2024 healthcare tax planning guide
There have been extraordinary stresses on healthcare systems, from the pandemic to chronic labor shortages, but that has been accompanied by growth and public goodwill. Now more than three years on, those impacts may have changed healthcare permanently, with new expectations, opportunities and models for delivering services.
Staffing shortages continue as the numbers of new medical school students are still well short of what is needed in the industry. Widespread macroeconomic concerns also have implications for both for-profit and non-profit health systems. High interest rates, and the persistently high inflation contributing to them, are affecting investment and financing decisions. Recent tax changes are only making the issue worse for for-profit health companies.
Our guide to tax planning for the healthcare industry lays out many of these challenges. For instance, taxpayers now face a stricter limit on the ability to deduct interest expense, just as we hit the highest interest rates in years. On top of that, healthcare organizations now must generally capitalize and amortize their research costs over five years. In addition, bonus depreciation fell to 80% for property placed in service this year, meaning healthcare organizations can no longer fully expense investments in new equipment.
“Healthcare companies should analyze the provisions together,” said Grant Thornton National Managing Principal of Healthcare David Tyler. “They can interact with each other and other items on the tax return in meaningful ways. Modeling is key both to identify planning opportunities and understanding the impact on investment and financing decisions.”
Tax-exempt and for-profit healthcare companies should anticipate increasing regulatory scrutiny. The IRS has an unprecedented $60 billion in special funding that it’s planning to use to step up enforcement efforts. Nonprofit hospitals will not escape the spotlight. Lawmakers from both parties and chambers have followed up on a raft of negative press to accuse nonprofit hospital systems of failing to provide enough community benefit. States are also aggressively looking for revenue, putting pressure on economic nexus determinations and management services agreements.
“The IRS now has plenty of enforcement funding now to target both for-profit and non-profit healthcare systems,” said Grant Thornton Healthcare Tax Leader Mary Torretta “The IRS is under increasing pressure to the community benefit standard claims a Schedule H on Form 990.”
The good news is there are opportunities for all organizations. The research and development (R&D) credit remains a powerful incentive for for-profit entities, while the new more generous energy incentives are available for all taxpayers.
“It’s never been more economical to pursue renewable energy or efficiency energy projects,” said Torretta. “The energy savings plus the tax incentives create offer significant returns, especially with organizations with ESG goals. Even better, Congress specifically wrote the legislation so tax-exempt healthcare entities can claim the credits as refundable payments.”
As 2023 closes and the new year begins, it’s an ideal time for healthcare organizations to assess their investment plans and identify key tax planning considerations.
Capital and research considerations
Deductions and investments
For for-profit healthcare organizations, three major changes in tax law over the last two years have broadly affected the tax treatment of capital and research spending and the debt used to finance it:
- Section 174: For tax years beginning in 2022 and later, domestic R&E costs under Section 174 must now be amortized over five years instead of being expensed. Since a mid-year convention must be used, this effectively reduced the deduction for these domestic R&E costs in 2022 by 90%. Foreign R&E must be amortized over 15 years.
- Section 163(j): The deduction for net interest expense is generally limited to 30% of adjusted taxable income under Section 163(j). Previously, adjusted taxable income was similar to earnings before interest, taxes, depreciation and amortization (EBITDA). For tax years beginning in 2022 or later, depreciation and amortization must be included, lowering adjusted taxable income to an amount similar to EBIT.
- Bonus depreciation: Property placed in service this year can no longer be fully expensed and is instead eligible only for 80% bonus depreciation, with the rest of the cost recoverable over the normal depreciable period. This treatment is scheduled to decrease over time, with the bonus rate dropping to 60% for property placed in service in 2024, 40% in 2025, and 20% in 2026. Bonus depreciation is scheduled to disappear entirely in 2027.
Many healthcare sectors hesitated to address these changes in the hope that Congress would reverse them legislatively. Most taxpayers were finally forced into implementation when filing 2022 returns, so companies should have completed the significant work of identifying R&E costs under Section 174 and applying the new interest limit. Now is the time to look at more proactive planning. There may be one last chance for lawmakers to provide retroactive relief before the end of this year, so watch out for potential legislation.
“Healthcare often requires significant capital spending on the latest technology,” said Tyler. “Losing bonus depreciation can be painful, especially as it gets more expensive to finance investments. Planning for the tax consequences is essential.”
High interest rates have proven frustratingly resilient and the limit under Section 163(j) could affect healthcare systems using debt to finance expansions in services and technology. Companies facing a cap on their interest deduction may have opportunities to instead allocate interest to the research and development, production, construction or acquisition of a wide range of tangible and intangible property. Once recharacterized to another asset, the interest becomes part of the cost of that asset and is recovered using the accounting method applicable to that item. For example, if interest is recharacterized to a fixed asset, it would be recovered through depreciation deductions. See our previous article for a more detailed discussion.
Section 174 is also a significant issue, especially for healthcare groups developing software, which must generally be capitalized under Section 174. The IRS released important guidance on how to apply these rules just weeks before returns were due for many calendar-year corporations. The guidance offered important insight into how the IRS views the scope of what’s included in software development, but some uncertainty remains. The IRS may offer additional rules to help taxpayers identify and segregate software costs that are still deductible as maintenance rather than an upgrade or enhancement.
For now, taxpayers should analyze the new rules, which are proposed to be applicable for tax years beginning after Sept. 8, 2023. Some of the rules provide favorable results, while others could present challenges and compliance burdens.
With bonus depreciation shrinking to 80% this year and 60% next, it’s worth looking at opportunities to accelerate deductions for fixed assets. An analysis to identify costs that can be considered “repairs” has always been valuable when looking at structural property that doesn’t qualify for bonus depreciation. With bonus depreciation at 60% next year, this repairs analysis could also now significantly accelerate the cost recovery of other types of property. Healthcare groups can also consider a broader cost segregation analysis, which identifies costs eligible for recovery as property with a shorter depreciable period. This effort can be paired with Section 163(j) planning to accelerate the recovery of any related interest expense.
R&D credit
For profit healthcare companies shouldn’t overlook the R&D credit, particularly as the industry shifts to embrace telehealth, launch new platforms, and implement more sophisticated software solutions.
The credit is actually more valuable with the new requirement to amortize R&E costs under Section 174 because many companies discovered they had qualified activities for which they had never taken the credit previously because they had not identified the research activities. Additionally, some taxpayers may no longer need to reduce either their R&D credit or the amount recovered under Section 174.
Section 280C(c) long required taxpayers to reduce their deductions under Section 174 by the amount of any R&D credit, or to reduce the R&D credit by the tax effect. The Tax Cuts and Job Act amended Section 280C(c) so taxpayers only need to reduce their capital account for future Section 174 expenditures to the extent that any R&D credit exceeds the deduction for those costs. For many healthcare groups, the deduction will exceed the R&D credit, meaning they can claim the full R&D credit without any reduction in the ability to recover Section 174 costs. Taxpayers should monitor this issue, however, as the IRS has not yet issued any guidance on interpreting the new statutory language.
The IRS scrutiny of the R&D credit underscores the need for taxpayers to properly document and substantiate their R&D credit claims. The IRS has won several recent cases based on the failure of taxpayers to establish that “substantially all” of all the development activities constituted elements of the process of experimentation or that there was not sufficient uncertainty from the outset.
Healthcare groups should consider an R&D credit study. Some of the taxpayers who lost recent cases could potentially have preserved partial credits under the “‘shrink-back rule’” if they had provided the documentation to apply their analysis to subcomponents of a project that the court’s found did not qualify as a whole. Healthcare groups should consider a full R&D credit study that not only maintains detailed records to the extent available, but also explores whether there are missed opportunities in areas identified by the need to capitalize Section 174 expenditures.
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Other taxation challenges
State and local tax
State taxes are increasingly becoming a top concern for all healthcare organizations. States looking for new revenue sources are aggressively targeting service providers.
“States are also closely scrutinizing management services agreements common in healthcare practices and other industries. A refreshed transfer pricing analysis for these arrangements can often uncover opportunities and mitigate risk.”
As we move farther from the 2018 decision in South Dakota v. Wayfair, states continue to push the envelope with economic nexus provisions requiring sales and use taxes on services and licensing. Sales and use taxes are growing increasingly complex with the interplay between various states and evolving nexus rules.
Many states are also looking at applying economic nexus concepts and unique sourcing rules to income and gross receipts taxes. In certain cases, such laws could require healthcare service providers to recognize revenue based on where the production costs for the services take place. This is a particularly relevant issue as COVID-19 created new opportunities for healthcare organizations to source and provide services remotely.
“States are also closely scrutinizing management services agreements common in healthcare practices and other industries,” Torretta said. “A refreshed transfer pricing analysis for these arrangements can often uncover opportunities and mitigate risk.”
Property taxes are also often a very large cost for an industry with such a large physical footprint. These taxes, generally based on formulas that consider the value of property, can be notoriously sensitive to inflation. Commercial property values took a big hit at the outset of the pandemic, but with people returning to cities to work at least part of the time, and a reimagination of what work could look like post-pandemic, these values are again increasing. Some of the increases may not be supportable. Healthcare organizations have a right to challenge valuations, and a property tax assessment can uncover significant savings.
Technology transformation
Tax departments at both for-profit and nonprofit healthcare organizations are under tremendous pressure to do more with less. Tax laws are changing at a historic pace, while a volatile economic climate is driving major business changes. Tax accounting and compliance together require significant investments in resources, and the tax industry is not immune to widespread workforce shortages.
There may be opportunities to dramatically improve both efficiency and product. Many tax departments at even the most sophisticated organizations are still dedicating most of their time to basic number crunching and repetitive processes. Tax functions may rely heavily on Excel spreadsheets, experience poor or nonexistent integration between data sources and workpapers or employ redundant data gathering for different uses.
“Automation and data transformation and analytics could be the solution,” said Tyler. “Healthcare organizations could benefit from an analysis of their processes and functions to understand where they have weaknesses and risks.”
The difference between manual data preparation and automation can be seconds versus hours. Automated tax engines and tools can drive startling efficiencies for managing income taxes as well as indirect taxes like value added taxes and sales and use taxes.
Automated data transformation and analytics can also be a valuable tool for all tax types, including income tax and provisions preparation, sales and use taxes, and property tax. Once data is prepared, visualization can help businesses see into the data and manage the tax function by noting exceptions and anomalies, instead of hunting for the story manually. This can help tax departments prepare data in a faster, better way for tax deliverables, audit support, reports and presentations. It drives efficiency in the process, accuracy and risk reduction in reporting, and immediate visibility into the tax and finance functions of the business.
Public stock byback tax
Public healthcare companies face a new 1% excise tax on the fair market value (FMV) of stock repurchases beginning in 2023. The IRS is still working on guidance, but has said the tax will be remitted and reported annually with the Form 720 for the first quarter after the end of the tax year. This means the 2023 tax and form will likely be due for calendar-year taxpayers by April 30, 2024. Healthcare companies that will be affected need to move quickly to understand the impact.
The tax applies to corporations with stock traded on an established securities market, which includes corporations with stock that is traded on a national securities exchange. The tax may also apply to certain acquisitions of a foreign corporation’s stock. A repurchase is defined for this purpose as a redemption under Section 317(b), plus “economically similar” transactions. The tax could increase costs on many kinds of common stock redemption activity, including redemptions related to M&A and stock compensation plans. The new excise tax is not deductible for income tax purposes.
Under initial guidance from the IRS, the tax will cover a variety of corporate transactions, including acquisitive reorganizations, certain E and F reorganizations and exchanges in some split-off transactions. The tax can also apply to redemptions of non-publicly traded stock, such as preferred stock, if the corporation has other stock traded on an established securities market.
There are important exceptions and exclusions. Stock issued effectively reduces the amount considered repurchased for purposes of calculating the tax. There are specific rules for determining the FMV of stock issued and repurchased. In addition, the following repurchases are excluded:
Public stock buyback tax
- Reorganizations within the meaning of Section 368(a) where no gain or loss is recognized
- Repurchases to the extent that stock is contributed to an employer-sponsored retirement plan, employee stock ownership plan, or similar plan
- If the aggregate FMV of stock repurchased in a year does not exceed $1 million
- Repurchases by a dealer in securities in the ordinary course of business
- Repurchases by a regulated investment company (RIC) or a real estate investment trust (REIT)
- To the extent that a repurchase is treated as a dividend
Planning for the tax is important. Different types of transactions can be treated differently under the current guidance. Some M&A transactions can give rise to a large increase in a tax base if they are recharacterized as a repurchase, so the tax should be considered as part of transaction planning and structuring. Because stock issued by a corporation may offset stock repurchases during the year, companies should consider the timing of repurchases related to their stock issuances. Any excess of stock issuances cannot be carried forward and used against stock repurchases in future years.
More scrutiny, more opportunity
IRS enforcement
The healthcare industry should expect elevated scrutiny from the IRS over the next few years. The Inflation Reduction Act provided the IRS with $80 billion in new funding and over 50% is earmarked for enforcement. The debt limit deal included a handshake agreement to reallocate $20 billion of that money to other spending priorities, but $60 billion is still a staggering sum compared to normal IRS funding. It represents more than four years of annual appropriations based on recent IRS funding levels and it comes on top of regular annual funding with no restrictions on when it can be spent.
The increased enforcement may come more quickly than some taxpayers expect. The IRS has already significantly expanded its workforce in the last two years and is actively recruiting 3,700 new auditors. Much of the activity will be focused on partnerships, but all entities have seen a dramatic decrease in audit rates over the last several years and should expect more activity.
Tax-exempt hospitals must generally report the community benefits they provide on Form 990 Schedule H. Lawmakers from both chambers have accused tax-exempt hospitals of not providing enough community benefits. The Senate Health Education and Labor and Pensions Committee released a critical report, and Senate Finance Committee members from both parties wrote to the IRS commissioner accusing tax-exempt hospitals of failing to provide enough “essential care in the community for those who need it most.” The IRS often responds to pressure from Congress so expect the IRS to be focused on this issue in the coming years.
Energy credits
Investment in energy projects has exploded with the more than $500 billion in incentives offered by the IRA. It’s never been more economical for healthcare organizations to pursue renewable, conservation, and efficiency improvements, especially for healthcare organizations with ESG goals.
“When you add the energy cost savings together with the tax benefits, it makes a compelling case,” Torretta said. “Even better, all healthcare organizations can benefit regardless of whether they’re in losses or tax-exempt.”
Tax-exempt entities can claim most of the credits as refundable payments. For-profit companies can claim the credits against tax, or if they have no tax, sell the credits to an unrelated party for cash. The ability to sell credits is a novel concept in the federal space, and the market will be large and active. There are significant restrictions on transfer transactions that can limit flexibility and create risk. Buyers and sellers will need to manage risk with indemnification clauses, insurance, and documentation to support the credit claim.
The credits for energy incentives most likely to benefit healthcare organizations include:
- Investment tax credit: Section 48 generally provides a credit of 30% for investments in projects that generates electricity, including solar, wind, and geothermal. Projects will generally be exempt from prevailing wage and apprenticeship rules unless they exceed 1 megawatt. There are also 10% bonus credits for domestic sourcing and for projects in specific geographic areas. Qualifying properties have also been expanded to include dynamic glass, energy storage, microgrid controllers, and interconnection property. With the credit, microgrid and battery storage can be competitive with backup generator systems. Solar investments can also provide a healthy return.
- Qualified commercial clean vehicle credit: Healthcare systems with vehicle fleets can consider credits under Section 45W for plug-in electric vehicles. The commercial vehicle credit doesn’t suffer from the same stringent new battery and mineral sourcing requirements that are imposed on the consumer credit. The credit offers 30% against the cost of the vehicle (15% if it is a hybrid with an internal combustion engine), but is limited to the incremental cost over a similar gasoline-powered vehicle. For cars, trucks, and vans under 14,000 pounds, the credit will generally be capped at $7,500. Vehicles exceeding that threshold can be eligible for a credit of up to $40,000. The credit is fully refundable for tax-exempt entities.
- EV charging: Healthcare systems greening their fleet or looking to encourage electric vehicles can claim a 30% credit of up to $100,000 per charging station installed. The credit if refundable for tax-exempts, but is only available limited to property placed in service in non-urban census tracts and census tracts eligible for the new markets tax credit.
- Building design incentives: Section 179D provides for an immediate deduction for energy-efficient HVAC, lighting and building envelope property such as windows and roofing. It offers as much as $5 per square foot to reward the construction of energy-efficient commercial buildings and is available for energy-efficient ground-up construction and energy-efficient retrofits of older buildings. The credit requires certification using specialized software. Tax-exempts can allocate the deduction to a designer or architect, usually in exchange for consideration toward the cost of the project.
Next steps
Healthcare organizations facing the previously described tax planning challenges should make sure they’re addressing all of them and seizing any planning opportunities. As companies close out 2023 and head into 2024, it’s the ideal time to reassess business plans now and consider their tax implications. Waiting can be costly.
Often, healthcare organizations can benefit from the input of a third-party advisor familiar with these issues and their applicability in the healthcare sector.
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