Regardless of what your opinion may be of the Patient Protection and Affordable Care Act ("ACA"), certainly one of the most unnecessary and insidious provisions of ACA (Public Law 111-148, 124 Stat. 119, 868 (2010)) was the addition of a new Section 162(m)(6) to the Internal Revenue Code. Section 162(m)(6) limits to $500,000 the allowable deduction for the "aggregate applicable individual remuneration" and "deferred deduction remuneration" attributable to services performed by an "applicable individual" for a "covered health insurance provider" in a "disqualified taxable year" beginning after December 31, 2012.
The random, retributive $500,000 limit on compensation for health insurance providers was bad enough. What is worse, however, is how broadly the law "covered health insurance provider" to reach all members of a controlled group of corporations that includes a health insurance provider.
The IRS/Treasury Department has issued Proposed Regulations under new Code Section 162(m)(6). (In December 2010, IRS/Treasury had issued Notice 2011-2, which provided some guidance on certain issues under Section 162(m)(6).) The Proposed Regulations go on for over 100 pages. However, among the more critical (and complicated) provisions of the Proposed Regulations are those providing extensive rules for the attribution of deferred compensation, non-qualified plan benefit accruals, equity-based compensation, and even severance pay.
These rules are critical because, unlike the other provisions of Code Section 162(m), the determination of whether the $500,000 deduction cap applies to the compensation paid to or earned by an applicable individual (including compensation deferred, non-qualified plan benefits accrued, equity compensation awarded and severance payments made) is made in the year in which the individual performed the services, not in the year the amounts are actually paid.
For example, if a covered health insurance provider pays $400,000 in salary to an applicable individual in 2014 and a $300,000 bonus, which the individual elects to defer under a non-qualified deferred compensation plan, the $400,000 salary is deductible in 2014. If the $300,000 deferral is held until the individual's termination of employment in 2021, and earns interest of $50,000 during that period, only $100,000 of the $350,000 lump sum paid out to the individual in 2021 will be deductible in that year. The $200,000 is never deductible. Whether the $50,000 in investment earnings is deductible will depend on the amount of other compensation paid to the individual (and deducted by the company) in each year. If the individual's deferred compensation account earned $10,000 in "interest" in 2015 and the company paid the individual a salary of $450,000 – and nothing else – the $10,000 would be deductible when paid in 2021.
Similarly, for equity compensation awarded to an applicable individual, the proposed regulations provide that:
- "Compensation" resulting from the exercise of stock options or SARs generally is attributable, on a daily pro rata basis, to services performed by the applicable individual over the period beginning on the date of grant of the stock option or SAR and ending on the date that the stock right is exercised, excluding any days on which an applicable individual was not a service provider.
- "Compensation" resulting from the vesting of restricted stock (other than for which an 83(b) election was made) generally is attributable, on a daily pro rata basis, to services performed by the applicable individual over the period beginning on the grant date of the restricted stock and ending on the date on which the substantial risk of forfeiture lapses and the stock become vested and taxable.
- "Compensation" resulting from RSUs is generally attributable, on a daily pro rata basis, to services performed over the period beginning on the date the applicable individual obtains the legally binding right to the RSU and ending on the date the compensation is paid or made available such that it is includible in gross income, which often is the same date (again, excluding any days on which an applicable individual is not a service provider).
What about deferred compensation, non-qualified plan benefits, equity compensation and severance payments that are subject to a vesting schedule? The proposed regulations provide that any forms of compensation that are subject to a substantial risk of forfeiture must be attributed using a two-step process.
- First, the compensation is attributed to taxable years of the covered health insurance provider using to the legally-binding-right rule or the rules applicable to account balance or non-account balance plans (shown in the example), as applicable.
- Second, the compensation that was subject to a substantial risk of forfeiture is reattributed on a daily pro rata basis over the period that it was subject to a substantial risk of forfeiture (in other words, reattributed evenly over the vesting period).
The proposed regulations adopt the definition of "substantial risk of forfeiture" provided under the Section 409A regulations.
The proposed regulations provide the following example for an award of restricted stock.
F is an of U for all relevant taxable years. On January 1, 2017, corporation U grants applicable individual F 100 shares of restricted U common stock. Under the terms of the grant, the shares will be forfeited if F voluntarily terminates employment before December 31, 2019. F does not make an 83(b) election under and continues in employment with U through December 31, 2019, at which time F's rights in the stock become vested and the fair market value of a share of U stock is $109.50. The deferred deduction remuneration resulting from the vesting of the restricted stock is $10,950 ($109.50 x 100).
The remuneration resulting from the vesting of the restricted stock is attributable to services performed by F on a daily pro rata basis over the period beginning on the date U granted the restricted stock to F and ending on December 31, 2019. Therefore, the $10,950 will be attributed to services over the 1,095 days between January 1, 2017 and December 31, 2019 (365 days per year for the 2017, 2018, and 2019 taxable years), so that $10 ($10,950 divided by 1,095) is attributed to each calendar day in this period, and remuneration of $3,650 (365 days x $10) is attributed to services performed by F in each of U's 2017, 2018, and 2019 taxable years.
The cliff vesting schedule appears to be ignored. Whether U will be able to deduct the $3,650 of remuneration attributed to F in any of the 2017, 2018, or 2019 taxable years will depend upon how much other compensation U paid to F in each of those years.