Oral arguments in California v. Texas will likely occur later this year, which means the Supreme Court will not rule on the case until at least summer 2021. Since the PPACA contains several tax-related provisions, including the 3.8% net investment income tax (NIIT) and the 0.9% additional Medicare tax on earned income, a ruling from the Supreme Court that the PPACA is unconstitutional would have significant implications with respect to taxation. Taxpayers who have paid significant amounts of NIIT and/or additional Medicare tax reported on income tax returns filed within the past three years should consider filing what is known as a “protective claim” in order to preserve their right for a potential refund in the event the Supreme Court rules that the PPACA is unconstitutional.
The NIIT is a 3.8% tax on “net investment income,” which generally includes: (i) capital gain, interest, dividends, certain annuities, royalties, and certain rents (unless derived from a business activity in which the taxpayer materially participates); (ii) income and gains from a business activity in which the taxpayer does not materially participate; and (iii) income and gains from the trading of financial instruments and commodities (whether or not the taxpayer materially participates), in each case subject to exceptions and qualifications in the Treasury Regulations. The NIIT applies to (1) estates and trusts that have undistributed net investment income and adjusted gross income above $12,400 for 2016 (and a similar inflation-adjusted amount for later years, namely, $12,500 for 2017 and 2018, $12,750 for 2019 and $12,950 for 2020), and (2) individuals electing the married filing jointly filing status with adjusted gross income above $250,000 ($200,000 using the single filing status). The additional Medicare tax is an additional 0.9% on wages, salaries, and self-employment income in excess of $250,000 for individuals who elect the married filing jointly filing status ($200,000 using the single filing status).
If the Supreme Court ultimately rules that the PPACA is unconstitutional, a taxpayer who paid the NIIT and/or additional Medicare tax may be entitled to a refund of the tax paid. This would likely affect taxpayers (including trusts, estates and individuals) who earned significant investment income or who are higher-income earners. As noted above, however, the NIIT applies to estates and trusts at a very low threshold (i.e., to any undistributed net investment income and adjusted gross income above just $12,400 for 2016 and a similar inflation-adjusted amount for later years). Tax returns for which the applicable statute of limitations has not expired (i.e., tax returns filed within the past three years) should be reviewed for any previous NIIT or additional Medicare tax assessed. These totals would be reported on Form 8959, line 18 and Form 8960, line 17 (individuals) or line 21 (estates and trusts).
Taxpayers have a limited time to claim a refund of a tax later ruled unconstitutional. Specifically, if a taxpayer paid a tax that they anticipate may be ruled unconstitutional more than three years from the time the return was filed, the taxpayer would need to file a protective claim within the later of (1) three years from the time the return was filed or (2) two years from the time the tax was paid. Therefore, since the Supreme Court’s ruling in California v. Texas will likely occur in summer 2021, taxpayers who, within the past three years, filed their 2016 tax return on extension or timely filed their 2017 tax return or filed their 2017 tax return on extension may want to consider filing a protective claim in order to preserve their right for a potential refund pending the outcome in California v. Texas (i.e., without filing a protective claim for those tax returns, the three-year statute of limitations would likely expire prior to the Supreme Court’s anticipated ruling in California v. Texas in summer 2021). A separate protective claim would need to be filed for each applicable tax year. For 2018 tax returns (and later years), however, the return would not have been filed until 2019 (or later) and will therefore be within the applicable three year statute of limitations to claim a potential refund. In the event the Supreme Court does rule that the PPACA is unconstitutional, a taxpayer would need to then perfect any protective claim previously filed. Perfection is accomplished by filing a complete refund claim with a cover letter explaining the circumstances and furnishing a copy of the filed protective claim and the date the protective claim was filed.
A valid protective claim must meet the following criteria:
- Be received by the IRS or postmarked by the U.S. Postal Service or an approved private delivery service before the expiration of the period of limitations for filing a claim for refund;
- Be in writing and signed;
- Include the taxpayer’s name, address, taxpayer identification number, and other contact information;
- Identify and describe the contingencies affecting the claim (e.g., the potential outcome of the Supreme Court’s ruling in California v. Texas);
- Be sufficiently clear to alert the IRS to the essential nature of the claim; and
- Identify the specific year or years for which a refund is claimed.
If a protective claim is filed on behalf of an estate, the filer (typically the trustee and/or executor) must file an additional written statement affirming the fact that the filer has continuing authority to act in a fiduciary capacity for the estate. In addition, if a protective claim is rejected by the IRS, a corrected protective claim can be refiled before the expiration of the period of limitation or within 45 days after the date of the IRS’s notice of the defect, whichever occurs later.
Ultimately, if the Supreme Court rules the PPACA unconstitutional in California v. Texas, only those affected taxpayers who filed a protective claim for tax returns filed more than three years prior to the Supreme Court’s ruling would be entitled to a potential refund of NIIT and/or additional Medicare tax paid for those tax years.
Should you have any questions on this matter or other wealth, tax and estate planning strategies, please contact a member of Reed Smith’s Private Client Services team.
Client Alert 2020-510
