Recent legislation may require tax accounting adjustments in Q1-2010

ASC 740 (formerly FAS 109) requires that changes to deferred taxes attributable to a change in tax law must be recorded in the interim period in which the new law is enacted. This Alert highlights several provisions of the new legislation that could affect a company's forecasted tax rate or require a company to re-measure their deferred taxes in Q1 of 2010.

Elimination of tax deduction for Medicare Part D subsidy

Currently, companies that offer retiree prescription drug insurance may receive a government subsidy. The subsidy is equal to the value of the benefit provided that equals Medicare Part D coverage. Prior to the new legislation, a company could deduct the entire cost of retiree prescription coverage even though it received a subsidy for some part of its expense. The new legislation disallows (after 2012) a tax deduction for the amount of the retiree prescription cost equal to the subsidy received.
Many companies have substantial deferred tax assets on their balance sheet for the future tax deduction of retiree medical expenses. These companies will need to reduce the deferred tax asset with a charge to the tax provision for the tax effect of the amount of federal subsidies they expect to receive in 2013 and later. For example, a company that expects $100 of future retiree medical expenses, with a $28 government subsidy, would currently establish a deferred tax asset for the future deduction of $100. Because of the law change, this company would need to take a tax provision charge to write-off $28 which will no longer be deductible.

News reports have estimated that companies nationwide would need to take a $14 billion hit to their financial statements this quarter to reflect the elimination of this future tax deduction.

Limitation on deductions for compensation paid to certain health insurance
provider employees

The new legislation limits the tax deduction for compensation paid to certain employees of a “covered insurance provider” to $500,000 per year.

This limitation can increase effective tax rates for health insurance companies in a similar manner as does the $1 million limitation that currently exists on compensation to executives of public companies. One significant difference is that the limitation on health insurance employee compensation applies to deferred compensation. Although this change is effective for payments made in taxable years beginning after 2012, the provision also applies to deferred compensation earned beginning in 2010 which is paid after 2012. Companies normally establish deferred tax assets for deferred compensation which is accrued in the current year but will be deductible in a future period. This limitation will create a permanent tax difference related to any non-deductible portion of deferred compensation.

Public companies must forecast their full-year effective tax rate for purposes of determining the Q1 tax provision. Therefore, if deferred compensation is accrued in 2010 for which no future tax deduction will be allowed, a company must take into account the permanent tax impact that this limitation will have on its 2010 forecasted effective tax rate.

Therapeutic project tax credit

Companies with fewer than 250 employees are eligible for a tax credit for qualified investments made in acute and chronic disease research during 2009 or 2010. The credit equals 50% of the qualified investment. The Department of the Treasury, in consultation with the Department of Health and Human Services, will award certifications of eligibility for this credit.
Companies who plan to amend or file their 2009 tax returns to take the benefit of this tax credit must establish a tax receivable for this credit in Q1 of 2010. In addition, companies that expect to benefit from this credit in 2010 must take the tax benefit into account in calculating their 2010 forecasted effective tax rate.

Credit for small businesses providing employee health coverage

Businesses with fewer than 25 employees and average annual wages of less than $50,000 which offer health insurance coverage to their employees will be eligible for a tax credit to help offset the cost of health insurance. The provision is effective for amounts paid or incurred after 2009. The amount of the credit is a sliding scale of up to 35% through 2013. In 2014 and later, eligible small employers who purchase coverage through the Insurance Exchange will be eligible for a tax credit for two years of up to 50% of their contribution.

Although this will not affect most public companies, any public company that does expect to use this benefit should take the credit into account when calculating its 2010 forecasted effective tax rate.

Codification of economic substance

The health care reform legislation codifies the economic substance doctrine, under which transactions undertaken by a business are only respected if they have legitimate non-tax business purposes and have a non-tax economic impact on the taxpayer. This provision is effective for transactions entered into after the date the legislation became law and imposes severe penalties for understatements of tax.

Companies should take into account the new economic substance codification when evaluating transactions under ASC 740-10 (formerly FIN 48) for possible uncertainty in tax benefits.