The Internal Revenue Service recently issued Notice 2011-02 providing much-needed guidance on the Code1 Section 162(m)(6) deduction limit for compensation paid by “covered health insurance providers,” which was enacted as part of the Patient Protection and Affordable Care Act. As we reported in our November 2010 Compensation and Benefits Insights, new Code Section 162(m)(6) generally limits the deduction allowable for compensation paid to a service provider by a covered health insurance provider (and its related entities) to $500,000, effective for amounts deductible in 2013 or later tax years. Notice 2011-02 clarifies the application of this limit in a number of important respects.

 Background

     Code Section 162(m)(6) limits the allowable deduction by a “covered health insurance provider” for the 2013 and later tax years to $500,000, for both current compensation and deferred deduction remuneration that is attributable to services performed by a covered individual. “Deferred deduction remuneration” is compensation relating to services a covered individual performs during the 2010 or later tax years in which the employer is a “covered health insurance provider” and that is not deductible until the 2013 or later tax years.

     The term “covered health insurance provider” is defined differently under Code Section 162(m)(6) for each of two different periods. For the 2010 through 2012 tax years, a “covered health insurance provider” is defined broadly as any employer that is a health insurance issuer receiving premiums from providing health insurance coverage.

     For the 2013 and later tax years, a “covered health insurance provider” is defined more narrowly as an employer that is a health insurance issuer with respect to which not less than 25 percent of the premiums received by the employer from providing health insurance coverage is from the provision of the “minimum essential coverage” that individuals will have to maintain under the new health care reforms.

Definition of “Covered Health Insurance Provider”

Confusion Arising As a Result of Two Different Definitions

     As a result of the two different definitions of “covered health insurance provider,” questions have been raised regarding whether an employer who satisfies the broad pre-2013 definition, but who never satisfies the more narrow post-2012 definition, would be subject to the Code Section 162(m)(6) deduction limit. Notice 2011-02 clarifies that such an employer would not be subject to the new deduction limit.

     Specifically, Notice 2011-02 provides that the deduction limit applies to “deferred deduction remuneration” for the 2010 through 2012 tax years only if (1) the employer was a pre-2013 covered health insurance provider and (2) the employer is a post-2012 covered health insurance provider for the tax year in which the deferred deduction remuneration is otherwise deductible.

     Both a Pre-2013 and a Post-2012 Covered Health Insurance Provider: For example, assume that XYZ corporation is a pre-2013 covered health insurance provider for the 2010, 2011 and 2012 tax years and a post- 2012 covered health insurance provider for all tax years after 2012. Any deferred deduction remuneration attributable to services performed in the 2010, 2011 or 2012 tax year would be subject to the Code Section 162(m)(6) deduction limit in the tax years after 2012 in which such amounts are otherwise deductible.

     In addition, assume that XYZ corporation is a pre-2013 covered health insurance provider for the 2010, 2011 and 2012 tax years and a post-2012 covered health insurance provider for all tax years after 2016. Any deferred deduction remuneration attributable to services performed in the 2010, 2011 or 2012 tax year would be subject to the Code Section 162(m)(6) deduction limit in the 2016 and later tax years in which such amounts are otherwise deductible. However, any deferred deduction remuneration attributable to services performed in the 2010, 2011 or 2012 tax year that is otherwise deductible in the 2013, 2014 or 2015 tax year would not be subject to the deduction limit. Moreover, any deferred deduction remuneration attributable to services performed in the 2013, 2014 or 2015 tax year would similarly not be subject to the deduction limit for the tax years in which such amounts are otherwise deductible.

     Neither a Pre-2013 nor a Post-2012 Covered Health Insurance Provider: On the other hand, if XYC corporation was not a pre-2013 covered health insurance provider, and never becomes a post-2012 covered health insurance provider, any deferred deduction remuneration attributable to services performed in the 2010, 2011 or 2012 tax year would not be subject to the Code Section 162(m)(6) deduction limit in the tax years after 2012 in which such amounts are otherwise deductible.

     Only a Post-2012 Covered Health Insurance Provider: Moreover, if XYZ corporation was not a pre- 2013 covered health insurance provider, but is a post-2012 covered health insurance provider, any deferred deduction remuneration attributable to services performed in the 2010, 2011 or 2012 tax year would not be subject to the Code Section 162(m)(6) deduction limit in the tax years after 2012 in which such amounts are otherwise deductible.

De Minimis Rule

     In addition, Notice 2011-02 provides a “de minimis” exception to the definition of “covered health insurance provider.” For the 2010 through 2012 tax years, an employer will come within this exception if the premiums received by the employer for providing health insurance coverage for that year are less than 2% of the employer’s gross revenues for that year. For the 2013 and later tax years, an employer will come within this exception if the premiums received by the employer for providing health insurance coverage are from providing minimum essential coverage for that year are less than 2% of the employer’s gross revenues for that year.

 Reinsurers not Covered

     Moreover, Notice 2011-02 clarifies that for purposes to determining whether an entity is a “covered health insurance provider,” premiums received under an indemnity reinsurance contract will not be treated as premiums from providing health insurance coverage.

Certain Independent Contractors

      Notice 2011-02 also clarifies that an employer’s independent contractors whose compensation arrangements are exempt from Code Section 409A (which generally exempts arrangements with independent contractors providing substantial services to multiple unrelated customers) are not subject to the Code Section 162(m)(6) deduction limit.

Effective Date

     The guidance under Notice 2011-02 is effective for the 2010 and later tax years.