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Affordable Care Act restricts tax-deductible pay to health insurance executives amid record profits for the industry

Opportunities for non-qualified compensation planning in 2014

Non-qualified executive bonus plans are fast and easy to set up and do not require IRS approval so this is the most likely response by both large and small health insurance companies with better than expected financial results this year.

by Tony Novak, CPA, MBA, MT    originally published December 29, 2010, last revised August 28, 2014

 

A lesser-known provision in the Affordable Care Act is designed to limit the pay of health insurance company executives. The law attempts to expand health insurance coverage by bringing millions of new customers to the commercial insurance companies and provide government help for the marketing of their insurance. In return, the insurance companies are required to give up certain business practices that boost profitability. This provision to limit executive pay was primarily included to combat public criticism of the individual mandate which requires individuals to become customers of commercial insurance companies. The new law causes a change to Section 162 of the Internal Revenue Code that controls business tax deductions for wages and compensation as an ordinary business expense. This week IRS issued Notice 2011-2 to provide additional guidance to insurance companies.

First, we should recognize that the law does not, in reality, limit pay to insurance executives. Rather it limits the company's income tax deduction to the first $500,000 of compensation. Pay above that amount is essentially treated the same as other non-deductible supplemental executive compensation plans. Some companies use non-deductible compensation plans already anyway, especially for non-qualified deferred compensation plans funded with cash value life insurance.

Second, we recognize that the future of law is in doubt. Courts will likely uphold the unconstitutionality of the individual mandate that is the backbone of the health reform law. If the individual mandate is not upheld, the other provisions are not sustainable either legally or economically. Recall that the law was intentionally drafted without a severability provision because, in fact, the provisions are directly depend on each other. We could not require commercial insurance companies to accept unhealthy individuals, for example, without providing the extra premium pool and a mechanism to eliminate adverse selection. Attempts to enforce one provision without the other would fail on both legal and economic basis.

In 2014 health insurance companies are likely to see record profits. Recent increased earnings projection reports from health care giants like HCA Holdings, LifePoint Hospitals and UnitedHealth Group are likely an indication of a trend that may reflect in many smaller companies as well. Compensation planners may see an increase in requests for non-qualified deferred compensation plans in the latter part of 2014. These compensation bonus plans are easy to set up, do not require IRS or shareholder approval, and are the most likely form of executive compensation above the $500,000 limit. Even at lower levels of compensation, these are popular for executives who are already at maximum contribution levels in 401(k) plans and pension plans. Life insurance is the preferred funding choice because of the safety of cash value benefits, the non-taxable buildup of value and the ability to borrow from that value at any time without triggering a taxable event.

Following is an excerpt from the Affordable Care Act that limits the tax deduction for executive compensation:

Part III – Administrative, Procedural, and Miscellaneous Guidance on the Application of Section 162(m)(6)
Notice 2011-02

I. PURPOSE
This notice provides guidance on the application of section 162(m)(6) of the Internal Revenue Code (Code). Section 162(m)(6) limits the allowable deduction for remuneration for services provided by individuals to certain health insurance providers. Section 162(m)(6) was added to the Code by section 9014 of the Patient Protection and Affordable Care Act (Public Law 111-148, 124 Stat. 119, 868 (2010)). Section III of this notice provides guidance on certain issues the Treasury Department and the IRS have determined require immediate guidance. Section V requests comments as to the application of the provisions of this notice as well as all other aspects of the application of section 162(m)(6). The Treasury Department and the IRS anticipate that the guidance provided in this notice will be incorporated into future regulations issued under section 162(m)(6).

II. BACKGROUND
Section 162(m)(6) limits the allowable deduction to $500,000 for “applicable individual remuneration” and “deferred deduction remuneration” attributable to services performed by “applicable individuals” that is otherwise deductible by a “covered health insurance provider” in taxable years beginning after December 31, 2012. Section 162(m)(6)(C)(i)(I) provides that for taxable years beginning after December 31, 2009, and before January 1, 2013, the term "covered health insurance provider" means any employer that is a health insurance issuer as defined in section 9832(b)(2) and which receives premiums from providing health insurance coverage (as defined in section 9832(b)(1)) (“pre-2013 covered health insurance provider”). For taxable years beginning after December 31, 2012, section 162(m)(6)(C)(i)(II) provides that the term “covered health insurance provider” means any employer that is a health insurance issuer as defined in section 9832(b)(2) and with respect to which not less than 25% of the gross premiums received from providing health insurance coverage (as defined in section 9832(b)(1)) are from minimum essential coverage (as defined in section 5000A(f)) (“post-2012 covered health insurance provider”). Section 162(m)(6)(C)(ii) provides that two or more persons who are treated as a single employer under section 414(b), (c), (m), or (o) are treated as a single employer for purposes of section 162(m)(6), except that in applying section 1563(a) for purposes of any such subsection, paragraphs (2) and (3) thereof are disregarded. Section 162(m)(6) applies to applicable individual remuneration attributable to services performed in a “disqualified taxable year” beginning after December 31, 2012 that is otherwise deductible in such taxable year. Section 162(m)(6)(B) provides that a disqualified taxable year for any employer is any taxable year for which the employer is a covered health insurance provider.

Section 162(m)(6)(D) provides that applicable individual remuneration for any disqualified taxable year is the aggregate amount otherwise allowable as a deduction for such taxable year for remuneration for services performed by such individual (whether or not during the taxable year), but does not include any deferred deduction remuneration with respect to services performed during the disqualified taxable year.

In addition, section 162(m)(6) applies to deferred deduction remuneration attributable to services performed in a disqualified taxable year beginning after December 31, 2009 that is otherwise deductible in a taxable year beginning after December 31, 2012. Section 162(m)(6)(E) provides that deferred deduction remuneration is compensation for services that an applicable individual performs during a disqualified taxable year but that is not deductible until a later taxable year (for example, nonqualified deferred compensation). In the case of deferred deduction remuneration attributable to services performed in a disqualified taxable year, the unused portion of the $500,000 limit (if any) for the taxable year in which the services to which the deferred deduction remuneration is attributable were performed is carried forward to the taxable year or years in which such compensation is otherwise deductible, and applied in calculating the allowable deduction with respect to such amount.

Section 162(m)(6)(F) provides that an applicable individual, with respect to any covered health insurance provider for any disqualified taxable year, is any individual (i) who is an officer, director, or employee in such taxable year, or (ii) who provides services for or on behalf of such covered health insurance provider during such taxable year.

III. GUIDANCE
A. Application of Deduction Limitation to Deferred Deduction Remuneration for 2010 through 2012 Taxable Years
The deduction limitation under section 162(m)(6) applies to applicable individual remuneration and deferred deduction remuneration attributable to services performed in a disqualified taxable year beginning after December 31, 2012 that is otherwise deductible by a covered health insurance provider in a taxable year beginning after December 31, 2012. In addition, the deduction limitation under section 162(m)(6) applies to deferred deduction remuneration attributable to services performed in a taxable year beginning after December 31, 2009 and before January 1, 2013 if (1) the employer was a pre-2013 covered health insurance provider for the taxable year in which the services were performed to which the deferred deduction remuneration is attributable, and (2) the employer is a post-2012 covered health insurance provider for the taxable year in which such deferred deduction remuneration is otherwise deductible.
The following examples illustrate this rule:

Example 1. Corporation A is a calendar year taxpayer. For 2010, 2011, and 2012, Corporation A is a pre-2013 covered health insurance provider. Corporation A is a post-2012 covered health insurance provider for all taxable years after 2012 because 25% or more of its gross premiums from health insurance coverage (as defined in section 9832(b)(1)) are from minimum essential coverage (as defined in section 5000A(f)). Corporation A is a covered health insurance provider for all taxable years. Accordingly, deferred deduction remuneration attributable to services performed in 2010, 2011, and 2012 is subject to the section 162(m)(6) deduction limitation in the taxable years after 2012 in which such amounts are otherwise deductible.

Example 2. Assume the same facts as in Example 1, except that for all taxable years after 2012, Corporation A remains a health insurance issuer (as defined in section 9832(b)(2)), but does not qualify as a post-2012 covered health insurance provider because less than 25% of its gross premiums from health insurance coverage (as defined in section 9832(b)(1)) are from minimum essential coverage (as defined in section 5000A(f)). For all taxable years beginning after 2012, Corporation A is not a covered health insurance provider. Accordingly, any deferred deduction remuneration attributable to services performed in 2010, 2011, and 2012 is not subject to the section 162(m)(6) deduction limitation in the taxable year in which such amounts are otherwise deductible.

Example 3. Assume the same facts as in Example 1, except that after its 2012 taxable year, Corporation A remains a health insurance issuer (as defined in section 9832(b)(2)), but does not qualify as a post-2012 covered health insurance provider for the 2013, 2014 and 2015 taxable years because less than 25% of its gross premiums from health insurance coverage (as defined in section 9832(b)(1)) are from minimum essential coverage (as defined in section 5000A(f)). However, for 2016 and subsequent taxable years, Corporation A qualifies as a post-2012 covered health insurance provider because 25% or more of its gross premiums from health insurance coverage (as defined in section 9832(b)(1)) are from minimum essential coverage (as defined in section 5000A(f)). Corporation A is a covered health insurance provider during its 2010, 2011, 2012, 2016 and subsequent taxable years. Accordingly, deferred deduction remuneration attributable to services performed in 2010, 2011, and 2012 that is otherwise deductible in 2016 and subsequent years is subject to the deduction limitation under section 162(m)(6) in the year in which such amounts are otherwise deductible. Any deferred deduction remuneration attributable to services performed in 2010, 2011, and 2012 that is otherwise deductible in 2013, 2014, or 2015 is not subject to the deduction limitation under section 162(m)(6) in the year in which such amounts are otherwise deductible. Any deferred compensation attributable to services performed in Corporation A’s 2013 through 2015 taxable years is not subject to the deduction limitation under section 162(m)(6) for the taxable years in which such amounts are otherwise deductible.

Example 4: Assume the same facts as in Example 1, except that for its 2010, 2011, and 2012 taxable years, Corporation A is not a pre-2013 covered health insurance provider. However, Corporation A is a post-2012 covered health insurance provider for its 2013 taxable year and all subsequent years because 25% or more of its gross premiums from health insurance coverage (as defined in section 9832(b)(1)) are from minimum essential coverage (as defined in section 5000A(f)). Accordingly, any deferred compensation attributable to services performed in Corporation A’s 2010, 2011, and 2012 taxable years is not subject to the deduction limitation under section 162(m)(6) for the taxable years in which such amounts are otherwise deductible.

B. De Minims Rule
An employer (including an employer as determined in accordance with the aggregation rules under section 162(m)(6)(C)(ii)) will not be treated as a covered health insurance provider within the meaning of section 162(m)(6)(C)(i)(I) for a taxable year beginning after December 31, 2009 and before January 1, 2013 if the premiums received by the employer for providing health insurance coverage as defined in section 9832(b)(1) are less than 2% of the employer’s gross revenues for that taxable year. For taxable years beginning after December 31, 2012, an employer will not be treated as a covered health insurance provider within the meaning of section 162(m)(6)(C)(i)(II) for a taxable year beginning after December 31, 2012 if the premiums received for providing health insurance coverage as defined in section 9832(b)(1) that are from providing minimum essential coverage (as defined in section 5000A(f)) for that taxable year are less than 2% of the employer’s gross revenues for that taxable year.

The following example illustrates this rule:
Example. Corporations D and E are treated as a single employer under section 162(m)(6)(C)(ii). Corporations D and E are calendar year taxpayers. Corporation E does not receive any health insurance premiums within the meaning of section 9832(b)(1) for the 2010 taxable year. Corporation D receives health insurance premiums within the meaning of section 9832(b)(1) for the 2010 taxable year in an amount that is less than 2% of the combined gross revenues of D and E. Accordingly, Corporations D and E are not treated as a covered health insurance provider within the meaning of section 162(m)(6)(C) for the 2010 taxable year. Deferred compensation attributable to services performed in the 2010 taxable year that is otherwise deductible for taxable years after 2012 is not subject to the deduction limitation under section 162(m)(6).

C. Definition of Applicable Individual
Section 162(m)(6)(F) provides that an applicable individual, with respect to any covered health insurance provider for any disqualified taxable year, is any individual (i) who is an officer, director, or employee in such taxable year, or (ii) who provides services for or on behalf of such covered health insurance provider during such taxable year. For purposes of section 162(m)(6)(F), the term “applicable individual” for a taxable year does not include an independent contractor with respect to whom a compensation arrangement would not be subject to section 409A pursuant to Treasury Regulation §1.409A-1(f)(2) (generally excepting arrangements with independent contractors providing substantial services to multiple unrelated customers).

D. Certain Reinsurers Are Not Covered Health Insurance Providers
Solely for purposes of determining whether a taxpayer is a "covered health insurance provider" within the meaning of section 162(m)(6)(C), premiums received under an indemnity reinsurance contract are not treated as premiums from providing health insurance coverage.

IV. EFFECTIVE DATE
The guidance provided in section III of this notice is effective for taxable years beginning on or after January 1, 2010. The Treasury Department and the IRS anticipate incorporating this guidance into regulations. Any future guidance, including regulations, addressing the issues covered by this notice in a manner that would expand the coverage of section 162(m)(6), such as a modification of, or a restriction on, the application of the de minimis rule in section III.C, or broadening of the definition of an applicable individual under section III.D, will apply prospectively.

This law applies to all insurance companies that issue major medical insurance in 2010, 2011 and 2012. Beginning in 2013, the law also applies to companies that issue "minimum essential" or mini-med insurance. Even if the originally conceived minimum essential mandate plans are not developed due to obstacles discussed, the law could affect the rapidly expanding mini-med and supplemental health insurance business.

Professional groups wonder if the IRS could interpret the term “health insurance provider” broadly enough to include employers that sponsor their own health plans, and if the term “applicable individual” could include a health insurer’s top consultants, lawyers or accountants. This would appear to be an overly broad interpretation that would not be reasonable but, if used, would significantly affect workers in other professions. The IRS says that, for purposes of this rule, it will exclude the employees of companies whose health insurance premium revenue is les than 2% of total gross revenues. However, many companies (including those outside of the insurance industry) collect more than 2% of their gross revenue from employees as contributions to health insurance premiums so the exemption would not appear to offer much help.

The law does not appear to impact the compensation of executives of the state health insurance exchanges that will be funded by the new federal law nor the executives of commercial exchanges or heir support systems. Contractors are also exempt.

We note that the primary author of this Notice actually works in the Tax Exempt and Government Entities division of the IRS. In contrast, most of the health insurance companies affected by the law are for-profit entities. We wonder if this indicates the mindset of IRS with regard to the direction of future audit and compliance actions for health insurance companies.

This provision appears to have only minor impact in deterring the expansion of affordable health insurance. Health insurance companies have already signaled a pull back from their core health insurance business and have redeployed highly compensated executives to more profitable lines of business. The most significant impact, ironically, may be an expansion of opportunities for compensation planners like me who serve the insurance industry.

Author's note: I welcome the opportunity to discuss compensation planning with anyone affected by the new law. I can be reached directly at (610) 572-1724 or onlineadviser@live.com.


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Opinions expressed are the sole responsibility of the author Tony Novak and do not represent the opinion of any other person, company or entity mentioned. Information is from sources believed to be reliable but cannot be guaranteed. Freedom Benefits is not an agent, broker, producer or navigator for any federal or state health insurance exchange but may provide advice, reviews and referrals to these official resources. Novak is compensated as an accountant, adviser, affiliate consultant, marketer, reviewer, endorser, producer, lead generator or referrer to some of the commercial companies listed on this site.