New Compensation Deduction Limit for Health Insurance Providers

Section 162(m) of the Internal Revenue Code (the “Code”) generally limits compensation paid by public companies to certain executives to $1 million per year. Section 9014 of the Patient Protection and Affordable Care Act (PPACA) amended Section 162(m) by reducing the $1 million limit to $500,000 for officers, directors and employees working for certain health insurers. The new $500,000 limit does not go into effect until tax years beginning after 2012, but does apply to compensation that is attributable to services performed in a tax year beginning after December 31, 2009, that is deductible in a tax year beginning after December 31, 2012 (i.e., generally deferred compensation payable in years beginning after December 31, 2012).

Overview of Section 162(m)

Under Section 162(m), a publicly held corporation is generally limited to a $1 million deduction in any tax year for compensation paid to the chief executive officer and the next three highest paid officers (each, a “covered employee”). However, in a widely used exception, the $1 million limit does not apply to “qualified performance-based compensation.” Qualified performance based compensation is compensation which is payable based solely on the attainment of objective, pre-established performance goals. In order to meet the requirements for “qualified performance based compensation,” (i) the performance goals must be determined by a committee consisting of at least two outside directors, (ii) the material terms of the performance goals must be approved by the majority of the corporation’s shareholders, and (iii) the committee which includes the outside directors certifies that the performance goals were attained prior to any compensation being paid.

Section 162(m)(6)

Section 9014 of the PPACA added Section 162(m)(6) to the Code. This section reduces the $1 million deduction normally applicable to public companies described above to $500,000 for “covered health insurance providers.” For years beginning after December 31, 2009, and before January 1, 2013, covered health insurance providers include health insurance issuers that receive premiums from providing health insurance coverage. For tax years beginning after December 31, 2012, covered health insurance providers include health insurance issuers that receive premiums for providing health insurance coverage where 25 percent or more of such premiums are attributable to providing minimum essential health insurance coverage.

Additionally, while the standard Section 162(m) limit described above applies only to the four covered employees, Section 162(m)(6) applies to a much broader class of individuals: any individual who is an officer, director or employee of a covered health insurance provider or any individual who provides services on behalf of a covered health insurance provider.

While the Section 162(m)(6) limit does not apply until tax years beginning after December 31, 2012, it does apply to compensation that is attributable to services performed in a tax year beginning after December 31, 2009, that is deductible in a tax year beginning after December 31, 2012 (i.e., generally deferred compensation payable in years beginning after December 31, 2012). Qualified performance based compensation would remain outside the $500,000 Section 162(m)(6) limit.

Notice 2011-02

On December 23, 2010, the Internal Revenue Service issued Notice 2011-02 (the “Notice”), which provides further guidance under Section 162(m)(6). Because whether an entity will be deemed to be a covered health insurance provider will be determined on a taxable year by taxable year basis, the Notice goes through a number of examples of entities that go in and out of covered health insurance provider status over a period of years and how the imposition of the limits of Section 162(m)(6) would apply in such circumstances.

The Notice also clarifies that independent contractors whose compensation arrangements would not be governed by Section 409A of the Code will not be governed by the $500,000 Section 162(m)(6) limit. This exception covers independent contractors who provide substantial services to multiple unrelated customers (i.e., consultants, etc.). Finally, the Notice also clarifies that premiums received under indemnity reinsurance contracts will not be treated as premiums attributable to health insurance coverage for purposes of Section 162(m)(6).