United States: Health Insurance Providers Face Broad New Limitations on Tax Deductions for Compensation

BACKGROUND - SECTION 162(m) LIMIT ON TAX DEDUCTIONS

Before the ACA, Section 162(m) of the Internal Revenue Code ("Code") applied only to publicly traded companies, limiting their tax deductions for compensation paid to the chief executive officer and up to three additional most highly paid senior executives to $1 million each per taxable year of the company. This rule included exceptions so that certain incentive compensation and equity awards did not count toward the $1 million cap on tax deductible compensation. As a result, many publicly-traded companies rely heavily on incentive compensation and stock options to provide executive pay packages.

Troubled Asset Relief Program ("TARP") recipients became subject to rules under Section 162(m)(5) of the Code, which limits tax deductions for compensation payable to a specified group of executives to $500,000 each per taxable year of the Company, with no exceptions for incentive compensation or equity awards or commissions. Congress extended and broadened this trend with Section 162(m)(6) of the Code, which was added by the ACA as a revenue raiser.

New Section 162(m)(6) of the Code applies to any entity - whether publicly traded or privately held and, it appears, whether or not it is a corporation - that is a "covered health insurance provider." The new rule limits the deduction to $500,000 per employee, director or other service provider per year, whether among the most highly compensated or not. There is no exception for incentive compensation, equity awards of any type, commissions or other performance-based pay.

WHAT IS A COVERED HEALTH INSURANCE PROVIDER?

The term "covered health insurance provider" is defined differently depending on whether the taxable year is before 2013 or after.

2010 through 2012. For taxable years after 2009 and before 2013, a covered health insurance provider is a "health insurance issuer" that receives premiums from providing "health insurance coverage". A health insurance issuer generally means an insurance company, insurance service, or insurance organization (including a health maintenance organization as defined in the Code), which is licensed to engage in the business of insurance in a state and which is subject to state law which regulates insurance. Health insurance coverage means benefits consisting of medical care (provided directly, through insurance or reimbursement or otherwise) under any hospital or medical service policy or certificate, service plan contract or HMO contract offered by a health insurance issuer. Health insurance coverage does not include a number of "excepted benefits" including accident and disability income insurance, medical benefits that are supplementary to liability insurance, liability insurance, workers compensation insurance, automobile medical payment insurance, credit-only insurance, coverage for on-site medical clinics and similar insurance coverage as provided in regulations where medical care is secondary.

So insurance companies that receive premiums from providing medical benefits that are not excepted benefits are subject to this limit in 2010.

2013 and Subsequent Years. This definition narrows in 2013. For taxable years after 2012, an entity is a covered health insurance provider if it meets the definitions described above but only if 25% or more of the gross premiums received from providing health insurance coverage is from "minimum essential coverage" (a new ACA term).

As written, the ACA does not include any de minimus exception. Employers who are determining whether this limitation applies will want to consider the particular insurance products that they provide to see if they are "excepted benefits" or are "minimum essential coverage." An employer's self-insured plan covering its own employees should not cause the employer to become a covered health insurance provider.

RULE APPLIES IN 2010 FOR DEFERRED COMPENSATION AND IN 2013 FOR ANNUAL COMPENSATION

Compensation paid in 2013 in later years. The limitation applies to any compensation paid in a taxable year starting in 2013. The deduction for "applicable individual remuneration" is limited to $500,000 for each officer, director or employee or service provider for or on behalf of the covered health insurance provider during that taxable year.

Deferred Compensation. The limitation applies to any compensation for services performed in 2010 or later that is deferred to 2013 or any subsequent year. "Deferred deductible remuneration" which is attributable to services performed in 2010 or later may be deducted to the extent that the $500,000 limit was not fully used in the taxable year in which the services were performed.

So, for 2013 and subsequent years, a covered health insurance provider cannot deduct compensation for any employee, director or service provider in excess of $500,000, whether the compensation is paid in the taxable year or deferred to a later year.

The legislative history of the ACA refers to rules applicable to limitations on executive compensation to TARP recipients applied by the Treasury and appears to contemplate that similar rules apply to covered health insurance providers. As an example, an employee is paid $400,000 in cash in 2014 and defers $250,000 to 2018. The $400,000 would be deductible in 2014, but only $100,000 remains as the unused portion for deferred compensation relating to 2014. $100,000 of the $250,000 will be deductible in 2018 when paid.

This rule will limit deferrals in 2010 if the amount is deferred to a year after 2012. So, for example, if an employee performs services for a covered health insurance provider in 2010 and received payments of $850,000 and deferred an additional $300,000 to 2013, none of the $300,000 would be deductible in 2013. This could be the result even if the employer were not a covered health insurance provider in 2013. Section 162(m)(6) would not limit the deductibility of the $850,000 paid in 2010.

These rules will require close analysis of deferred compensation and vesting rules with matching to the appropriate years. Since stock options will be treated as deferred compensation under Section 162(m)(6), the deduction on exercise of stock options will also be limited.

Employers will need to keep careful records of payments and deferrals, since multiple awards and grants of stock options may make this very complicated. For employees who make over $500,000 annually, determining the unused portion may not be as important since there will be no chance of a subsequent deduction. However, since this rule covers all employees, directors and other service providers, the company will not know which employees will make in excess of $500,000 (including deferred compensation and stock options) until the stock options are exercised. In addition, it will be difficult to determine the amount of the future tax deduction for purposes of GAAP accounting.

Since employers set up deferral programs earlier in the year and Section 409A of the Code imposes restrictions on changes, employers' ability to affect deferrals for 2010 and possibly later years may be limited. While the TARP rules provide some guidance, it is not clear that the Internal Revenue Service will follow them as interpretative of the new Section 162(m)(6). The TARP rules themselves leave many open questions on which interpretation is needed. More specific guidance is needed, especially regarding compensation deferred after 2009 but before 2013.

APPLICATION TO CONTROLLED GROUP MEMBERS

The new rule applies to covered health insurance providers and, under aggregation rules, to any entity in a parent-subsidiary controlled group with a covered health insurance provider, whether higher or lower in the chain. Controlled group members who are in a brother-sister relationship or consolidated group members are not swept in. Payments from any member of this group count toward the $500,000 limitation.

WHAT EMPLOYERS SHOULD DO NOW

To apply these rules, an employer needs to first determine whether it, or a parent or subsidiary, is a covered health insurance provider. An entity which is a covered health insurance provider, a parent or subsidiary of a covered health insurance provider, an investor, or an entity planning on acquiring or investing in a covered health insurance provider, should carefully consider the impact of the new limit on deductibility of compensation under Section 162(m)(6) of the Code. Companies should work with counsel and auditors to determine the scope and appropriate recordkeeping. Application of these new rules will depend on facts on the business, corporate structure and compensation structure of the employer.

Publicly Traded Entities

Publicly traded entities have been subject to Code Section 162(m) but typically have taken advantage of exceptions for incentive compensation and certain equity awards. Since these new rules do away with these exceptions for covered health insurance providers, compensation committees may want to determine whether the structure of those awards continues to make sense in light of these new rules.

Employers who are publicly traded will also want to start considering the effect of these rules on proxy disclosure. SEC proxy rules state that the impact of tax and accounting treatment of the particular form or compensation of named executive officers may be material information requiring disclosure in the Compensation Discussion and Analysis ("CD&A") section of the company's annual proxy statement. Compensation committees of entities that are considered to be covered health insurance providers (or parents or subsidiaries) will want to act in 2010 to review compensation arrangements so that the actions can be reflected in the CD&A for fiscal 2010 in next year's proxy statements.

Privately Held Entities

Privately held entities that are covered health insurance providers have likely not been subject to limitations on deductibility of compensation so long as it was reasonable compensation under the Code. The limitations on deductibility will impact not only cash compensation but deferrals through stock options, phantom stock arrangements and deferred compensation programs.

Private Equity Investors and Acquisitions

Private equity and other investors whose investment may cause them to be considered a parent of a covered health insurance provider should also carefully consider these new rules.

Acquisitions, Mergers and Divestitures

Potential acquiring entities will want to carefully analyze their acquisition targets to determine whether an acquisition or investment could result in their becoming a member of a parent-subsidiary controlled group with a covered health insurance provider, thereby potentially triggering a loss of tax deductibility for compensation. Covered health insurance providers who may not be subject to these limits on deduction in 2013 and later years because they receive less than 25% of gross premiums from minimum essential health coverage will also want to take care that a divestiture or sale of a business does not cause them to exceed 25%.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.