Insurers face complex tax deduction rules

The Patient Protection and Affordable Care Act (PPACA) added Section 162(m)(6) to the Internal Revenue Code that limits the deduction that may be taken by certain health insurance providers for compensation paid to officers, board members and certain independent contractors to $500,000 per year for tax years beginning after December 31, 2012. The IRS has recently issued proposed regulations on this limit.

Highlights of the proposed regulations include:

• Compensation attributable to tax years beginning before January 1, 2010 is not subject to the deduction limit, even if it vests and is paid after 2009.

• Unless a specific exclusion applies, if a health insurance provider is part of a larger controlled group, the compensation limit applies to the aggregate group.

• A de minimis exception applies where premiums from providing health insurance coverage are less than 2% of the gross revenue of the controlled group.

• An employer will not be deemed a covered health insurance provider merely because it maintains a self-insured medical reimbursement plan.

• Equity awards granted before 2010, such as stock options, are not subject to the deduction limit even if the options vest and are exercised after 2010.

Q: Who is a covered health insurance provider?

A: Beginning in 2013, the limit will apply to any health insurance issuer in which at least 25% of its gross premiums from providing health insurance coverage are from minimum essential coverage, Minimum essential coverage generally includes any employer-sponsored coverage, as well as governmental coverage and coverage offered in the individual market in any state.

The compensation limit applies to all entities in the aggregate group. Thus, if one entity in a parent-subsidiary group is a covered health insurance provider, the $500,000 limit applies to compensation paid to employees, directors, etc. of every entity in that group.

There is an exception where premium income is de minimis in comparison to the aggregate group’s revenue. If premiums received within the group are less than 2% of the gross revenue of the aggregate group for the tax year, then 162(m)(6) will not apply even if one entity in the group is a covered health insurance provider. In addition, there is a grace period rule so that if the group qualified for the 2% exception in one year but does not meet the 2% test in the next tax year, 162(m)(6) will not apply in the first year the 2% rule is not met. This will give some relief and planning time for groups that begin to creep near the 2% threshold

Note that unlike other compensation limits (including 162(m)), the limit extends beyond publicly-traded companies. This limitation also applies to partnerships and other non-corporate groups.

Q: Whose compensation is subject to the limit?

A: If section 162(m)(6) does apply, the deduction limit applies to the compensation earned by all “applicable individuals”. An applicable individual is any individual who is an officer, director, or employee of a covered health insurance provider. Certain independent contractors' compensation may also be subject to the limit if they perform services solely for one health insurance provider.

Unlike the provisions of Section 162(m), the deduction limitation is not solely focused on the CEO and the next three highest paid officers (excluding the Chief Financial Officer). Note that 162(m)(6) applies to all officers and employees who are paid compensation in excess of $500,000. Therefore, the impact of this legislation can be wide-spread throughout the organization. And, unlike the basic rules under 162(m), there is no exception for performance based compensation.

Q: How does the limit apply?

A: The limit applies first to the individual’s current compensation. Thus, current salary and bonuses are deductible up to the $500,000 limit. If there is any available deduction left, the limit will apply to any deferred deduction remuneration that is earned in that year. Deferred deduction remuneration is remuneration earned in one tax year that is deductible in a later tax year, such as nonqualified deferred compensation and most stock-based compensation.

For example, an applicable individual is paid salary and bonus of $300,000 in 2015 and also receives a vested cash bonus under a nonqualified deferred compensation plan of $600,000 to be paid in 2017. The deferred compensation is deemed to be invested in various mutual funds.

• The $300,000 of salary is fully deductible.

• The remaining $200,000 may then be applied to the nonqualified deferred compensation (the deferred deduction remuneration) when it would otherwise be deductible.

• In 2017 when the payment is made, only $200,000 of the deferred compensation is deductible by the covered health insurance provider. The balance of $400,000 of deferred deduction remuneration is not deductible even if the entity is not a covered health insurance provider in 2017, because it was earned in a year when the entity was subject to the rules. In addition, any earnings over the two-year period can be allocated either to 2015 when the award was made or over the two-year period.

Another key distinction between 162(m)(6) and the rules under 162(m) is the elimination of the performance-based compensation exception. There is no ability to offer stock options or cash bonuses in a manner that is exempt from the provisions of Section 162(m)(6)

The takeaway

The exclusion for deferred compensation allocated to years before 2010 is welcome relief for employers. The 2% de minimis exclusion will also be helpful for aggregate groups with small health insurance entities. However, for covered health insurance providers that are subject to the limitation, the rules will require complex calculations and recordkeeping.

For example, stock options typically have a 10-year term. The regulations, as currently drafted, will require allocation of the deduction across all tax years from grant to exercise and a determination whether any of the allocated deduction is deductible based on the entity's status as a covered health insurance provider for that year and the remuneration paid to the individual that year.

There are also decisions for companies to make with respect to the treatment of severance payments and account balance plans. Needless to say, covered health insurance providers should be taking action now to ensure the ability to monitor and comply with these regulations.

AmyLynn Flood is a partner and Susan Lennon is a managing director in the PricewaterhouseCoopers Human Resource Services practice.