It is well known that the Patient Protection and Affordable Care Act (PPACA, or the federal health-care reform law) significantly limits the ability of health-insurance companies to deduct payment of compensation beginning in 2013. What is not so well known is that the Internal Revenue Service might apply this limitation to health-care services providers that are not typically considered to be insurance companies, to captive insurance companies, and even to companies outside the health-insurance industry.

The articulated rationale of the congressional sponsors of this tax-deduction limitation was fairly straightforward. It was widely anticipated that health-insurance companies would realize significant increases in revenue due to the PPACA’s individual mandate to obtain health insurance. Fearing that a significant portion of this revenue increase would be used to provide more pay to highly compensated health-insurance-company employees, Congress added Section 162(m)(6) to the Internal Revenue Code.

Section 162(m)(6) limits tax deductions that may be taken by health insurers that materially benefit from the individual mandate (i.e., at least 25% of gross premiums received in a year are attributable to “minimum essential coverage” under the PPACA’s individual-mandate requirement). Specifically, a “covered health insurance provider” (CHIP) is unable to deduct compensation paid during a fiscal year to an employee or director in excess of $500,000.

Section 162(m)(6) is quite draconian and much broader than the $1 million deduction limitation applicable to public companies. Aside from being applicable to any form of taxable entity at a lower threshold amount ($500,000), Section 162(m)(6) applies to all forms of compensation. There is no exception for commissions or performance-based compensation (such as gains from the exercise of stock options) as there is for the $1 million deduction limit. In addition, Section 162(m)(6) generally applies to all service providers (subject to an exception for certain independent contractors), not just the CEO and the three other most highly paid officers (other than the CFO), as is the case with public companies.

What may make Section 162(m)(6) a potential trap for the unwary is the broad language that was used to implement this seemingly simple objective. An entity may be a CHIP if it is a “health insurance issuer” according to rules established under the Health Insurance Portability and Accountability Act (HIPAA). Among other reasons, Congress enacted HIPAA to limit the denial of medical coverage because of preexisting conditions. In setting forth rules to implement this limitation, HIPAA did not limit the definition of a “health insurance issuer” to just insurance companies. Instead, that definition also included a so-called insurance service as well as an “insurance organization” that is licensed as an insurer and subject to state insurance regulation, as broadly interpreted under ERISA rules.

The ways health-care services are now increasingly being provided and compensated, particularly in light of health-care reform, create serious questions as to whether state-licensed/certified risk-bearing provider organizations (RBOs) that provide or arrange for the provision of health-care services might be considered “health insurance issuers” for purposes of Section 162(m)(6).

RBOs engage in certain activities that may be considered to be insurance-related. For example, an RBO often may be paid for designating health-care services on a “capitated” basis; i.e., at a fixed monthly covered rate for each member assigned to it, regardless of the number, nature, or overall cost of covered health-care services. An RBO may be at risk for just physician services or for the full range of health-care services, including inpatient hospital services.

Under the PPACA, Medicare’s Shared Savings Program Accountable Care Organizations (MSSPACOs) and Pioneer ACOs will be required to assume similar significant insurance-type downside financial risk for the full range of health-care services. If such an RBO is subject to state licensing or other insurance-type certification regulation that includes solvency restrictions, the RBO might be considered to be a health-insurance issuer, depending on the applicable state law and the IRS’s analysis of it.

Consequently, in an ironic twist, Section 162(m)(6) could significantly impair the development of ACOs. Considered to be one of the “crown jewels” of the PPACA, MSSPACOs, as well as the separate Pioneer ACOs under Medicare, reflect a new type of payment and delivery model for providing medical services to Medicare beneficiaries. It links reimbursement to achieving high quality of care standards while significantly reducing the total cost of care for a designated patient population. Each such Medicare ACO will, either at the outset or after three years, be required to assume substantial downside financial risk, and perhaps full capitated risk. Commercial ACOs are also proliferating in the wake of the PPACA, with payments to such ACOs for both hospital and physician often being on a capitated or other basis involving substantial downside financial risk.

Another situation in which Section 162(m)(6) might apply outside the context of a traditional health-insurance company involves the use of captive insurance companies. Many large employers use such companies for a variety of purposes, including providing insurance coverage for their group medical plans. Typically, a captive will provide health-insurance coverage only to employees of its parent company and its subsidiaries, as opposed to the general public.

Notwithstanding that there will be no increased revenue from the sale of insurance as a result of the PPACA’s individual mandate, that type of insurance may trigger application of Section 162(m)(6) (subject to a de minimis exception noted below). CHIP status under Section 162(m)(6) may also be triggered if the captive insurer issues stop-loss coverage for the employer’s group health plans in a manner that is viewed to be akin to a form of direct health insurance, because of the attachment points for coverage being too low. Unlike the issues with respect to RBOs and ACOs discussed above, the IRS has announced it is considering whether and under what circumstances Section 162(m)(6) might apply to captive insurance companies and certain stop-loss insurance arrangements.

The potential tax-deduction taint under Section 162(m)(6) is not limited to ACOs, other forms of RBOs, captive insurers, and certain forms of stop-loss insurance coverage. Other business entities that have nothing to do with the health-insurance industry may also be subject to the $500,000 tax deduction limitation under Section 162(m)(6). That’s because the IRS to date has broadly interpreted so-called employer aggregation rules that were likely intended to prevent health-insurance companies from doing an end run around the $500,000 tax-deduction limitation by employing individuals in related noninsurance companies.

All entities required to be treated as a single employer with a health-insurance issuer under tax-qualified retirement-plan rules are potentially subject to the Section 162(m)(6) tax-deduction limit. Affiliated entities for this purpose could include companies in a parent-subsidiary or brother-sister relationship based on having certain levels of equity ownership as well as affiliated service groups, which are based on limited or no common equity ownership. To date, the IRS has provided relief only from the employer aggregation rules under a so-called de minimis exception if the gross premiums from applicable health-insurance coverage are less than 2% of the aggregated employer’s overall revenue from all sources.

Therefore, the Section 162(m)(6) tax-deduction limitation could be applicable to compensation paid to employed, highly paid specialist physicians, as well as to executives and other highly compensated employees of not only an ACO or other RBO itself but also to such employees of all entities affiliated with the ACO or other RBO under employer aggregation rules. If so, every highly paid employee of a sponsoring for-profit health system or other entity owning an RBO could be subject to the Section 162(m)(6) limitation, potentially costing millions of dollars in lost tax deductions, which would be likely to have a profound, chilling effect on the willingness of such physicians and companies to participate or invest in ACOs and other RBOs.

Similarly, if a captive insurance company provides health insurance to employees of its parent company and its subsidiaries, tax deductions for compensation paid to all highly compensated employees of the parent and its subsidiaries would be at risk unless the de minimis rule noted above applies.

The tax-deduction limitations under Section 162(m)(6) will first apply to compensation paid during taxable years beginning after December 31, 2012. Regulators have stated that the IRS is working on proposed regulations, which hopefully will provide needed clarification and relief before then. Clouding the picture even further is the potential impact on Section 162(m)(6) if the Supreme Court rules that the PPACA’s individual mandate is unconstitutional. Until we know more from the IRS and the Supreme Court, ambiguity as to what is a CHIP and the potentially broad application of the $500,000 limitation suggest that caution be exercised in any acquisition, equity investment, or other affiliation that might trigger Section 162(m)(6).

Andrew Liazos heads the executive compensation practice at law firm McDermott Will & Emery. The author would like to thank his colleague J. Peter Rich for his assistance with this article.

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