Expenses & Deductions
The IRS issued final regulations (T.D. 9694) under Sec. 162(m)(6), which imposes a $500,000 federal income tax deduction limitation for compensation paid by a covered health insurance provider (CHIP). These regulations apply in determining when any entity in a controlled group that includes a health insurer is subject to the $500,000 annual limit. These regulations also provide rules for determining how the $500,000 annual limit is allocated to years of service for various types of compensation—including equity and deferred compensation. The deduction limitation under Sec. 162(m)(6) took effect for tax years beginning in 2013. This item summarizes the key provisions of the regulations, highlights the changes from the proposed regulations, and discusses implications for taxpayers.
Sec. 162(m)(6), added by the Patient Protection and Affordable Care Act (PPACA), P.L. 111-148, imposes a $500,000 limit on the federal income tax deduction for compensation that is otherwise deductible by CHIPs for tax years beginning after Dec. 31, 2012. The key concept under Sec. 162(m)(6) is that an annual $500,000 limit applies for each individual who is providing services to the CHIP. To determine whether the $500,000 limit is exceeded, compensation for an individual is allocated to the year in which the relevant services are performed. Thus, salary is allocated to the year for which it is paid, and other types of compensation, including deferred compensation and equity compensation, are allocated to the years over which the compensation is earned. (As discussed below, the final regulations provide methods for this allocation that differ from those contained in the proposed regulations.)
When the CHIP is entitled to the deduction for compensation (which generally will be when it is paid), it must determine to what extent any of the compensation is allocable to a year in which the $500,000 limit is exceeded and, therefore, the deduction is limited. The first year for which the $500,000 limit applies to deferred compensation is the tax year beginning after Dec. 31, 2009. Thus, CHIPs must track the $500,000 limit for compensation that is earned beginning in 2010 and later years. Because Sec. 162(m)(6) applies only to amounts that are otherwise deductible in 2013 or later years, however, any compensation exceeding the $500,000 limit that is deductible in a tax year beginning before Jan. 1, 2013, is not subject to the $500,000 limit.
Sec. 162(m)(6) applies only to CHIPs, but this includes any entity that is in the controlled group with a CHIP, as determined under Sec. 414 (but disregarding the brother-sister and combined group rules). Thus, any entities in a controlled group (under this definition) with a CHIP, regardless of the entity's line of business, are also subject to the deduction limit for all their individual service providers with compensation over $500,000.
Definition of a CHIP
Sec. 162(m)(6) includes two definitions of a CHIP—one that applies for tax years beginning before Jan. 1, 2013, and one that applies for tax years beginning in 2013 and thereafter. In Notice 2011-2, the IRS issued guidance providing that an entity will not be treated as a CHIP for any year unless it meets the definition of a CHIP applicable to 2013 and later years. That definition treats any insurer (and its affiliates under Sec. 414) as a CHIP if 25% or more of its gross premiums from health insurance are from the sale of "minimum essential coverage," as stated in the formula in the exhibit below.
Minimum essential coverage is defined in Sec. 5000A(f) and generally applies to health insurance coverage that individuals must maintain under PPACA to avoid incurring tax penalties. The provisions in PPACA generally would include in minimum essential coverage those policies sold in the state-sponsored insurance exchanges and employer-provided health insurance.
In addition, Notice 2011-2 included a de minimis rule under which an entity will not be considered a CHIP for any tax year beginning after Dec. 31, 2009, and before Jan. 1, 2013, if the employer's premium revenue from minimum essential coverage for the year is less than 2% of the employer's gross revenue for the year (referred to as the 2% de minimis rule).
Like Notice 2011-2 and the proposed regulations, the final regulations include a 2% de minimis rule (subject to certain clarifications discussed below). The final regulations also clarify whether certain coverage is treated as health insurance for purposes of determining whether an insurer is a CHIP. For those entities meeting the definition of a CHIP, the proposed regulations set forth allocation methods for determining the $500,000 limit. An overview of the key provisions of the final regulations follows.
Aggregated groups: Commenters to the proposed regulations asked the IRS to provide relief from the controlled-group rule. Because the rule is statutory, the IRS concluded that it did not have regulatory authority to loosen it. Thus, the regulations do not provide any exceptions from the definition of the controlled group for determining whether an entity is treated as a CHIP. The definitions discussed (i.e., the 25% minimum essential coverage test and the 2% de minimis rule) are applied taking into account the premiums and gross revenues of the entire controlled group under Sec. 414 (disregarding the brother-sister and combined-group rules under Secs. 1563(a)(2) and (a)(3)). This means that an entity that is aggregated with an insurer that meets the definition of a CHIP is also subject to the $500,000 limit, even though the entity and its employees may not be engaged in the health insurance business.
The regulations address how the aggregation rules apply when the members of the controlled group do not share the same tax year. In that instance, the parent of the controlled group is treated as a CHIP for any tax year with which, or in which, the tax year of a CHIP member of the group ends. Other members of the group are CHIPs for tax years ending with, or within, a tax year of the parent entity during which the parent entity is a CHIP. For an aggregated group that is an affiliated service group or a group described in Sec. 414(o), the regulations provide that the parent entity is the health insurance issuer in the aggregated group. If there is more than one health insurance issuer in an affiliated service group or a group described in Sec. 414(o), then the parent is the entity designated in writing by the other members as the parent. If there is no designation, the members of the group are considered for all tax years to have a parent with a calendar tax year.
Self-insurance and captive insurance companies: The proposed regulations clarified that employers that maintain self-insured medical reimbursement plans are not CHIPs solely as a result of self-insurance. Self-insurance for this purpose also includes assets set aside in an employee trust (a voluntary employee beneficiary association, or VEBA) under Sec. 501(c)(9). The final regulations clarify that an employer maintaining a self-insured plan will not be a CHIP solely because the employer provides additional coverage (such as prescription drugs) through an insurance policy.
Commenters asked the IRS to provide an exception for premiums received by captive insurance companies for coverage provided to current and former employees of entities in the captive's controlled group. Employers insuring the health risks of their employees through captive insurance companies, however, generally use the approach outlined in U.S. Department of Labor (DOL) individual prohibited transaction exemptions to avoid engaging in a prohibited transaction and incurring a Sec. 4975 excise tax. These individual exemptions require a captive to reinsure an unrelated insurance corporation that directly insures the health risk of the plan sponsor's employees. In this structure, the captive insurance company would be treated as providing indemnity reinsurance, which is not subject to Sec. 162(m)(6) (see discussion of indemnity reinsurance and stop-loss coverage below). The IRS also concluded that a special rule for a captive insurance arrangement following the DOL class exemption was not necessary because this arrangement requires a significant portion of the insurance business to be with unrelated third parties.
The 2% de minimis rule: The final regulations incorporate the 2% de minimis rule. As provided under the proposed regulations, in applying the ratio of premiums to gross revenues, the calculation is to be made on the basis of U.S. GAAP. The IRS declined to expand the 2% de minimis rule to as high as 5% of gross revenues, as some commenters had requested.
The final regulations provide a one-year transition rule if a health insurance issuer or member of an aggregated group fails to satisfy the 2% de minimis rule. Under this transition relief, if the 2% de minimis threshold is not satisfied in a tax year, the health insurance issuer and the aggregated group will not be considered a CHIP until the subsequent tax year, provided certain other requirements are satisfied.
Indemnity reinsurance contracts and stop-loss coverage: Consistent with the proposed regulations, the final regulations specify that, for purposes of the CHIP rules, premiums received under an indemnity reinsurance contract generally are not treated as premiums from providing health insurance coverage.
Several commenters asked the IRS to clarify the treatment of stop-loss coverage for purposes of Sec. 162(m)(6). Because the scope of stop-loss coverage that may constitute health insurance has not been determined, the preamble states that premiums under a stop-loss contract will not be considered premiums from providing health insurance coverage for purposes of Sec. 162(m)(6) "until such time and to the extent that future guidance addresses the issue of whether and, if so, under what circumstances, stop-loss coverage constitutes health insurance."
Direct service payments: The final regulations follow the proposed regulations regarding what constitutes a premium for purposes of determining which is a CHIP when a health insurer enters into arrangements with third parties to provide, manage, or arrange for the provision of services by physicians, hospitals, or other health care providers. In that case, the health insurance issuer may pay compensation to the third party in the form of capitated, prepaid, periodic, or other payments (direct service payments), and the third party may bear some or all of the risk that the compensation is insufficient to pay the full cost of the services. These direct service payments are not treated as premiums for purposes of Sec. 162(m)(6).
The IRS had requested comments on whether capitated, prepaid, or periodic payments a government entity made to a third party to provide, manage, or arrange for the provision of services by physicians, hospitals, or other health care providers should be treated as premiums from providing health insurance coverage for purposes of Sec. 162(m)(6). One commenter urged the IRS to confirm in the regulations that Medicaid managed care organizations and providers of Medicare Advantage and Medicare Part D prescription drug plans are not considered health insurance issuers that provide health insurance coverage and, thus, are not considered CHIPs under Sec. 162(m)(6). Another commenter asked the IRS to also confirm in the regulations that capitated payments made under the Medicare Shared Savings program or the Medicare Accountable Care Organization program to a clinical risk-bearing entity should not be treated as premiums for health insurance coverage. The IRS did not adopt any further specific exceptions to the definitions in the final regulations but confirmed that an entity must be a health insurance issuer as defined in Sec. 9832(b)(2) that provides health insurance coverage as defined in Sec. 9832(b)(1) to be a CHIP subject to Sec. 162(m)(6).
Independent contractors: The final regulations (like the proposed regulations) state that compensation for services paid only to individual service providers is subject to the $500,000 limit. Thus, payments to a partnership or corporation that includes service providers (such as physicians) would not be subject to the $500,000 limitation (although the preamble indicates that the IRS may issue guidance in the future identifying situations in which services performed by an entity will be treated as services performed by an individual for purposes of Sec. 162(m)(6)). The regulations exempt compensation paid to certain independent contractors. The exemption applies if the independent contractor (1) is actively engaged in providing services other than as an employee or a member of the board of directors; (2) provides significant services to two or more persons to which the independent contractor is not related and that are not related to one another; and (3) is not related to the CHIP or any member of its aggregated group.
Allocation rules for the $500,000 limit: The final regulations provide rules for attributing compensation to a particular year of service for purposes of applying the $500,000 limit. In general, compensation is attributable to services performed by an individual in the tax year of the CHIP in which the individual obtains a legally binding right to the compensation. Compensation is not attributable to a tax year ending before the later of (1) when the individual begins providing services or (2) when the individual obtains a legally binding right to the compensation. Compensation that is deductible in a year after the year in which the related services were performed is referred to as deferred deduction remuneration (DDR).
The rules for attributing DDR to one or more years of service are complicated and have been revised significantly by the final regulations. The regulations distinguish between different types of compensation plans in determining how DDR is to be allocated to years of service. In general, these categories of compensation are consistent with the categories used for determining the taxation of nonqualified deferred compensation under Sec. 409A.
Account balance plans: The regulations describe two alternative methods for attributing compensation under account balance plans. Under the "account balance ratio" method, which differs from any method under the proposed regulations, remuneration that becomes otherwise deductible is attributed to services performed by the applicable individual in each tax year of the CHIP in which the applicable individual was a service provider and for which the account balance increased. The amount attributed to each of these tax years equals the total amount that becomes otherwise deductible for the year, multiplied by a fraction whose numerator is the increase in the account balance for that tax year, and whose denominator is the sum of all increases in the account balance for all tax years during which the individual was a service provider.
For this purpose, an increase occurs for a tax year only if the account balance on the last day of the tax year is greater than the highest account balance on the last day of every prior tax year. The amount of the increase for any tax year is the excess of the account balance as of the last day of that year over the account balance as of the last day of any prior tax year. Certain adjustments are made to account balances for in-service payments and for payments of grandfathered amounts.
The second method is the "principal additions" method and is similar to the alternative method provided in the proposed regulations. Under this method, principal additions are attributed to the tax year in which they are made. In addition, earnings and losses on a principal addition are attributed to the tax year in which an applicable individual is credited with the principal addition under the plan to which the earnings and losses relate. The final regulations clarify that this method is available only for account balance plans that separately account for each principal addition to the plan and any earnings and that can trace any amount that becomes otherwise deductible under the plan, through separate accounting, to a principal addition made in a CHIP's tax year.
The regulations require CHIPs to use their chosen attribution method consistently under all of their account balance plans for all tax years.
Non-account balance plans: The final regulations provide two attribution methods for non-account balance plans—the present-value-ratio method and the formula-benefit-ratio method—and a CHIP may choose either method.
Under the present-value-ratio method, each time an amount becomes otherwise deductible, the amount is attributed to services in a tax year of a CHIP during which an applicable individual was a service provider and for which there was an increase in the present value of payments due under the plan. The amount attributed to each of these years equals the total amount that is otherwise deductible, multiplied by a fraction whose numerator is the increase in the present value of the individual's benefit for the tax year and whose denominator is the sum of all those increases in present value for all tax years during which the individual was a service provider.
Under the formula-benefit-ratio method, remuneration is attributable to each year in which the applicable individual provided services and for which there was an increase in the formula benefit. The amount attributed to each tax year equals the amount that becomes otherwise deductible, multiplied by a fraction whose numerator is the increase in the formula benefit for the tax year and whose denominator is the sum of all those increases during which the applicable individual was a service provider.
Equity-based compensation: The final regulations generally provide the same rules as the proposed regulations for the attribution of equity-based compensation. They generally attribute the compensation resulting from the exercise of stock options or stock appreciation rights (SARs) to services the individual performed, on a daily pro rata basis, over the period beginning on the grant date of the stock option or SAR and ending on the date that the stock option or SAR is exercised, excluding any days on which the individual is not a service provider. Based on comments received, the final regulations also allow equity compensation to be attributed to services pro rata over the period of grant to vesting, the method typically used to determine the sourcing of compensation under an equity grant. The IRS rejected comments requesting attribution entirely to the tax year in which equity-based compensation vests, is exercised, or is otherwise includible in income.
Compensation resulting from the vesting or transfer of restricted stock for which an election under Sec. 83(b) has not been made is generally attributable to services the individual performed, on a daily pro rata basis, over the period beginning on the grant date of the restricted stock and ending on the earliest of the date on which (1) the substantial risk of forfeiture lapses or (2) the restricted stock is transferred, excluding any days on which the individual is not a service provider. If a Sec. 83(b) election is made, the compensation is treated as attributable to the tax year in which the grant of the restricted stock is made.
Compensation resulting from a restricted stock unit (RSU) is attributed on a daily pro rata basis to services performed over the period beginning on the date the individual obtains a legally binding right to the RSU and ending on the date the compensation is paid or made available, excluding any days on which the individual is not a service provider.
Involuntary separation pay: Under the final regulations, involuntary separation pay is attributable either (1) to services performed during the tax year in which the involuntary separation from service occurs, or (2) on a daily pro rata basis to services performed beginning on the date that the individual obtains a legally binding right to the involuntary separation pay and ending on the date of the individual's involuntary separation from service with the CHIP. Involuntary separation pay may be attributed to different individuals using different methods but must be consistent for any particular individual.
Substantial risk of forfeiture: For compensation that is subject to a substantial risk of forfeiture (i.e., a vesting provision), the final regulations generally follow the proposed regulations and attribute this compensation to tax years using a two-step process: (1) The compensation that is subject to the substantial risk of forfeiture is first attributed to the tax year or years of the CHIP under the attribution rules that otherwise apply, and (2) the compensation that was subject to a substantial risk of forfeiture is reattributed on a daily pro rata basis over the period that the compensation was subject to a substantial risk of forfeiture. The substantial-risk-of-forfeiture provision does not apply to compensation that otherwise is allocated under the equity-based compensation rules.
Corporate transactions: The final regulations provide a transition period for entities that become CHIPs solely as a result of a merger or other corporate transaction. As under the proposed regulations, the final regulations stipulate that, if an entity that is not otherwise a CHIP would become a CHIP solely as a result of a corporate transaction, the entity generally is not treated as a CHIP for the tax year in which the transaction occurs (the transition period).
Services performed before Jan. 1, 2010 (grandfathered amounts): The final regulations provide a "grandfather" rule that will be helpful to many CHIPs. As under the proposed regulations, compensation attributable to services performed during tax years beginning before Jan. 1, 2010, is grandfathered and not subject to the $500,000 limit, regardless of whether the compensation was subject to a substantial risk of forfeiture after that time. The final regulations provide modified attribution rules for determining grandfathered amounts under account balance and non—account balance plans. Equity-based awards—such as options, SARs, or restricted stock—granted prior to Jan. 1, 2010, are not subject to the deduction limitation.
The first step in applying Sec. 162(m)(6) is determining whether the controlled group is a CHIP. The application of the 2% de minimis rule and clarification of the rules around stop-loss coverage, reinsurance, and self-funded employer plans will be helpful to many taxpayers. The regulations rejected the need for special rules for captive insurance companies, so these companies must analyze whether they are CHIPs, based on the rules that apply to other potential CHIPs. Insurers under governmental benefit programs may need to consider whether they satisfy the definition of a health insurance issuer under Sec. 9832(b)(2). For insurers and their affiliates that are CHIPs, these regulations provide specific rules on how to allocate compensation over years of service and apply the $500,000 limit. In many cases, the rules will require complex calculations and detailed recordkeeping. These taxpayers may also want to consider any tax accounting implications of the deduction limitations.
Michael Dell is a partner at Ernst & Young LLP in Washington.
For additional information about these items, contact Mr. Dell at 202-327-8788 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.