The Patient Protection and Affordable Care Act included a little-discussed provision limiting the compensation deduction allowable for “health insurance providers.” Significantly, the definition of “health insurance provider” under this provision is so broad that this limit likely will catch many companies by surprise. The new compensation deduction limit, which is codified in new Section 162(m)(6) of the Internal Revenue Code of 1986, as amended (the “Code”), generally limits the deduction allowable for compensation paid to a service provider by certain health insurance providers (and their related entities) to $500,000, effective for amounts deductible in tax years starting after December 31, 2012.
Code Section 162(m), in general, limits the deduction allowed for compensation paid by a publicly-held corporation to a “covered employee” to $1 million. A “covered employee” is the CEO and four other most highly paid employees of the corporation with reportable (under the Securities Exchange Act of 1934) compensation. “Compensation” for purposes of this limit includes taxable wages but excludes commissions and other performance-based compensation.
There is also a $500,000 compensation deduction limit for compensation paid to “covered executives” by certain employers that participated in the Troubled-Asset Relief Program (“TARP”). “Covered executives” include the CEO, the CFO and the three other most highly-compensated employees of the employer. In addition, TARP limits the ability of these employers to pay or accrue bonuses, retention awards or executive compensation while any TARP obligation is outstanding.
Which Employers are Subject to the New Limit?
The new limit applies only to employers that are “covered health insurance providers.” Code Section 162(m)(6) sets forth two different definitions of a “covered health insurance provider” for each of two different periods. (See Code Section 162(m)(6)(C))
For tax years starting after December 31, 2009, and before January 1, 2013, a “covered health insurance provider” is defined broadly as any employer that is a “health insurance issuer,” such as an insurance company or HMO, that receives premiums from providing “health insurance coverage”.
For tax years starting on or after January 1, 2013, 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.
“Health insurance coverage” for both definitions means benefits consisting of medical care (provided directly, through insurance or reimbursement, or otherwise) under any hospital or medical service policy or certificate, hospital or medical service plan contract, or HMO contract offered by a health insurance issuer, but does not include the following supplemental or incidental-type benefits:
- Accident or disability income insurance,
- medical care coverage supplemental to liability insurance,
- liability insurance, including general liability insurance and automobile liability insurance,
- workers' compensation or similar insurance,
- automobile medical payment insurance,
- credit-only insurance,
- coverage for on-site medical clinics, and
- other similar benefits specified in regulations under which benefits for medical care are secondary or incidental to other insurance benefits
Notably, the following types of benefits qualify as “health insurance coverage” under the new rules, even if offered separately or as independent, non-coordinated benefits:
- Limited scope dental or vision benefits,
- benefits for long-term care, nursing home care, home health care or community-based care,
- coverage only for a specified disease or illness,
- hospital indemnity or other fixed indemnity insurance, and
- Medicare supplemental health insurance.
Unlike the general $1 million deduction limit under Code Section 162(m)(1), the new limit under Code Section 162(m)(6) is applicable to an employer without regard to whether it is publicly-traded. In addition, all compensation paid by any member of the controlled group must be aggregated to determine whether the $500,000 limit is exceeded.
What About Employers Related to a Covered Health Insurance Provider?
Code Section 162(m)(6) applies the Code Section 414 controlled group rules used for qualified retirement plans (other than the “brother-sister” and “combined group” rules) to make the new compensation deduction limit applicable to all members of a covered health care provider’s controlled group. Thus, if any member of an employer’s controlled group is a covered health care provider under these rules, the deduction limit will apply to that employer and every other member of that controlled group.
In addition, all compensation paid by any member of the controlled group must be aggregated to determine whether the $500,000 limit is exceeded.
How Does the Limit Apply?
Code Section 162(m)(6) will apply to both current and nonqualified deferred compensation. With respect to current compensation, Code Section 162(m)(6) provides that no income tax deduction will be allowed in the case of “applicable individual remuneration” in excess of $500,000 for any tax year beginning after December 31, 2012 in which an employer is a “covered health insurance provider” if such remuneration is attributable to services performed by an “applicable individual” during such tax year.
With respect to nonqualified deferred compensation, Code Section 162(m)(6) applies to compensation defined as “deferred deduction remuneration,” which is remuneration relating to services an individual performs during any taxable year starting after December 31, 2009, in which the employer is a “covered health insurance provider,” that is not deductible until a tax year starting after December 31, 2012, such as nonqualified deferred compensation. In the case of deferred deduction remuneration, the unused portion (if any) of the $500,000 limit for current compensation for the year is carried forward until the year in which the deferred compensation is otherwise deductible, and the remaining unused limit is then applied to the deferred compensation.
For example, assume that XYZ Corporation is a covered health insurance provider for 2013 and pays its valued employee Donna $400,000 in current compensation in 2013. In addition, Donna earns $200,000 in nonqualified deferred compensation in 2013, payable in 2015. Donna’s $400,000 in current compensation is fully deductible in 2013 by XYZ Corporation since it is within the $500,000 limit for 2013. In 2015, when Donna’s $200,000 in deferred compensation becomes payable, XYZ Corporation will only be able to deduct $100,000 of such deferred compensation, which represents the unused portion of the limit from 2013.
Note that any unused portion of the $500,000 deduction limit that is carried forward under these rules does not reduce the $500,000 limit for current compensation. Thus, if XYZ Corporation pays Donna $600,000 in current compensation in 2015, it would be able to deduct (in addition to the $100,000 in deferred compensation) $500,000 of Donna’s current compensation.
What Compensation is Subject to the New Limit?
The new compensation deduction limit applies to “applicable individual remuneration,” which essentially includes all current compensation, and unlike the $1 million deduction limit applicable to compensation paid by publicly-traded companies, there are no exceptions for commissions or performance-based compensation.
Which Service Providers are Subject to the New Limit?
The new compensation deduction limit applies to all “applicable individuals” with respect to a covered health insurance provider, which include any individual who is an officer, director, or employee or who provides services for, or on behalf of, the covered health insurance provider. Unlike the $1 million limit under Code Section 162(m)(1) and the $500,000 limit under TARP, which apply only to certain officers and highlycompensated employees, the new limit under Code Section 162(m)(6) applies to any service provider working for, or on behalf of, a covered health insurance provider. Moreover, if an individual is an “applicable individual” with respect to a covered health insurance provider for any taxable year, the individual is treated as an applicable individual for all subsequent taxable years (and is treated as an applicable individual for purposes of any subsequent taxable year for purposes of the special rule for deferred compensation).