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Health Care Reform and Executive Compensation: Section 162(m)(6) Proposed Regulations-The Devil Is Certainly in the Details

Tuesday, April 30, 2013
By Susan E. Stoffer, Nelson, Mullins, Riley & Scarborough

In 2010, Section 162(m)(6) was added to the Internal Revenue Code of 1986, as amended by Section 9014 of the Affordable Care Act.1 It resulted in a giant leap from the precipice of previously limiting corporate tax deductions for compensation paid to highly paid executives of publicly held corporations and executives of employers receiving financial assistance under the Troubled Asset Relief Program2 to the dark hole of limiting deductions for all employees, outside directors, and independent contractors of health insurance providers.

Specifically, tax code Section 162(m)(6) provides a $500,000 limit on compensation deductions for tax years beginning on or after Jan. 1, 2013, for “covered health insurance providers” (CHIPs). Deductions are limited with respect to any compensation paid to any officer, director, or employee of a CHIP (or a member of its controlled group) or any other individual who provides services for or on behalf of the CHIP (or a member of its controlled group). Deduction limits apply to compensation paid in tax years beginning on or after Jan. 1, 2013, including compensation for services provided after 2009 that is paid in 2013 or later. In other words, there is no exception for deferred compensation. There is also no exception for commissions or performance-based compensation. Controlled group aggregation rules apply.

The Internal Revenue Service released its first stab at guidance in December 2010 in Notice 2011-2.3 The notice provided guidance on several key issues and first established the “de minimis” concept regarding the amount of premiums received by a health insurance provider for purposes of determining whether such provider is a CHIP. The notice also contained detailed examples including an example illustrating that a “lookback” rule would apply to any pre-2013 CHIP that is not a CHIP in 2013 but that later becomes a CHIP again (providing that the deferred deduction compensation attributable to those earlier CHIP years would be subject to the deduction limit when paid after the entity once again becomes a CHIP post-2013). The notice also requested comments on four primary issues:

  1. the definition of “covered health insurance provider” and the application of the “de minimis” exception;
  2. the method for attribution of deferred compensation to specific tax years for application of the deduction limit;
  3. the impact of a merger, acquisition, reorganization, or other corporate transaction on the inclusion of a covered health insurance provider in a controlled group of corporations; and
  4. the application of the deduction rules for insurers who are captive insurance companies or who provide reinsurance or stop loss insurance.

On April 2, IRS released proposed regulations4 that shine a glaring spotlight down the hole. So where does this new guidance take us? Let's look at the whole picture that has now been illuminated.

How Is a ‘Covered Health Insurance
Provider' Defined?

Section 162(m)(6)(C) defines a “covered health insurance provider” as any employer that is a health insurance issuer (as defined in tax code Section 9832(b)(2)), beginning with the 2010 tax year. For tax years starting after Dec. 31, 2012, this definition is limited to such health insurance issuers with at least 25 percent of gross premiums being received from providing health insurance coverage which is classified as “minimum essential coverage” under tax code Section 5000A(f).

Under Section 9832(b)(2), the term “health insurance issuer” means an insurance company, insurance service, or insurance organization (including a health maintenance organization) that is licensed to engage in the business of insurance in a State and that is subject to State law which regulates insurance (within the meaning of Section 514(b)(2) of the Employee Retirement Income Security Act of 1974. A “health maintenance organization” means a federally qualified health maintenance organization (as defined in Section 1301(a) of the Public Health Service Act (42U.S.C. 300e(a)), an organization recognized under State law as a health maintenance organization, or a similar organization regulated under State law for solvency in the same manner and to the same extent as such a health maintenance organization.

“Minimum essential coverage” for purposes of the deduction limit means health insurance coverage provided under an employer-sponsored group health plan other than coverage for “excepted benefits.” “Excepted benefits” are defined in Section 5000A(f)(3) generally as coverage for accident or disability income insurance, general liability and auto liability insurance, workers' compensation coverage, coverage for on-site medical clinics, and other similar insurance coverage.

IRS Notice 2011-2 provided for a “de minimis” exception to CHIP classification for those employers that would otherwise be considered CHIPs if the premiums received by the entity and all other members of its controlled group from providing health insurance coverage for a year (minimum essential coverage for 2013 and later years) are less than 2 percent of the combined gross revenues of such controlled group members for the tax year. The proposed regulations provided an accommodation for large swings in revenue by specifying that if an entity is not a CHIP for a year due to the “de minimis” exception, and then fails to meet such exception for a year, such entity will not be treated as a CHIP for the first tax year in which it does not meet the exception. Special rules apply when members of a controlled group have different tax years.

How Are Employers That Self-Insure
Their Employee Health Coverage Treated?

The proposed regulations confirm that employers that sponsor self-insured medical reimbursement plans are not treated as CHIPs. In addition, premiums received under an indemnity reinsurance contract are not treated as premiums from providing health insurance coverage. However, under the guidance in the Proposed Regulations, a captive insurance company is treated as a CHIP. The proposed regulations also provide that a health insurance issuer or other person receiving direct service payments (i.e., capitated, prepaid, periodic, or other payments made by a health insurance issuer or other person that receives premiums from providing coverage to a third party as compensation for providing, managing, or arranging for the provision of health care services by physicians, hospitals, or other health care providers) is not a CHIP.

How Do the Controlled Group Rules Apply?

Applying the controlled group aggregation rules of Section 414(b), (c), (m), and (o) can cause related companies to be treated as a single employer. These are the same rules that apply to tax-qualified retirement plans (but here, applying an exception that ignores brother-sister corporations and combined group arrangements). For example, if a corporation owns eight hospitals and one HMO, all of the companies within that controlled group, including the parent corporation, will be subject to the Affordable Care Act limit on deductible compensation. In addition, all compensation paid to an individual by any member of the controlled group must be aggregated to determine whether or not the $500,000 deduction limit is exceeded in a given year. There are special rules for controlled group members that do not have the same tax year. There are also special rules for “affiliated service groups” as determined under Section 414(m) (including special rules for written designation of a “parent” entity).

Are Stock Option Grants And Performance-Based Incentive Plans Exempt From This $500,000 Limit?

No. See the Attribution Chart at the end of this article.

Are Bonus Payments Provided for In Employment Contracts Entered Into Before The Effective Date of the Affordable Care Act Excepted From The Deduction Limit?

No. See the Attribution Chart at the end of this article for deferred compensation attribution, including severance pay.

Are Commissions Exempt From This $500,000 Limit?


Will Deferred Payments to an Individual (Even After Termination of Employment) Be Subject to the Deduction Limit?

Yes. The deduction limit cannot be avoided by deferring compensation for payment in later years. However, it should be noted that, if less than $500,000 is deducted on behalf of an individual during a tax year, then to the extent that the individual is credited with deferred compensation attributable to services performed by such individual during that year, such compensation may be able to be deducted for the year in which paid, up to the unused deduction amount. But here is where the devil enters the picture. The proposed regulations set out a complex web of attribution rules that will require an inordinate amount of administrative oversight. Deferred compensation, for purposes of the Section 162(m)(6) rules, is divided into seven categories (much like the Section 409A rules):

  1. account balance plans,
  2. nonaccount balance plans,
  3. equity-based compensation (stock options, stock appreciation rights, options under Section 423 stock purchase plans, restricted stock, restricted stock units),
  4. partnership units and other equity,
  5. involuntary separation pay,
  6. reimbursements and in-kind benefits, and
  7. split-dollar life insurance.

A summary overview of these attribution rules can be found in the chart at the end of this article. At least IRS did take notice that these attribution rules may be overly burdensome. Comments on the administrative burden were specifically requested. Despite the administrative burden, a careful study of the application of the attribution rules can provide a guide to future deferred compensation design. Vesting schedules and payment timing may be designed to maximize the deduction limits for each taxable year to which different categories of deferred compensation are is attributed.

To Which “Individuals” Is The Compensation Deduction Applied?

The deduction limit applies to any individual who is an officer, director, or employee of a covered health insurer. The limit also applies to any individual who provides services for or on behalf of a covered health insurer for a tax year. Unlike TARP and regular 162(m) rules, under the Affordable Care Act, the affected group of individuals is not limited to a group of executives. Remembering the controlled group rules, compensation deductions for service providers to companies that are not health insurance providers could also be affected.

What About CHIPs That Have Contracts With Physicians to Provide Services? Is the Deduction Limit Applicable?

The proposed regulations provide that payment to a person who is an independent contractor for services provided to a CHIP is not subject to the deduction limit as long as (1) the independent contractor is actively engaged in the trade or business of providing service to recipients (other than as an employee or board member), (2) the independent contractor provides significant services to two or more persons to which such person is not related (and they are not related to each other), and (3) the independent contractor is not related to the CHIP (or a member of its controlled group). However, the proposed regulations do not make the leap to applying this rule to doctors working for practice groups (which are incorporated or are partnerships). The proposed regulations specifically ask for comments on applying the deduction limits when persons form small or single-member personal service corporations.

What Rules Apply for the First Year That a CHIP Becomes a Part of a Controlled Group (Which Is Not Otherwise a CHIP Group) Through a Corporate Transaction?
What Rules Apply for the First Year That an Entity That Is Not a CHIP Is Acquired by a CHIP Group?

The proposed regulations provide for special transition period relief in these cases. Generally, there is relief for the transaction year, but not for any subsequent taxable years.

Attribution Rules

Note that there are more than a dozen specific examples of the application of the attribution rules set forth in the proposed regulations and summarized in the table below. There are numerous additional examples of the application of the attribution rules to grandfathered amounts (if attributable to services performed in tax years beginning before 2010). The examples paint a complicated picture and it will take some time to fully understand the nuances of the application of these rules.

A couple of final thoughts: No, an employer cannot ignore Section 162(m)(6) if Section 162(m)(1) applies (i.e., if the individual is both a covered employee of a publicly held corporation and an individual receiving compensation for services for a CHIP group). Nice try. These proposed regulations apply to tax years beginning after Dec. 31, 2012, and are effective upon publication of the final regulations. In the meantime, the employer may operate in reliance on these proposed rules.

Attribution Rules
Compensation Category  Standard Attribution Rule  Alternative Attribution Rule  Notes  
Account Balance PlanAttribute the increase (or decrease) in the account balance on the last day of the tax year vs. the balance as of the last day of the prior tax year. Increases are attributed to services in that tax year. Decreases are reductions to other deferred deduction compensation for that year.Attribute the amount of the principal addition for the tax year (contributions, credits, etc.) plus attribute earning/losses attributable to the same year as the principal addition.A consistency rule applies. All plans that would be treated as a single account balance plan under Section 409A must use the same attribution rule. If payment is in installments (rather than a lump sum), payments are deemed made first with respect to the earliest taxable years to which they could be attributed.
Nonaccount Balance PlanAttribute to the current tax year the increase or decrease in the present value of the vested future payment(s) over the prior year.NoneIf payment in installments (rather than lump sum), payments deemed made first with respect to the earliest taxable years to which they could be attributed.
Equity Compensation – Stock Options/Stock Appreciation Rights (SARs)Attribute the compensation received from exercise as allocated on a daily pro rata basis from the grant date to the exercise date (excluding any days when the individual is not a service provider).NoneThis rule also applies to Section 423 employee stock purchase plans.
Equity Compensation – Restricted StockIf there is no Section 83(b) election, attribute on a daily pro rata basis from the date that a legally binding right arises to the earliest of (i) the date the substantial risk of forfeiture lapses, or (ii) the transfer date (excluding any days when the individual is not a service provider).None 
Equity Compensation – Restricted Stock UnitsAllocate on a daily pro rata basis from the date that a legally binding right arises to the date compensation is paid or made available (taxable) (excluding any days when the individual is not a service provider).  
Partnership Units and Other EquityApply by analogy the same rules as set forth above for other equity compensation.  
Involuntary Separation PayAttribute to the tax year in which the involuntary separation occurs.Attribute on a daily pro rata basis from the date that a legally binding right occurs to the separation date. For example, if an employee's employment contract specifies that the employee will receive separation pay upon an involuntary separation from service, the “daily pro rata” method is applied from the date of the contract through the separation date.Separation from service defined with reference to Section 409A definition. Can use different methods for different individuals. However, if separate payments are made to the same individual over multiple years (installment payments), then all payments to that individual must use the same attribution method.
Reimbursements and In-Kind BenefitsFor reimbursements, attribute in the year in which the individual makes the payment for which he or she has a reimbursement right. For in-kind benefits, attribute in the year of receipt of the in-kind benefit (but if not a service provider in such year, attribute to the first prior year in which the individual was a service provider). Example: country club dues
Split-Dollar Life InsuranceFor company-owned, economic benefit doctrine arrangements, attribute in the year in which the legally binding right arises. For employee-owned, loan regime arrangements, there is no deferred deduction compensation (unless the loan is waived, canceled, or forgiven).  
Sue Stoffer ( is a partner with Nelson, Mullins, Riley & Scarborough in Atlanta, practicing in executive compensation and employee benefits law.
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