New health care act presents financial issues for both employers and employees

Overview
In recent weeks, much attention has been focused on the individual mandate included in the new health care act. Potentially of equal importance, the law imposes new costs and responsibilities on employers with more than 50 full-time workers. Such employers will be required to provide all full-time employees with minimum amounts of employer-subsidized health insurance, which could cost a typical employer approximately $4,000 per worker, and possibly more (this cost is approximate as explained below).

Alternatively, the employer may pay a penalty of $2,000 for each full-time employee. Section 4980H(c)(7) refers to the penalty as a tax, and makes clear that these $2,000 payments are nondeductible. As a result, for an employer in the 40 percent tax bracket (combined federal and state), the $2,000 nondeductible payment would be equivalent of paying approximately $3,300 of additional wages for each full-time worker.

Except for minimum wage workers and those covered by existing labor contracts, the new mandates and penalties do not require any minimum amount of total employee compensation. The rules only require that the total compensation package, whatever it is, include a minimum amount of employer-subsidized insurance. Thus, there is no health act or tax law prohibition on reducing otherwise applicable cash salaries or benefits to compensate for the added costs of providing health insurance or paying a new per-job penalty to the government. In the case of minimum-wage employees, however, the new mandates and penalties will necessarily increase the payroll costs of employers not currently providing insurance, unless those positions become part-time jobs which are not covered by the new law.

In the long run, because the employer's total payroll costs for each employee will increase, these new requirements could depress the levels of cash compensation paid to employees of companies with more than 50 employees. Such wages may decline or slow their rate of increase. If cash payroll costs for smaller companies are similarly affected in a competitive labor market, the net effect may be a tax subsidy for small companies. That is because the health insurance costs of their employees will be subsidized directly by the taxpayers through refundable tax credits, while large employers will bear those costs themselves.

Illustrative Example
The overall effects of the new health care law can be illustrated by assuming a business with 2,000 employees, each with household income over $100,000 per year and currently receiving a $12,000 health insurance policy for which the employee pays $4,000 and the employer pays $8,000. Because it is assumed that the workers are all married, and that half of them obtain their insurance from their spouse's employer, it is projected that this business currently incurs costs of $4,000 per employee when it pays $8,000 per policy for the half of its employees who elect to be covered under its plan. While the cost of any actual policy would vary based on many factors, the $12,000 total premium cost for the least expensive qualifying health insurance policy appears reasonable in light of the projections of the Congressional Budget Office for health care costs and the rate of medical inflation.

Also assume that the business is considering the creation of a new division that would require the hiring of:

• 50 new workers at a salary of $50,000 per year
• 1,000 new workers at a salary of $22,500 per year
• 1,000 new minimum wage workers at a salary of $14,500 per year

In all cases, assume that the workers have spouses receiving identical salaries at other companies. The following discussion details how those prospective new hires may be affected by the new law.

Higher-wage workers may be unaffected
The new higher-wage workers with wages of $50,000 per year are likely to prefer employer-provided health insurance to additional cash wages because employer-provided health insurance is tax-free and they are in a moderately high income tax bracket. In addition, they have enough disposable income to afford a $4,000 out-of-pocket expenditure for health insurance. Thus, the new health care act may not have any effects on these prospective employees.

Lower-wage workers may face reduced take-home pay
The new lower-wage workers with wages of $22,500 per year – who might typically have positions as retail clerks, sales representatives, hair stylists or manual laborers – might prefer not to purchase the coverage. They may prefer to retain $4,000 of pre-tax wages rather than receive the $12,000 of tax-free insurance coverage. The individual mandate, however, is expected to induce them to elect into the employer's health insurance plan and pay $4,000 per married couple. When fully phased in during 2014, the mandate will assess a penalty on a married couple of approximately $1,400 or more, and the worker and spouse will receive nothing in exchange for the penalty. If an employee decides to reject the insurance and pay the penalty, there will be no further costs or obligations for the employer. This is because the employer has offered insurance costing the employee no more than 9.5 percent of the employee's household income and the employee has declined.

If an employee accepts the insurance the employee's disposable income will automatically decline due to the required payment of the employee's portion of the insurance premium. Without insurance, the employee's household (comprised of two spouses earning the same salary) would face income and social security taxes of approximately $7,000 leaving $38,000 of disposable income. After paying the $4,000 premium through a pre-tax premium payment plan (paid by one spouse or the other), they would be left with $34,000.

The effect on the employer must also be considered. Assuming that these employees would otherwise decline coverage, a decision to elect coverage would increase the employer's average total cost of hiring such workers from $22,500 to $26,500 -- plus, in both cases any FICA or other payroll taxes imposed on the employer. That $4,000 additional cost is attributable to the expectation that approximately half of the new workers will elect to be covered under their spouse's plan. Thus, the added cost of $8,000 per married couple will tend to be shared by both employers. Again, this assumes that none of the employees would have elected coverage before passage of the health care act, but are induced to do so by the individual mandate. In fact, a considerable number of lower wage employees do currently elect such coverage. As a result, this hypothetical may overstate the average increase in employer payroll costs triggered by the health care act and its individual mandate.

These new payroll costs, whatever they ultimately amount to, may affect the employer's business planning. It may seek to pass on the added costs in higher prices. If that is not possible, it may seek to offer the new employees lower cash wages. Remember that the employer will be fully in compliance with the health care act if the new jobs provide only $18,500 of gross cash wages, plus $12,000 of insurance for which the employer pays his required share of the premiums.

The reason that cash wages may decline for this group of workers, but not higher income workers, is that many more members of this group currently tend to decline health insurance, thus saving the employer money and allowing it to provide them with more cash wages. Once these workers are induced (as the legislation intends) by the individual mandate to elect health insurance they previously declined, the total payroll costs for them will increase, and their cash wages may decline or increase less rapidly in the future to compensate.

If wages decline by a total of $8,000 per married couple, an admittedly extreme hypothetical, the employer's required share of insurance premiums would increase slightly due to the decrease in cash wages. Still, an employee with $37,000 of household income could be required to pay $3,515. Thus, the employer's cost per policy would be $8,485 or an average of $4,242 for the half of its workforce that is expected to elect coverage with the employer, rather than obtaining insurance through a spouse's employer.

In the event of such a reduction in pre-tax cash wages the employees' cash flow after taxes and health care would obviously be more severely affected by the health care act. For a married couple with equal wages, the effects are as follows.

Recall that if their cash wages were not reduced and they did not elect insurance coverage they would have approximately $38,000 of after-tax cash. In addition, under the new rules, we assume that only one spouse would purchase an employer's policy. Thus, the total premiums the couple would pay would be $4,000. That would reduce after-tax cash to $34,000.

The next part of the analysis is a little complicated. If each of the employers had half of their employees buying a policy, with the other half obtaining it from a spouse's employer, each employer's insurance costs for those employees would increase by approximately $4,000 per employee. That is $8,000 per policy, divided by two. Again, that is because the cost of covering the workers as family members is shared by two employers.

If cash wages for all of those employees were reduced by the employer's average added insurance costs per worker (either immediately or over time, and perhaps simply by failing to increase cash wages with inflation), the couple's combined gross salaries could decline (in real dollars) from $45,000 to $37,000. That decline is a full $8,000 because there are two employees in the family, each expected to suffer a $4,000 decline in cash wages. After subtracting approximately $5,600 of combined FICA and income taxes, and $3,500 of cash insurance premiums (considering the 9.5 percent of household income maximum employee cost), they would be left with total household take-home pay of $37,000 less $5,600 less $3,500 or approximately $27,900. That is a reduction in their take-home pay from $38,000 (under current law, without any purchase of insurance) to $27,900, a reduction of $10,100. In exchange, however, they would receive the benefit of an insurance policy costing $12,000. Such an extreme reduction could be anticipated only if virtually all of the workers in this category currently decline insurance but are induced to elect it by the individual mandate.

Minimum wage workers may become part-time employees or be outsourced
For the minimum-wage workers, employers cannot reduce hourly cash compensation. In addition, the maximum amount of premiums that can be charged to a worker with household income of $29,000 is $2,750. Thus, the employer's added cost of providing a $12,000 insurance policy for that worker – assuming that half obtain the policy from a spouse's employer -- would be $4,620. No adjustments in cash wages are possible. As a result, this can be viewed as the equivalent of raising each employee's annual salary from $14,500 to $19,120.

Employer Options
One cost-saving option available to the prospective employer of minimum wage employees would be to hire only part-time workers. By limiting its minimum-wage or low-wage workforce to employees working less than 30 hours per week, the requirement to offer subsidized health insurance to those employees (or pay a penalty or tax instead) would be avoided.

For full-time employees, the employer could also choose to pay the per-job penalties instead of providing subsidized health insurance. Paying the penalty, in lieu of providing health insurance, could save some money. There could be added costs, however, to raise the cash wages of higher-income workers losing their health insurance benefits.

The employer could also provide insurance that is deemed "unaffordable" to some of its employees because it requires them to pay premiums greater than 9.5 percent of their household incomes. In that case, the penalty is the lesser of $2,000 per employee ($3,300 salary equivalent) or $3,000 for each employee that obtains subsidized insurance through a state-run exchange ($5,000 salary equivalent). If the employer anticipates that many low-wage or minimum-wage employees will choose not to purchase any insurance, even at the exchanges, then that may be a more cost effective option. However, it should be noted that the required employee payment at the exchanges will be far less than 9.5 percent of household income. Consequently, employees who might not purchase insurance at work might well purchase it at an exchange.

Will employers drop coverage in favor of paying the penalties or taxes?
The Congressional Budget Office (CBO) and Joint Committee on Taxation (JCT) have concluded that very few employers can be expected to drop employer-provided health insurance because the average mix of higher-wage and lower-wage employees makes that uneconomic. That is, if 50 percent of all workers nationwide have family incomes of $90,000 or more and prefer employer-provided health insurance, and 50 percent of such workers have lower family incomes and prefer added take-home cash, and if an employer's work force has the same distribution of higher-wage and lower-wage workers, the cost to an employer of extending health insurance to the lower-wage workers is approximately the same as the cost of eliminating health insurance for the higher-wage workers, paying the penalties or taxes for all employees, and providing higher-wage workers with additional pre-tax cash equivalent to their foregone fringe benefit.

It is not clear how many employees work in companies that actually have workforces similar to what the CBO/JCT consider average workforces. For example, a restaurant chain or retail chain may have predominantly lower-wage workers, while a pharmaceutical company that performs only research in the U.S. and manufactures its drugs overseas may have predominantly high-wage workers. In addition, the CBO and JCT have provided only limited analysis of the likelihood of companies spinning off (or franchising) lower-wage divisions or departments. There are related party rules, and draconian anti-discrimination rules, that limit the ability of commonly controlled or operated entities to be treated as separate employers, but those rules may not apply to a bona fide spin-off or sale of a going concern.

Will employer penalties be increased in the future?
If the CBO and JCT are wrong in predicting that very few employers will drop coverage, the cost to the government of the new subsidies provided at the state-run exchanges will be higher than they have estimated.

Under the new health care act, a two-earner family of four making $45,000 will be eligible for a federal grant of close to $9,500 to help them pay for a $12,000 insurance policy. That is the equivalent of a more than 20 percent raise – in tax-free dollars – paid for entirely by the federal government. Families of four earning as much as $88,000 will be eligible for grants close to $3,500, and those earning only $22,100 will be eligible for grants as high as $11,500. According to the IRS, there are at least 90 million tax returns reporting family income from salaries low enough to be eligible for these subsidies. If only $3,000 were claimed by each such family, the total cost to the budget would be $270 billion. In contrast, the CBO and JCT estimate that only $70 billion of subsidies will be applied for and provided. The gap is evidently attributable to the assumption that very few employers will drop coverage and that most employees of large employers will not utilize the exchanges.

If the cost of the new subsidies is higher than was estimated – because more large employers drop coverage or spin-off or outsource their lower-wage departments or divisions into new companies that fail to provide coverage – Congress may decide to increase the employer penalties either to raise revenue or to induce more employers to offer insurance instead of paying the tax or penalty. For example, increasing the penalty from $2,000 per worker to $3,000 per worker (the equivalent of approximately $5,000 of additional wages) might equalize the costs of maintaining or dropping insurance, even for employers with predominantly low-wage employees. That would tend to reduce the number of workers using the exchanges and the associated revenue costs. Thus, it is not unreasonable to anticipate that the current level of employer penalties may increase.

Congress might also consider reducing the gross costs of the least expensive "bronze" policy employers must purchase, while maintaining the currently mandated level of employer penalties or taxes. If that were done, the costs of providing insurance would more frequently be less than the cost of paying the employer penalties or taxes for not providing insurance.

Effects on small employers
If the JCT and CBO are correct, and only a minority of workers enters the exchanges, and prevailing wage rates continue to be dictated by large employers providing their own health insurance subsidies, the workers who are employed by small employers and receive subsidies from the exchanges may also suffer commensurate reductions in their cash wages.

This is the most intriguing aspect of the legislation. If that occurs, the beneficiaries of the health care subsidies ostensibly provided for individuals may end up being small employers. They may see their labor costs decline as a portion of their employees' total compensation package is effectively paid by the federal government.

Conclusion
As discussed, the new health care law presents significant financial issues that need to be evaluated by both employers and employees. The foregoing is a discussion of some potential effects of this new law. However, each employer and each employee must examine their own unique circumstances before making any decision relating to the new health care law. Thus, the discussion herein is not all encompassing, and each employer and employee should discuss their unique situation with their advisors.

For additional information read our recent insight Supreme Court Largely Affirms Affordable Care Act.

Don Susswein, principal, Washington National Tax
Bill O'Malley, director, Washington National Tax

Disclaimer
The information contained herein is general in nature and based on authorities that are subject to change. McGladrey LLP 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. McGladrey LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. 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.

This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of McGladrey