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What taxpayers should know about protective claims for possible ACA tax refunds

Many taxpayers enjoy receiving a tax refund. Largely, refunds result from the overpayment of income taxes through payroll tax withholding and/or quarterly tax estimates for any particular year. 

Another reason that tax refunds occur is because of retroactive changes to law. Tax returns are filed early in the first quarter following the close of the prior year, and bam! Congress continues to make sausage in the ensuing months and says the resulting recipe applies to the prior year; the rules change, and taxpayers then have to file amended returns to capture the savings if the refund value outweighs the filing cost. These rule changes can affect business or individual returns.

The third cause for tax refunds is tax rule changes resulting from court challenges of laws and how they apply to unique taxpayer situations. The wheels of justice grind slowly—it may take years to settle issues that affect how taxpayers report income and expenses in returns from prior years.

There is a statute of limitations that prevents taxpayers from filing amended returns older than three years as contested laws are sorted out. In general, this means three years from the date the return was filed, or two years after the date the tax was paid, whichever is later.

Taxpayers have an avenue of relief from refund denial resulting from the statute of limitations closing. If a taxpayer is aware of litigation or a pending law change that would be to her advantage, she can formally notify the Internal Revenue Service (IRS) before the deadline for return amendment. Notification of the IRS is called a “protective claim.” By filing a protective refund claim, the taxpayer is basically saying, “if the litigation resolves in my favor, I will be filing an amended return and asking for a refund despite the fact that the statute of limitations has passed.”

Currently, a case before the Supreme Court exemplifies why making a protective claim can be an important action. California v. Texas is the latest challenge to the Affordable Care Act (ACA) to rise to the Supreme Court, with the Justices expected to hear testimony starting on November 10. The Justices’ decision is not expected until sometime in spring 2021, perhaps as late as the end of the court’s term in June 2021.

Enacted in 2010, the ACA included several new taxes to help pay for the healthcare system expansion and patient insurance coverage. If the Supreme Court finds against the ACA, and the entire act is deemed unconstitutional and vacated, the taxes carved out within it will also be neutralized. Furthermore, if the court rules that the taxes should never have applied, taxpayers will be able to ask for refunds of taxes for the most recent years in which they applied.

The taxes particularly impact higher-income taxpayers. They commonly apply when taxpayer income includes investment gains and the taxpayer’s adjusted gross income (AGI) exceeds the threshold amounts, resulting in additional tax assessment.

The ACA-related taxes include:

  • The Net Investment Income Tax (NIIT) of 3.8% that kicks in at an AGI of $250,000 for married filing joint (MFJ) taxpayers, or a single-filer AGI of $200,000. These thresholds are not adjusted for inflation. The tax applies to the lesser of the amount of net investment income or the amount by which modified adjusted gross income exceeds the applicable threshold.

As an example, a married veterinarian sold his practice in 2016, with $1,000,000 of gains subject to NIIT. When all 2016 income sources are considered, the taxpayer’s AGI is $1,450,000 and results in an NIIT of $38,000.

Assume the veterinarian and his spouse filed their 2016 return on October 13, 2017 (it was extended from April 15, 2017). An amended return would be due by October 13, 2020, per the three-year statute of limitations. But since the court will not rule for several months, it is unknown whether the NIIT will be thrown out or not. Therefore, the taxpayer should have filed a protective claim by the October 13, 2020, deadline, to put the IRS on notice that if the law is thrown out, the taxpayer potentially will be filing an amended return for a Net Investment Income Tax refund.

  • Another ACA tax is the Medicare surtax of 0.9% on wages or self-employment income in excess of $200,000 (single) or $250,000 (MFJ). An employer is responsible for withholding the Additional Medicare Tax from wages or compensation it pays to an employee in excess of $200,000 in a calendar year.

As an example, a single taxpayer had $350,000 in wages in 2017 and originally filed her 2017 tax return on April 15, 2018. The Additional Medicare Tax would be $1,350 ($150,000 x 0.9%). Assume the Supreme Court does not rule until May 31, 2021. The taxpayer should file a protective refund claim by April 15, 2021, to ensure the option of later amendment if the ruling is in her favor.

The Net Investment Income Tax is calculated and reported on Form 8960, attached to individual income tax return Form 1040. The Additional Medicare Tax is reported on Form 8959. Taxpayers should check their 2017, 2018, and 2019 returns to determine whether the taxes were applied and how much, then discuss options with their tax preparers.

If a taxpayer files a protective refund claim, it only puts the IRS on notice of the potential for the taxpayer’s future filing of an amended return. Importantly, the taxpayer must follow through with the amended return at a later date to perfect the claim.

Other contested issues will undoubtedly arise in the years to come. Knowing how to guard your rights for a later refund claim is an important strategy. Read more at irs.gov about protective claims related to the ACA California v. Texas case.

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