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Beware this Threat to Exec-Comp Tax Deductions

An IRS compensation rule aimed at health insurers could actually apply to a wide range of companies.
Andrew Liazos, CFO.com | US
June 14, 2012

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 IRS 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 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 PPACA's individual mandate requirement). Specifically, a "covered health insurance provider" (CHIP) is unable to deduct compensation paid during a fiscal year to an employees 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 highest-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 pre-existing 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 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.

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 PPACA's individual mandate requirement). Specifically, a "covered health insurance provider" (CHIP) is unable to deduct compensation paid during a fiscal year to an employees 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 highest-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 pre-existing 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 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.

 

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. Even further clouding the picture is the potential impact on Section 162(m)(6) if the Supreme Court rules that PPACA's individual mandate is unconstitutional. Until we know more from the IRS and the Supreme Court, ambiguity as to what is 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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