United States: Health Care Reform: New Deduction Limit on Compensation Paid by Certain Health Insurers

New health care reform laws impose a $500,000 deduction limit on compensation paid by certain health insurers and their related companies to all employees and other individual service providers.

An expansive new provision in the health care reform law will limit the ability of many health insurers and their related companies to fully deduct compensation paid to employees and other individual service providers in 2013 and later tax years. All health insurers will want to take action now to determine the effect of the new rules and to review the compensation structure for their highly paid employees and individual service providers in order to maximize potential deductions.

Background

Generally employers may deduct employee compensation expenses as reasonable and ordinary business expenses. However, Section 162(m)(1) of the Internal Revenue Code places a special deduction limit on individual compensation paid to certain officers of a publicly held corporation when the compensation for the tax year exceeds $1 million. The 2008 economic stimulus bill, which enacted Code Section 162(m)(5), placed similar deduction restrictions on certain employers receiving federal assistance under the Troubled Asset Relief Program (TARP), although the deduction limit for TARP employers was $500,000 per covered employee. The $1 million and TARP deduction limits under Code Section 162(m) both apply to only a limited number of officers. One significant difference between these two deduction limits is that the $1 million deduction limit does not apply to commissions and performance-based pay, which is one of the reasons for the popularity of stock options, stock appreciation rights, and performance-based cash and equity awards to executives. By contrast, the TARP $500,000 deduction limit applies to all taxable compensation, including commissions and performance-based pay.

Covered Health Insurance Providers

The Patient Protection and Affordable Care Act (PPACA) enacted Code Section 162(m)(6), which establishes a new $500,000 deduction limit applicable to any employer (determined on a controlled group basis) that is a health insurance issuer—including insurance companies and HMOs—and which receives premiums for providing "health insurance coverage." For this purpose, health insurance coverage means benefits consisting of medical care offered by a health insurance issuer, excluding the following coverages: accident and/or disability income; insurance-only coverage; liability insurance (e.g., general liability or automobile liability); supplementary liability insurance; workers' compensation or similar insurance; automobile medical payment insurance; credit-only insurance; coverage for on-site medical clinics; and other similar insurance coverage in regulations where medical care is secondary or incidental.

For any tax year from 2010 through 2012, the health insurer's receipt of any premiums for providing health insurance coverage will subject certain deferred compensation paid to a covered individual (i.e., compensation earned during or after 2010 and paid after 2012) by a health insurer or any related company in its controlled group to the new $500,000 deduction limit. In contrast, for any tax year after 2012, the new $500,000 deduction limit will apply to all compensation earned by a covered individual of a health insurer or any related company in its controlled group, only if at least 25 percent of the gross premiums received by the health insurer from providing health insurance coverage are attributable to "minimum essential coverage."

The PPACA defines minimum essential coverage broadly to include government-sponsored programs (Medicare, Medicaid, CHIP, TRICARE, etc.), eligible employer-sponsored plans, plans in the individual market within a state, grandfathered plans and other health benefits coverage, such as a state health benefits risk pool designated by the Secretary of Health and Human Services. However, certain excepted benefits are not considered minimum essential coverage for this purpose, including the following (if provided under a separate insurance policy, certificate or contract): limited-scope dental or vision benefits, long-term care, nursing home care, home health care, community-based care, specified disease or illness coverage, hospital indemnity or other fixed indemnity insurance and Medicare supplemental coverage. Given the broad scope of the minimum essential coverage definition, most health insurers and their related companies will be affected by the new $500,000 deduction limit with respect to compensation earned in 2013 and later tax years, unless the insurer writes a substantial amount of excepted coverage.

Covered Individuals

Unlike the $1 million and TARP deduction limits, the new deduction limit applies to all employees, officers and directors, as well any individual providing services for or on behalf of the health insurer or any related company in its controlled group (e.g., consultants and brokers).

Compensation Subject to Limit

The new $500,000 deduction limit for health insurers (and related companies in their controlled group) applies to all compensation earned for services performed by a covered individual during the applicable tax year. Similar to the deduction limit for employers receiving TARP assistance, all compensation paid to a covered individual is counted and there is no special exclusion for commissions or performance-based pay.

For each tax year in which an employer is subject to the new $500,000 deduction limit, a covered individual's compensation that otherwise would be deductible for such tax year (determined without regard to the new $500,000 deduction limit) will be subject to a $500,000 deduction cap, including any deferred compensation amounts earned in that tax year, even if paid in later years. Thus, if a covered individual's compensation during any such tax year equals or exceeds $500,000, any deferred compensation attributable to services performed during that year will not be deductible in a later year. Conversely, to the extent a covered individual's compensation during any such tax year is less than $500,000 (i.e., the unused portion of the $500,000 deduction limit), any deferred compensation attributable to services performed during that year can be deductible in a later year (generally, the year in which it is paid), up to the unused portion of the $500,000 deduction limit.

Under the new rules, compensation paid in excess of these limits is effectively taxed twice. The covered individual pays individual income tax on the compensation and the employer essentially pays a second tax by not being able to deduct the compensation expense to the extent it exceeds the $500,000 deduction limit.

Effective Date

The new $500,000 deduction limit is effective for compensation earned in 2013 and later tax years, along with compensation earned in 2010 or later tax years and deferred until after 2012.

Next Steps

Health insurers should take action now in the following ways:

1. Determine whether and, if so, what tax years they will be subject to the new deduction limit, including with respect to deferred compensation earned during or after this year and deferred until after 2012
2. Analyze the potential tax impact of the new deduction limit
3. Implement a compliance program to identify employees and other individual service providers whose compensation will be subject to the new deduction limit, with special attention to allocating the limit to deferred compensation

The following table provides a high-level comparison of the various deduction limits under Code Section 162(m).

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.