The Internal Revenue Service (IRS) and the Department of Treasury (Treasury) have issued final regulations under section 162(m)(6) of the Internal Revenue Code of 1986, as amended (Code), which limit the deduction certain health insurers may claim for compensation payable to their employees and independent contractors. Treas. Reg. § 1.162-31, TD 9694, 79 FR 56891 (Sept. 23, 2014). The final rules are similar to the proposed regulations that were released in 2013 in many respects but add several rules clarifying the treatment of members of a controlled group after a corporate transaction, modify several rules for applying the limit to deferred compensation and other specific types of compensation, and clarify certain rules for determining the premiums for health insurance. The final regulations also retain the de minimis rule that was announced in Notice 2011-2 (2011-1 IRB 260) with certain clarifications.

BACKGROUND

Section¹ 162(m)(6) was added to the Code by the Patient Protection and Affordable Care Act (PPACA). It limits the deduction that covered health insurance providers (Health Insurers) may claim for compensation payable to any employee, director or independent contractor to $500,000 for any taxable year. The statutory provision generally is effective for all compensation deductible during a tax year beginning on or after January 1, 2013, but also applies to compensation earned during a tax year beginning after 2009 that is deferred and deductible in any tax year beginning after December 31, 2012. Section 162(m)(6) includes one rule for identifying Health Insurers subject to the rule for tax years 2010-2012 and another for tax years after 2012. The Code also provides that if a Health Insurer is a member of a controlled group or certain other types of aggregated groups, all members of the group are treated as Health Insurers subject to the deduction limit.

FINAL REGULATIONS

Definitions. The final rules define a number of terms that are fundamental to applying the deduction limit, including the “applicable individuals,” “applicable individual remuneration” and “deferred deduction remuneration” subject to the limit, as well as the “disqualified taxable years” for which Health Insurers are subject to the limit.

• Applicable individuals are defined as individuals who are officers, directors or employees of a Health Insurer during a disqualified tax year, any other individual providing service to or on behalf of the Health Insurer during the year, and any independent contractor to it, unless the contractor (1) is not related to the insurer, (2) is actively engaged in the trade or business of providing services, and (3) provides significant services to two or more unrelated service recipients. The rules of Treas. Reg. § 1.409A-1(f)(2)(ii) are generally used to determine when a contractor will be considered related, with one adjustment to the degree of relationship that will trigger the requirement to treat the contractor as related. In the preamble to the proposed regulations, IRS and Treasury noted a concern that Health Insurers might try to avoid the deduction limit by encouraging individuals to form personal service corporations or similar entities so that they would not be considered individuals under these rules. The preamble to the final rules indicates the regulators still have this concern, but they have not addressed it other than to say it may be the subject of future guidance.
• A disqualified taxable year is any tax year in which an insurer is a Health Insurer and employs or otherwise receives the services of applicable individuals.
• Applicable individual remuneration means the amount allowable as a deduction for a tax year as remuneration for services, excluding deferred deduction remuneration. Thus, it generally refers to current compensation, including a discretionary bonus paid in the current year but earned in a prior year. The acronym AIR is used for this term in the regulations; for ease of reference, it is referred to here as “Current Compensation (AIR).” The regulations define “remuneration” by cross-reference to section 162(m)(4), which is the definition used for the $1 million deduction limit for publicly traded companies, but without the exceptions for commissions and performance-based pay. The rules include exceptions for contributions to certain qualified retirement plans and for benefits excludible from gross income, such as for health and other welfare or fringe benefits.
• Deferred deduction remuneration, as the name implies, is remuneration that would be Current Compensation (AIR) for a year but for the fact that it is deductible in a later year. Generally, it includes  nonqualified deferred compensation, certain equity compensation and other types of compensation as determined under the attribution rules described below. The rules note that the time of payment is not relevant in determining whether amounts are deferred, except to the extent that the time of payment determines the time for deduction, as is generally the case for nonqualified deferred compensation. To refer to these amounts, the acronym DDR is used in the regulations, while the term “Deferred Compensation (DDR)” is used here.

Covered Health Insurance Providers (Health Insurers). Under the general rule, a Health Insurer subject to the deduction limit is:

1. A health insurance issuer (as defined in section 9832(b)(2)) for any tax year that begins after December 31, 2012, in which 25% or more of its gross premium receipts for health insurance coverage (as defined in section 9832(b)(1)) are from minimum essential coverage under section 5000A(f), which is generally coverage that will meet the PPACA individual mandate;
2. A health insurance issuer for any of its tax years that begin after December 31, 2009, and before January 1, 2013, in which it receives any premium for health insurance coverage under section 9832(b)(1);
3. The parent entity of a controlled group or other aggregated group including one or more Health Insurers meeting either of the above definitions; and
4. Each other member of an aggregated group including a Health Insurer.

Aggregated Groups. Aggregated groups for this purpose include a controlled group of corporations under section 414(b), a group of trades or businesses under common control as defined in section 414(c), an affiliated service group under section 414(m) or a group described in section 414(o), except that the brother-sister and combined group rules are disregarded, limiting aggregated groups to parent-subsidiary groups. The regulations provide that the parent of an aggregated group is (1) the parent under sections 414(b) or 414(c), or (2) the health insurance issuer in a group under sections 414(m) or 414(o). However, if the latter type of group includes more than one insurer, the members of the group are to designate which is to be treated as the parent, and, if they fail to do so, the parent is deemed to have a calendar year tax year.
The significance of the identity of the parent is for determining the members of the group when not all members have the same tax year or when there is a corporate transaction that affects the members of a group, as well as determining which tax years are disqualified tax years for which the group is subject to the deduction limit. The final regulations include several new rules clarifying how these rules apply to predecessor and successor entities and in the case of a short taxable year for a parent.

U.S. Possessions. A commenter on the proposed regulations recommended that the final rules provide that an insurer located in Puerto Rico not be considered a Health Insurer. In the preamble to the final rules, the regulators said they had not adopted this suggestion, pointing to the conclusion that had been reached under the regulations implementing the health insurance providers fee of PPACA section 9010 that an insurer may be a health insurance issuer under section 9832(b)(2) even if located in Puerto Rico. Presumably the same rule applies for insurers in other U.S. possessions.
 
De Minimis Exception. As noted above, the final regulations retain the de minimis exception to the definition of covered health insurance provider. Under this exception, a health insurance issuer is not a Health Insurer for a tax year after December 31, 2012, if its premium receipts for minimum essential coverage are less than 2% of the gross revenues of all members of its aggregated group. For the 2010-2012 tax periods, the exception is applied based on premiums for any health coverage. Gross revenue must be determined using generally accepted accounting principles for this purpose. The final rules clarify that an entity that is part of a group with a predecessor parent and a successor parent for any tax year is eligible for the de minimis exception for that year only if the rule for the exception is met based on the tax years of the predecessor and the successor. The regulations also include a one-year transition period that applies if an insurer that has been relying on the de minimis exception fails to meet it.
  
Premiums. For purposes of identifying the Health Insurers subject to the deduction limit, premiums mean premiums written, excluding indemnity reinsurance, without reduction for ceding commissions or medical loss rebates. The final rules clarify that premiums written include premiums for assumption reinsurance less assumption reinsurance ceded and exclude direct service payments. The terms “assumption reinsurance” and “indemnity reinsurance” are defined in the rules.  Also, direct service payments are generally defined as payments an insurer makes to another entity to compensate it for providing or managing healthcare services by hospitals or other providers, regardless of whether the entity is subject to licensing or similar regulations.

Self-Insurance. The rules specifically provide that an employer that self-insures a medical reimbursement plan will not be considered a Health Insurer solely because it maintains such a plan. In response to a comment, IRS and Treasury agreed that an employer that self-insures such a plan and maintains an additional insured plan, e.g., for prescription drugs, will not be considered a Health Insurer.

Other Comments Received. The preamble indicates that IRS and Treasury received comments requesting that providers that accept risk-based payments (clinical risk-bearing entities), Medicaid managed care organizations, and providers of Medicare Advantage and Medicare Part D prescription drug plans either be excluded from being Health Insurers or have the amounts they receive as payments be excluded from the definition of premiums. IRS and Treasury, however, said it would be inappropriate to provide guidance on these issues in the context of the section 162(m)(6) regulations since the terms health insurance coverage and health insurance issuer in sections 9832(b)(1) and 9832(b)(2), on which the definition of Health Insurer is based, have broader implications. The preamble went on to say that additional guidance with respect to these types of entities could be issued in other rules.

Similarly, the final rules do not take a position on whether a stop-loss carrier is a Health Insurer. Instead, the preamble says premiums for stop-loss coverage will not be treated as premiums for health insurance until such time, if any, that future guidance addresses the extent to which medical stop-loss policies will be treated as health insurance more broadly for purposes of the PPACA.

Applying the Limit. The deduction limit applies first to Current Compensation (AIR). Specifically, a Health Insurer is not permitted a deduction for any disqualified tax year beginning after December 31, 2012, for Current Compensation (AIR) attributed to an applicable individual’s services in that year to the extent the compensation exceeds $500,000. If the individual’s Current Compensation (AIR) for the year is less than $500,000, any remainder of the limit may be carried forward to allow a deduction for the individual’s Deferred Compensation (DDR) that later becomes deductible and that is attributable to services the individual performed in the disqualified tax year under the attribution rules described below. Each year the limit is applied, if any amount remains, it may be carried forward to allow a deduction for Deferred Compensation (DDR) otherwise deductible in a later tax year that is attributable to services in the disqualified tax year. Thus, to apply the limit, it is necessary to determine the year to which both types of remuneration – Current Compensation (AIR) and Deferred Compensation (DDR) – are attributable and to determine whether the Health Insurer was a Health Insurer in that year, with the result that the Health Insurer’s tax year is a disqualified tax year and the limit applies.

The regulations include detailed rules for determining the year(s) to which amounts of compensation are attributable, with a choice of two methods each for nonqualified deferred compensation plans based on an account balance and nonaccount balance plans, and additional rules for equity-based compensation, involuntary separation pay, reimbursement arrangements, and split-dollar life insurance arrangements.

General Rules. Several general rules apply for all types of arrangements and compensation.

• Compensation cannot be attributed (1) to a year before the later of (a) the date the individual became an employee or otherwise began providing services, or (b) the date he or she obtained a legally binding right to the compensation, or (2) to any year the individual is not employed or otherwise providing services.
• If the specific attribution rules would attribute an amount to a year earlier than permitted under the preceding rule, it is instead to be attributed to the year the individual began service or obtained a legally binding right to the amount, whichever is later.
• Several of the specific attribution rules require or permit attribution on a daily pro rata basis (i.e., pro rata to each day within a specified period), and these rules may be applied assuming that all years have 365 days and ignoring leap years.
• If stock or property is subject to a nonlapse restriction, such as limiting the value to book value, or if a similar formula limit applies to other compensation, the amount and attribution of it are determined by applying the nonlapse restriction or formula.

Legally Binding Rights. Unless one of the specific attribution rules described below applies, compensation will be attributed to the tax year of the Health Insurer in which the applicable individual earns a legally binding right to it. The standard for determining when a legally binding right arises is the same as under section 409A.

Account Balance Plans. The final rules cross-reference Treas. Reg. §§ 1.409A-1(c)(2)(i)(A) and (B), rather than defining account balance plans. The regulations permit a Health Insurer to choose one of two methods to attribute the balance to an individual’s years of service; however, except for a transition rule for years prior to the effective date of the final regulations and a special rule for corporate transactions, the insurer must apply the same rule for all plans for all years.

• Under the account balance ratio method, an amount becoming deductible under an account balance plan is attributed to the years the account balance increased by multiplying the amount otherwise deductible by a fraction, with the numerator being the increase for a specific tax year and the denominator being the sum of the increases for all tax years. An increase occurs for this purpose only when there is an increase over every earlier year, with detailed rules for when to measure increases and for making adjustments to the extent there are any in-service payments or increases after an individual separates from service (which are added to the balance for the year the individual last worked), as well as how to handle grandfathered amounts if another method is used to determine what is grandfathered. There is also a transition rule for amounts attributable to years before the final regulations are effective.
• Under the principal additions method, to the extent a Health Insurer separately accounts for hypothetical contributions or other additions to principal, a principal addition is attributed to the year for which it is credited and related earnings are attributed to the same year. Whether an amount is considered earnings or principal under this rule is determined using the same standards as under section 3121(v)(2), which require use of a reasonable rate of interest or crediting earnings based on a predetermined actual investment. Principal additions after an individual has separated from service must be attributed to the year he or she last worked.
• The rules provide many examples to illustrate the application of these two methods in various scenarios, such as with lump sum or multiple payments and with only earnings or earnings and losses. Examples that are the same, except that one uses the account balance ration method, while the other uses the principal  additions method, indicate that the account balance ratio method tends to back load the attribution (attributing more to later years), and the principal additions method tends to front load it.

Nonaccount Balance Plans. As for account balance plans, the final rules (1) do not define the term nonaccount balance plan but cross-reference to the definition in Treas. Reg. § 1.409A-1(c)(2)(i)(C), (2) permit a Health Insurer to choose between two methods for determining attribution, and (3) require consistent use of the method for all plans and all years except for a transition rule for years prior to the effective date and a special rule for corporate transactions.

• The present value ratio attribution method is similar to the account balance ratio method in many respects. It provides for determining the increase in the present value of future payments as the increase over every prior year and attributing the amount becoming deductible based on a fraction, the numerator of which is the increase for a year, and the denominator is the sum of the increases for all years. This method also requires use of a specific measurement date and adjustments to the present value for in-service payments and amounts attributed to years before the effective date of the final rules.
• The formula benefit ratio method applies a similar ratio to determine attribution, but rather than basing it on the present value, the amount otherwise deductible is attributed to tax years based on multiplying it by a fraction, the numerator of which is the increase in the formula benefit under the plan for a tax year, and the denominator of which is the increase for all years. The formula benefit under the plan is the benefit to which the individual has a legally binding right, assuming the benefit is vested and the individual meets the eligibility conditions for it. Increases in the benefit are measured as of specified dates, and adjustments are made for amounts not paid when deductible and increases after separation from service.
• Again, the rules include a number of examples to illustrate the application of the two methods in various circumstances.

Equity-Based Compensation. The final rules include separate rules for attributing the amount of different types of equity compensation to different periods, though each is based on attributing it on a daily pro rata basis.

• For an option, including an incentive stock option (ISO), or a stock appreciation right (SAR) not subject to vesting, the compensation is attributed on a daily pro rata basis over the period from the date of grant to the date of exercise, but disregarding any days the individual is not in service.
• Under a new rule, if an option or a SAR is subject to vesting, a Health Insurer may use the period under the preceding rule or the period from the date of vesting to the date of grant. An insurer electing to use the latter rule must use it consistently after the final rules become effective except if there is a corporate transaction.
• Restricted stock is attributed to the period beginning when the individual obtains a legally binding right to it and ending when (1) the stock becomes vested, or (2) the individual transfers the stock, if earlier. However, if an election under section 83(b) is made, the stock is attributed to the year the election is effective.
• Restricted stock units are attributed on a daily pro rata basis to the period that begins when the individual obtains a legally binding right to the units and ends when the units are paid or made available.
• Although the proposed regulations said analogous rules would apply to partnership or other equity interests, the final rules reserve with respect to these types of interests. Despite that, the preamble to the final rules says that, until future guidance is issued, analogous rules can be applied to this type of equity compensation, subject to any other rules of the Code for partnership interests that affect, e.g., the timing or amount of a deduction.

Involuntary Separation Pay. Generally, severance or other separation pay that is payable solely when an individual has an involuntary separation (as defined in Treas. Reg. § 1.409A-1(n)) is attributed to the year the individual separates from service. However, if the individual had a legally binding right to severance or separation pay in an earlier year, the Health Insurer may elect to attribute it on a daily pro rata basis over the period from the date the individual obtained the right to it to the date of separation. A Health Insurer may use different methods of attribution for different individuals, but if payments to one individual are made over multiple years, the same method must be used for all of the payments to that individual.

Reimbursements. Reimbursements of amounts or benefits paid in-kind are to be attributed to the year the individual makes a payment that will be reimbursed or receives the in-kind benefit. If that year occurs after the individual has separated from service though, the amount is attributable to the year he or she last worked.

Split-Dollar. A split-dollar arrangement under which an individual receives economic benefits under Treas. Reg. § 1.61-22(d) will give rise to compensation attributable to the year the legally binding right to those benefits arises.  Split-dollar loans generally will not result in Deferred Compensation (DDR), but may result in Current Compensation (AIR), e.g., if loan payments are waived or forgiven.

Special Rules. The final rules include provisions that address treatment of an individual who is paid by two or more members of an aggregated group and corporate transactions.

Aggregated Group. If the Health Insurer is a member of an aggregated group and an individual is entitled to compensation from more than one member of the group, the deduction limit must be allocated among the members.  The regulations provide that the available deduction is allocated to a member based on the ratio of the compensation otherwise deductible by the member to the total compensation deductible by all members.

Corporate Transactions. The regulations provide certain transition and other special rules for corporate transactions that affect Health Insurers and their aggregated groups. A corporate transaction for this purpose includes a merger, an asset or stock acquisition or disposition, or a reorganization or another transaction that changes the make-up of an aggregated group.

• Transition Relief for Entities that Are Not Health Insurers. If an entity or group that is not a Health Insurer acquires a Health Insurer, the acquiring group will not be treated as subject to the deduction limit for its tax year in which the corporate transaction occurs. The transition relief does not apply to the individuals employed by or providing services to the acquired Health Insurer, including to the extent that any such individuals also work for a member of the acquiring group that is otherwise entitled to the transition relief.
• Transition Relief for Consistency Rules. As noted above, the attribution rules for account balance plans, nonaccount balance plans, and certain types of equity compensation plans require consistent use of certain optional methods for all plans and all members of an aggregated group. The regulations provide an exception to this rule when there is a corporate transaction involving two or more Health Insurers that used different methods of attribution before the transaction. The rules permit use of different attribution methods for the year of the transaction, with a change to the method used by either insurer for future years unless future guidance restricts these choices. However, to the extent a method has been in use for any individual before the transaction, that method must continue to be used for the individual under the same type of plan for any amounts to which he or she had a legally binding right as of the transaction.
• Short Tax Year. The deduction limit is not prorated or reduced for a short tax year resulting from a corporate transaction.
• De Minimis Rule. If an insurance carrier becomes part of an aggregated group or ceases to be in a group as a result of a corporate transaction, the determination of whether the de minimis rule is met for either the old group or the new group is made taking into account only the premiums and gross revenue during the period the carrier is a member of the applicable group for the year.

Other Rules. The final regulations also provide rules for coordinating the section 162(m)(6) deduction limit with the $1 million deduction limit for a publicly traded company under section 162(m)(1) and the section 280G rules disallowing a deduction for parachute payments. In addition, there are several rules for determining the grandfathered amounts that are not subject to the limit. Under the general grandfather rules, the attribution rules are applied to determine the year to which amounts under various arrangements are to be attributed, and the amounts are grandfathered if attributed to years beginning before January 1, 2010. There is an exception to the consistency rule for account balance plans for this purpose. There is also a special grandfather rule for equity-based compensation.

Effective Date. The final regulations are effective September 23, 2014, and apply to taxable years beginning after that date.

¹ A reference to a section herein is a reference to a section of the Code unless otherwise specified.