code Sec. 162(l) deduction is allowed in computing adjusted gross income and because adjusted gross income is necessary for computing the premium tax credit, the taxpayer must know the allowable Code Sec. 162(l) deduction to compute the premium tax credit; and the amount of the Code Sec. 162(l) deduction is based on the amount of the Code Sec. 36B premium tax credit. Consequently, where a taxpayer is eligible for both a Code Sec. 162(l) deduction and a Code Sec. 36B premium tax credit, it may be difficult to determine the amounts of those items.

To address this problem, the IRS has issued Rev. Proc. 2014-41 and temporary and proposed regulations under Code Sec. 162. This guidance provides taxpayers with calculation methods to compute the premium tax credit and the deduction under Code Sec. 162(l).

Practice Tip: Use of the calculations described in Rev. Proc. 2014-41 is optional. According to the IRS, taxpayers can determine the Code Sec. 162(l) deduction and the Code Sec. 36B tax credit using any method, provided that the amounts claimed satisfy the applicable requirements.

Interaction of Code Section 36B and Code Section 162(l)

Under Code Sec. 36B, a taxpayer is eligible for a premium tax credit if the taxpayer enrolls in a qualified health plan. The premium tax credit is an advanceable, refundable tax credit designed to help eligible individuals and families with low or moderate income afford health insurance purchased through the Health Insurance Marketplace, also known as the Exchange, beginning in 2014. A taxpayer can choose to have the credit paid in advance to the taxpayer's insurance company to lower the taxpayer's monthly premiums, or the taxpayer can claim all of the credit when filing his or her tax return for the year. If the taxpayer chooses to have the credit paid in advance, the amount paid in advance must be reconciled with the actual credit when the taxpayer's return is filed. Under Code Sec. 36B(f)(2)(A), if an advanced credit payment for a tax year exceeds the credit allowed for the year, the taxpayer's tax is increased by the amount of the excess payment. However, under Code Sec. 36B(f)(2)(B), this increase in tax is limited where the taxpayer's household income is less than a certain amount (i.e., the limit on the additional tax).

The amount of the credit is based on the taxpayer's household income and a taxpayer's household income is calculated using modified adjusted gross income. Modified adjusted gross income is adjusted gross income plus certain additional items. Consequently, the amount of a taxpayer's premium tax credit is based in part on the amount of the taxpayer's adjusted gross income.

Some taxpayers eligible for the premium tax credit may also be eligible for a deduction under Code Sec. 162(l). Code Sec. 162(l) provides that a self-employed taxpayer (including partners and 2-percent S shareholders) may deduct from gross income on Form 1040 the premiums paid for health insurance (including medical, dental, and qualified long-term care insurance) for the taxpayer, the taxpayer's spouse, the taxpayer's dependents, and any child of the taxpayer under age 27.

Reg. Sec. 1.162(l)-1T, which was issued in conjunction with Rev. Proc. 2014-41, provides temporary rules for taxpayers who claim a Code Sec. 162(l) deduction and also may be eligible for a premium tax credit for the same qualified health plan or plans. Under the temporary rules, a taxpayer can take a Code Sec. 162(l) deduction for "specified premiums" not to exceed an amount equal to the lesser of (1) the specified premiums less the premium tax credit attributable to the specified premiums, and (2) the sum of (a) the specified premiums not paid through advance credit payments and (b) the additional tax imposed with respect to the specified premiums after applying the limitation on additional tax in Code Sec. 36B(f)(2)(B). The temporary rules define specified premiums as premiums for a specified qualified health plan or plans for which the taxpayer may otherwise claim a deduction under Code Sec. 162(l). A specified qualified health plan is a qualified health plan covering the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer (i.e., an enrolled family member) for a month that is a coverage month for the enrolled family member.

Practice Tip: Examples of premiums that are not specified premiums are: (1) premiums paid for coverage other than a qualified health plan; (2) premiums paid for a qualified health plan other than during a coverage month; and (3) premiums paid to cover an individual other than the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer. To the extent a taxpayer may claim a Code Sec. 162(l) deduction for premiums that are not specified premiums, such deductions are treated as the taxpayer treats all other deductions in determining adjusted gross income, modified adjusted gross income, and household income.

Taxpayers to Whom Rev. Proc. 2014-41 Applies

The guidance provided in Rev. Proc. 2014-41 applies to any taxpayer who is eligible for the deduction under Code Sec. 162(l) for specified premiums. If a specified qualified health plan covers individuals other than enrolled family members, the specified premiums include only the portion of the premiums for the specified qualified health plan that is allocable to the enrolled family members.

Calculating the Section 162(l) Deduction

Rev. Proc. 2014-41 describes the calculations necessary to determine the Code Sec. 162(l) deduction for specified premiums and the premium tax credit. Taxpayers who received advance credit payments must first determine the limit on the additional tax that applies before performing the computations. Taxpayers may use either the (1) iterative calculation or (2) the alternative calculation to compute the Code Sec. 162(l) deduction and the premium tax credit.

In both calculations, a taxpayer's Code Sec. 162(l) deduction is limited to the lesser of: (1) the taxpayer's earned income from the trade or business with respect to which the health insurance is established; and (2) the sum of (a) the specified premiums not paid through advance credit payments, and (b) the limitation on additional tax determined under Reg. Sec. 1.36B-4T(a)(3)(iii). This is referred to as the "Code Sec. 162(l) limit."

Iterative Calculation Method

Under the iterative calculation, the following steps are performed:

Step 1: Determine adjusted gross income, modified adjusted gross income, and household income by taking a Code Sec. 162(l) deduction for the amount of specified premiums after applying the Code Sec. 162(l) limit;

Step 2: Compute the premium tax credit using the adjusted gross income, modified adjusted gross income, and household income determined in Step 1;

Step 3: Determine the Code Sec. 162(l) deduction by subtracting the Step 2 premium tax credit amount from the specified premiums and then applying the Code Sec. 162(l) limit;

Step 4: Compute the premium tax credit using the adjusted gross income, modified adjusted gross income and household income determined by taking into account the Code Sec. 162(l) deduction in Step 3;

Step 5: Repeat Step 3 by substituting the Step 4 premium tax credit for the Step 2 premium tax credit.

Step 6: If changes in both the Code Sec. 162(l) deduction and the premium tax credit from Steps 2 and 3 to Steps 4 and 5 are less than $1, use the Code Sec. 162(l) deduction and premium tax credit amounts for the specified premiums determined in Steps 4 and 5. If the change in either the Code Sec. 162(l) deduction or the premium tax credit from Steps 2 and 3 to Steps 4 and 5 is not less than $1, repeat Steps 4 and 5 (using amounts determined in the immediately preceding iteration) until changes in both the Code Sec. 162(l) deduction and the premium tax credit between iterations are less than $1.

The taxpayer may claim a premium tax credit and Code Sec. 162(l) deduction for the specified premiums equal to the amounts determined under Step 6. If a taxpayer is unable to complete Step 6 because changes between iterations always exceed $1, the taxpayer should not use the iterative calculation method, but may use the alternative calculation method or another method that produces amounts that satisfy the applicable requirements.

Alternative Calculation Method

Under the alternative calculation method, the following steps are performed:

Step 1: Determine adjusted gross income, modified adjusted gross income, and household income by taking a Code Sec. 162(l) deduction for the amount of specified premiums after applying the Code Sec. 162 limit;

Step 2: Compute the initial premium tax credit using the adjusted gross income, modified adjusted gross income, and household income determined in Step 1;

Step 3: Determine the Code Sec. 162(l) deduction by subtracting the Step 2 premium tax credit amount from the specified premiums and then applying the Code Sec. 162(l) limit;

Step 4: Compute the final premium tax credit using the adjusted gross income, modified adjusted gross income and household income determined by taking into account the Code Sec. 162(l) deduction in Step 3.

The taxpayer may claim the amount of the premium tax credit determined under Step 4 and the amount of Code Sec. 162(l) deduction for the specified premiums determined under Step 3.

Example: In 2014, Ann, her husband, and their two dependent children enroll in the second-lowest-cost silver plan, with an annual premium of $14,000. Ann is engaged in a trade or business as a sole proprietor and has household income (before taking into account the Code Sec. 162(l) deduction) of $82,425, which includes $75,000 of earned income derived by Ann from the trade or business with respect to which the health insurance is established. Ann received $10,500 in advance credit payments for the year. Because she received advance credit payments, Ann determines which limitation on additional tax applies and determines that her limitation on additional tax is $2,500. She performs the alternative calculation as follows:

Step 1. Ann determines the Code Sec. 162(l) deduction after applying the Code Sec. 162(l) limit. Her Code Sec. 162(l) deduction is $6,000, the sum of (1) the specified premiums not paid through advance credit payments, $3,500 ($14,000 premiums - $10,500 of advance credit payments); and (2) the limitation on additional tax (determined under Reg. Sec. 1.36B-4T(a)(3)(iii)) of $2,500. Ann's Step 1 household income is $76,425 ($82,425 - $6,000), which is 325 percent of the federal poverty line for a family of four (applicable percentage of 9.5).

Step 2. Ann's initial premium tax credit based on household income of $76,425 is $6,740 ($76,425 x .095 = $7,260; $14,000 - $7,260 = $6,740).

Step 3. Ann computes the specified premiums minus the premium tax credit as $7,260 ($14,000 - $6,740). However, as in Step 1, the Code Sec. 162(l) limit applies so that her Code Sec. 162(l) deduction may not exceed $6,000.

Step 4. Ann's household income based on a Code Sec. 162(l) deduction of $6,000 is $76,425. Ann's premium tax credit based on household income of $76,425 is $6,740 ($76,425 x .095 = $7,260; $14,000 - $7,260 = $6,740).

Ann's allowable Code Sec. 162(l) deduction is the amount determined under Step 3, $6,000, and her premium tax credit is the amount determined under Step 4, $6,740. If Ann chose to use the iterative calculation, the result would be the same. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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