The Affordable Care Act’s ‘Play or Pay’ Tax: Determining Coverage Alternatives

Journal of Financial Planning: February 2013

Executive Summary

• Financial planners of all levels should be aware of the Affordable Care Act’s “play or pay” tax that takes effect for employers in 2014. This article examines the Act by describing the following six important factors: (1) which employers are subject to the tax, (2) how the tax is triggered for employers not offering coverage, (3) how the tax is triggered for employers offering unaffordable coverage, (4) how to calculate the tax for an employer not offering coverage, (5) how to calculate the tax for an employer offering unaffordable coverage, and (6) whether employers will continue to offer health care coverage or drop coverage and pay their tax liability.
• The paper provides an in-depth analysis to help financial planners aid their clients when making a tough decision about whether to continue to offer employer-sponsored health care coverage in 2014 and beyond. The tax itself can be much less expensive than the cost of offering employer-sponsored health care coverage, but this analysis illustrates that there are several other factors to take into consideration during the decision-making process. Factors to be considered include the cost of increasing employee salaries to make up for the lost benefits if coverage is dropped, employee turnover costs if coverage is dropped, and the cost to employee morale and employee productivity if an employer drops coverage.

Arthur Tacchino, J.D., is an assistant professor of health insurance at The American College. He is a graduate of Widener University School of Law, where he received his J.D. He received his B.S. in economics from Susquehanna University. At The American College, he designed and authored two unique courses on the Affordable Care Act. He also has taught business law and ethics at Widener University.

In 2014, the “Employer Shared Responsibility Tax,” better known as the “play or pay” tax of the Affordable Care Act, will take effect¹. The question that has been looming over employers, and especially their employees, nationwide has been, “Will employers drop their employer-sponsored health care coverage and simply pay the tax penalty for doing so?” Employers have the option of doing this, and sending their employee population to one of the Affordable Insurance Exchanges that have been established under the Affordable Care Act, where health care coverage will be offered to the individual and small group markets². This paper examines which employers will be subject to this new tax, how the tax is triggered, how to calculate potential employer tax liability, and under what conditions some employers will actually drop coverage or keep the employer-sponsored plans that many Americans have grown accustomed to over the past several decades.

Who Is Subject to the Tax?

Under the Act, “applicable large employers” will be subject to the Employer Shared Responsibility Tax starting in 2014. An applicable large employer is any employer that employed 50 or more full-time equivalent employees in the preceding year³. The full-time equivalent employee calculation has been clarified by the IRS for financial planners. First, planners must determine how many full-time employees the employer has each month. Full-time employees include anyone who works 30 or more hours a week⁴. Once the number of full-time employees has been determined, attention can turn to everyone else. Each month the number of hours that are worked by the part-time employees (everyone other than full-time employees) must be aggregated. This aggregated figure is then divided by 120 (established in the Internal Revenue Code). This calculation will give an indication as to the number of “equivalent employees” each month. To this figure is added the number of full-time employees during that month for the final determination of the number of full-time equivalent employees who are employed by the employer⁵. Advisers, planners, human resource agents, and others will need to do this calculation on a monthly basis throughout 2013 to determine the average number of full-time equivalent employees who were employed throughout the year. If this average equals 50 full-time equivalent employees or more throughout 2013, then this employer is considered an “applicable large employer” for purposes of this tax, and therefore may be subject to tax liability starting in 2014.

How Is the Tax Triggered?

Under this new tax, an employer may be subject to tax liability for either not offering the opportunity to enroll in minimum essential health care coverage to their full-time employees and their dependents, or offering the opportunity to enroll in “unaffordable” minimum essential health care coverage to their full-time employees and their dependents. Coverage will be deemed “unaffordable” when either the plan’s share of the total allowed costs of benefits provided under the plan is less than 60 percent of those costs (that is, the plan does not provide “minimum value”), or the required employee contribution for employee-only coverage premiums exceeds 9.5 percent of the employee’s household income (note: the latest regulations change the “9.5 percent of household income” terminology to “9.5 percent of the employee’s compensation”). Minimum essential health care coverage under the Affordable Care Act is defined as coverage that has an actuarial value of 60 percent or higher⁶. An example will help illustrate this.

Example: Assume an individual consumer incurs $10,000 of medical claims during the calendar year. If their health care coverage covers $6,000, and the individual covers the remaining $4,000 through a deductible, co-payments, and coinsurance, then this coverage would be said to have a 60 percent actuarial value. This is an example of coverage that employers will need to offer to their full-time employees and dependents in 2014 if they wish to avoid potential tax liability. The following discussion will look at how the tax liability is triggered for both an employer that does not offer coverage, as well as an employer that offers “unaffordable” coverage.

Triggering the Tax for an Employer Not Offering Coverage. For an employer that does not offer coverage to their full-time employees and their dependents, tax liability will be triggered in any month that an employer meets the following two thresholds:

1. The employer does not offer the opportunity to enroll in minimum essential coverage to their full-time employees and their dependents, and
2. At least one full-time employee is verified as enrolled in a qualified health plan through an Affordable Insurance Exchange and receives a cost-sharing subsidy⁷.

Triggering the Tax for an Employer Offering “Unaffordable” Coverage. For an employer that offers coverage, albeit “unaffordable” coverage, to their full-time employees and their dependents, tax liability will be triggered in any month that an employer:

1. Offers the opportunity to enroll in minimum essential coverage to their full-time employees and their dependents, and
2. At least one full-time employee is verified as enrolled in a qualified health plan through an Affordable Insurance Exchange and receives a cost-sharing subsidy due to the employer-sponsored plan being verified as “unaffordable”⁸.

For an employer who offers “unaffordable” coverage, the tax is more complicated. First, anyone who is offered employer-sponsored coverage is initially ineligible for cost-sharing subsidies through an exchange, unless they can show that the employer-sponsored coverage is unaffordable, in which case they will receive an “affordability waiver” from the exchange⁹. Even if an affordability waiver is granted by the exchange, the individual must still meet the cost-sharing eligibility requirements established within the exchange¹⁰. It is important to note that “unaffordable” coverage is determined in one of the following two ways:

1. If the plan’s share of the total allowed costs of benefits provided under the plan is less than 60 percent of those costs (that is, the plan does not provide “minimum value”), or
2. The required employee contribution toward the premium cost of employee-only coverage exceeds 9.5 percent of the employee’s household income¹¹ (this will be determined using the employee’s compensation rather than household income when the regulations are finalized).

Also note that under the tax, employers are required to offer coverage to their “full-time employees and their dependents;” however, affordability is solely based on the required employee contribution toward the premium cost of employee-only coverage. This means that planners will use only the required employee contribution toward the premium cost of employee-only coverage to determine whether the employer’s plan is affordable under the 9.5 percent threshold test. Either the plan not being of “minimum value” or the 9.5 percent threshold test can cause the tax to be triggered. Both conditions are not required to be met simultaneously to trigger the tax.

Assuming that the tax is triggered, it will be crucial that financial planners understand how to calculate the tax liability for an employer. The penalty tax is calculated differently for employers who do not offer coverage, compared to employers that offer “unaffordable” coverage.

Calculating the Tax for an Employer Not Offering Coverage. The penalty amount for an employer that does not offer coverage in 2014 is calculated as follows:

The penalty tax is equal to the product of the “applicable payment amount” and the number of full-time employees employed by the employer (less a 30-employee reduction that is statutorily authorized) of full-time employees during the month. The “applicable payment amount” for 2014 is $166.67 with respect to any month¹².

It is important to note that while determining whether an employer is subject to the tax, financial planners should use the number of full-time equivalent employees; however, the penalty amount is calculated using only the number of actual full-time employees (those working 30 or more hours a week).

Example: XYZ Inc. has 100 full-time employees in January 2014. Assume that the company has dropped its employer-sponsored health care coverage, and it has been determined to be an “applicable large employer,” therefore it may be subject to the tax. Assuming that the tax is triggered, meaning that at least one full-time employee has received subsidized coverage through the exchange, the tax is calculated as follows:

(100 full-time employees – [30 authorized 30-employee reduction]) × $166.67 = $11,666.90 estimated monthly tax liability

Assuming the number of full-time employees remains the same throughout the year, and assuming the tax is triggered each month, then the yearly tax liability is projected to be:

$11,666.90 estimated monthly tax liability × 12 months = $140,002.80 estimated annual tax liability

It is important to note that any penalty tax that is paid by an employer will not be deductible for tax purposes. This is a significant factor to consider when comparing the after-tax cost of offering employer-sponsored coverage to the cost of the estimated penalty amount.

Calculating the Tax for an Employer Offering “Unaffordable” Coverage. As stated above, the tax liability is calculated differently for an employer that offers “unaffordable” coverage. For an employer that offers “unaffordable” coverage, assuming the tax is triggered, the tax is calculated as follows:

The penalty tax is equal to $250 multiplied by the number of full-time employees for any month who receive premium tax credits or cost-sharing assistance (this number is not reduced by 30) through an exchange. This penalty tax is capped at an overall limitation equal to the maximum tax that an employer that is not offering coverage would have to pay¹³.

Example: ABC Inc. offers its employees coverage in 2014. It is determined that it is an “applicable large employer,” therefore it may be subject to tax liability. Ten of its employees are being offered “unaffordable” coverage because they are required to contribute more than 9.5 percent of their household income (this will be determined by the employee’s compensation when regulations are finalized, because the Internal Revenue Service has argued that employers would not be aware of an employee’s household income and may struggle to obtain this information) for employee-only coverage. These 10 employees verify this with their exchange and receive an “affordability” waiver. It is then verified that they are eligible for a cost-sharing subsidy (meaning that their household income is below 400 percent of the federal poverty level), so they enroll in subsidized coverage through a qualified health plan within the exchange. ABC Inc.’s estimated tax liability is as follows:

10 employees who received subsidized coverage × $250 penalty amount = $2,500 estimated monthly tax liability

Assuming the same number of full-time employees trigger the tax liability each month, the estimated annual tax liability is:

$2,500 estimated monthly tax liability × 12 months = $30,000 estimated annual projected tax liability

It is important to note that this tax liability, which is not tax deductible, will be paid in addition to whatever it may cost the employer to offer the “unaffordable” employer-sponsored coverage.

The Issue and the Analysis

Now that basic facts have been established regarding to whom the tax applies, how the tax is triggered, and how to calculate the tax, it is time to address the bigger issue that was mentioned at the outset of this paper: which employers may be more likely to drop their employer-sponsored health care coverage and simply pay the tax liability for doing so? National surveys conducted by various organizations and entities have given mixed results to this question. Studies suggest that anywhere from 8 percent to 30 percent of employers will likely drop coverage in 2014 and beyond¹⁴.

Advisers and planners must understand the proper analysis that needs to be undertaken before an employer makes a decision about their employer-sponsored health care coverage. When the employer begins to make this decision there are many factors they must consider. The first, and most obvious, factor to consider is cost. What does it cost the employer to offer their employer-sponsored coverage? At first glance, most employers will notice the cost of offering coverage will be significantly greater than the cost of paying the estimated penalty tax liability. An example will help illustrate this.

Example: Consider again the example of the fictitious employer XYZ Inc. that was used previously in this paper. Assume XYZ Inc. offers employee only, employee plus spouse, employee plus dependent, and family coverage at the following annual premium levels.

• Employee only coverage annual premiums = $5,400
• Employee plus spouse coverage annual premiums = $6,600
• Employee plus dependent coverage annual premiums = $7,200
• Family coverage annual premiums = $10,000

Now assume the following employer contributions to these tiers of coverage:

• Employer contribution to employee only coverage = 80 percent
• Employer contribution to employee plus spouse coverage = 70 percent
• Employer contribution to employee plus dependent coverage = 65 percent
• Employer contribution to family coverage = 60 percent

Assume the following enrollment figures for the employer (remember that XYZ Inc. has 100 full-time employees):

• Employees enrolled in employee only coverage = 25
• Employees enrolled in employee plus spouse coverage = 15
• Employees enrolled in employee plus dependent coverage = 15
• Employees enrolled in family coverage = 20
• Employees not enrolled in any employer-sponsored plan = 25

Based on these assumptions, it would cost XYZ Inc. $367,500 to pay the cost of its health care coverage.

• Cost of employee only coverage: $108,000
• Cost of employee plus spouse coverage: $69,300
• Cost of employee plus dependent coverage: $70,200
• Cost of family coverage: $120,000

Total Cost of Coverage: $367,500

It is important to remember that this cost is deductible to the employer. Assume that the employer’s marginal tax rate¹⁵ is 25 percent. The estimated after-tax cost of coverage for the employer is calculated as follows:

(1 – .25 marginal tax rate) × $367,500 = $275,625 (after-tax cost of coverage)

This is now compared to the potential tax liability that XYZ Inc. faces if they drop coverage, which is:

$140,002.80 (estimated annual tax liability) versus $275,625 (estimated annual after tax-cost of coverage)

While this may seem enticing and quite frankly easier to the employer, the analysis cannot and should not end just yet. Other factors and questions that financial planners and other advisers must present to their clients include:

• What will dropping coverage do to employee recruitment?
• What will dropping coverage do to employee retention/turnover?
• What will dropping coverage do to employee morale/productivity?
• If coverage is dropped, will the employer increase employee salaries to make up for loss of benefits?

For many of these questions, there may not be a way to associate a monetary value with the response. However, for some of these questions, a financial planner can do just that. For example, a planner can ask an employer what is the expected increase to employee turnover if employer-sponsored coverage is dropped? Using just an average cost of turnover by industry (assuming no more accurate data is available that may be specific to the employer) and the expected increase to employee turnover, the employer and adviser can determine how much increased employee turnover, caused by dropping coverage, may cost the employer that elects to drop coverage.

Example: In this example it is assumed that XYZ Inc. is in the manufacturing industry. The firm employs 100 full-time employees in 2014. Management decides that in 2014 they will drop coverage and pay the tax liability under the “play or pay” tax. Further assume that the average cost of employee turnover in the manufacturing industry is roughly $8,000¹⁶, meaning it would cost the employer $8,000 to replace one full-time employee. Now assume an estimated 10 percent increase to employee turnover due to the employer dropping their health care coverage¹⁷.

Based on these two assumptions, the cost of employee turnover associated with dropping coverage for XYZ Inc. would be $80,000 ((10 percent increased employee turnover × 100 full-time employees) × $8,000 average cost of employee turnover). This may be considered a tax deductible employer business expense, therefore the estimated after-tax cost of employee turnover is $60,000 ((1 - .25 marginal tax rate) × $80,000 cost of employee turnover). In addition to the cost of employee turnover, if the employer is considering increasing employee salaries to compensate for the loss of benefits to the employee, the adviser and employer can determine what this additional cost may be.

Example: Continuing with the XYZ Inc. example, assume that the employer would consider increasing their annual full-time employee salaries by $2,000¹⁸ to make up for the loss of health care coverage. Assuming they will replace any full-time employees they lost to the increase in turnover due to dropping coverage (presume the same turnover as shown in the example above, even with a $2,000 salary increase), and an increase of $2,000 for each full-time employee, the cost of increased employee salaries would be estimated at $200,000 (100 full-time employees × $2,000 increase in employee salary). Increased employee salaries also will be tax deductible for the employer, which will result in an estimated after-tax cost of increased employee salaries of $150,000 ((1 - .25 marginal tax rate) × $200,000 cost of increased employee turnover).

Using the amount of projected penalty tax ($140,002.80 estimated annual tax liability), estimated cost of employee turnover ($60,000 after-tax estimated cost of employee turnover), and estimated cost of increased employee salaries ($150,000 after-tax estimated increased cost of employee salaries), the adviser can give the employer a much more informative matrix to the decision-making process associated with dropping employer-sponsored health care coverage and dealing with the Employer Shared Responsibility Tax of the Affordable Care Act.

A cost comparison matrix is shown in Table 1. This table does not include the costs associated with decreased employee morale and productivity, which may not be as easy to calculate because age, demographics, the overall health of the employee population, and other factors may dictate the value of the employer-sponsored coverage. What most advisers and employers will find is that the cost of dropping coverage will be much closer than they think compared to the cost of continuing to offer employer-sponsored coverage, and in some cases, it may be even more expensive to drop employer-sponsored coverage.

So, before any financial planner leads a client to believe that dropping coverage is easier, smarter, and/or cheaper, it is first essential to make sure that a proper and thorough analysis is conducted. This will require in-depth discussion with the employer to fully understand what financial impact dropping employer-sponsored health care coverage may have on the firm and its employees.

Endnotes

1. Internal Revenue Code § 4980H as amended by the Affordable Care Act.
2. Patient Protection and Affordable Care Act, Pub. L. No. 111-148, § 1311(b)(1) (2010) (PPACA).
3. Internal Revenue Code § 4980H(c)(2)(A).
4. Internal Revenue Code § 4980H(c)(4)(A).
5. Internal Revenue Code § 4980H(c)(2)(E).
6. Code § 5000A(f)(1).
7. Internal Revenue Code § 4980H(a).
8. Internal Revenue Code § 4980H(b)(1).
9. Internal Revenue Code § 36B(c)(2)(C); PPACA, Pub. L. No. 111-148, § 1402(f)(2) (2010).
10. 45 CFR § 155.305(f).
11. Internal Revenue Code § 36B(c)(2)(C); PPACA, Pub. L. No. 111-148, § 1402(f)(2) (2010).
12. Internal Revenue Code § 4980H(a).
13. Internal Revenue Code § 4980H(b)(2); Code § 4980H(c)(2)(D)(i)(II).
14. Mercer and McKinsey have conducted separate studies regarding the impact that health care reform has had and will have on employers. Mercer conducted their National Survey of Employer-Sponsored Health Plans (June 2011). In this survey, 8 percent of respondents said that they were very likely or likely to drop health care coverage in 2014 and beyond. www.mercer.com/press-releases/1421820. McKinsey conducted the Employer Survey on US Health Care Reform (February 2011) in which 30 percent of respondents said they would likely drop health care coverage. www.mckinsey.com/features/us_employer_healthcare_survey.
15. In addition to the tax deduction the employer receives for the cost of coverage, they also avoid the 7.65 percent payroll tax on the compensation the employee contributes to the employer-sponsored health care plan. This is another factor planners may consider when tackling this issue.
16. This $8,000 cost of employee turnover is fictitious. There are many factors that can affect the cost of employee turnover; human resource professionals use several different methods in determining this cost.
17. The estimated 10 percent increase to employee turnover due to dropping coverage is also fictitious. There does not seem to be valid data regarding the expected increase to employee turnover if employer-sponsored health care coverage is dropped.
18. A $2,000 increase to employee salaries is a random assumption in this example. The actual increase can be much less or much more depending on how the employer wishes to handle the situation.