Current developments in employee benefits and pensions.

• Author: Walker, Deborah
• Position: Part 2

This two-part article covers significant developments in late 2009 and 2010 in employee benefits, including executive compensation, health and welfare benefits, qualified plans, and employment taxes. Part I, in the November issue, contained updates on employment taxes and an overview of the health care reform legislation. Part II focuses on guidance released and changes to the rules for executive compensation and qualified plans.

New Sec. 162(m)(6): Deduction Limits for Compensation Paid by Health Insurance Providers

The health care reform legislation (PPACA) (1) transforms the nation's health care system and changes the compensation structure of corporate executives in the health care industry. As part of generating revenue to help offset the cost of health care reform, PPACA, among other revenue provisions, limited the deduction for compensation for services provided by most individuals to a covered health insurance provider to $500,000 per year. (2) Prior to 2012, a "covered health insurance provider" is any employer qualifying as a health insurance provider that receives premiums for providing health insurance coverage. After 2012, an employer is a covered health insurance provider for a year if at least 25 % of the provider's gross premium income is derived from health insurance plans that meet the minimum essential coverage requirements in the legislation. In determining a covered health insurance provider, the controlled group aggregation rules (Secs. 414(b), (c), (m), or (o)) apply, but only to parent-subsidiary controlled groups, not to brother-sister controlled groups. (3) Employees with self-insured plans are not considered covered health insurance providers.

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The deduction limits apply to compensation attributable to services performed by an applicable individual. Applicable individuals include all officers, employees, directors, and other workers or service providers (such as nonemployee independent contractors) performing services for or on behalf of a covered health insurance provider. Thus, the deduction restrictions will apply to any individual providing compensated services to a covered health insurance provider, not just the top executives.

The deduction limits apply to both current and deferred compensation. The limit that applies to deferred compensation earned in a year is equal to the $500,000 limit for that year reduced by the amount of current compensation paid. Thus, if an employee receives a salary of $400,000 in 2013, the deduction for deferred compensation attributable to the same year is limited to $100,000 in the year in which the compensation is otherwise deductible. In this example, deferred compensation for that year that exceeds $100,000 will not be deductible in the year paid.

Although this limit is an amendment to the existing $1 million limitation on executive compensation under Sec. 162(m), this deduction limit applies differently in many respects:

* The limit is based on the year in which compensation is earned, rather than the year in which the deduction is claimed. A limit based on when compensation is earned requires determination of the period to which compensation is attributable and has the effect of limiting deductions for both current and former service providers. It will also have the effect of limiting deductions for compensation earned when the company is considered a health insurance provider, even if the company ceases to be a health insurance provider by the time the compensation is paid.

* The limit applies to compensation to any individual service provider, including independent contractors as well as all employees, rather than just the chief executive officer and highest three officers, as disclosed in Securities and Exchange Commission (SEC) filings.

* The deduction limitations apply to covered insurance providers, regardless of whether the provider is a publicly held corporation that is subject to SEC registration requirements.

* The deduction limits apply to compensation paid by all entities within the insurer's parent subsidiary controlled group. For this purpose, controlled group status is determined using rules similar to those for determining controlled group status for qualified plans.

* Some of the exceptions for performance-based compensation and commission compensation are inapplicable. These limits are effective for remuneration paid in tax years beginning after 2012 for services performed after 2009. Thus, the limits will apply to current compensation paid in years after 2012 but will apply to deferred compensation earned after 2009 and paid after 2012.

Sec. 409A: Document Failure Correction Program

Although Sec. 409A was signed into law in 2004, the IRS continues to issue guidance to ease the burden of complying with the new nonqualified deferred compensation (NQDC) rules. On January 5, 2010, the IRS issued Notice 2010-6, (4) which provides methods for taxpayers to voluntarily correct certain types of failures to comply with the document requirements of Sec. 409A. The notice addresses eligibility and provides methods for correcting plan provisions that do not comply with Sec. 409A(a) plan document requirements. In some cases, plans may he corrected without service providers having to include amounts in income under Sec. 409A, while in other cases as much as 50% of the amount deferred under the plan must he included in income, subject to the 20% additional income tax rate (although not the additional premium interest tax). In addition, taxpayers taking advantage of the correction program are generally required to attach a statement to their tax returns.

Correction under the notice isolates the document failure to the year of correction so that it will not taint prior years. Notice 2010-6 also modifies Notice 2008-113 (5) (providing relief for certain operational failures to comply with Sec. 409A) and Notice 2008-115 (6) (providing guidance on Sec. 409A reporting and withholding requirements for 2008 and subsequent years). In particular, the modifications clarify treatment of correction of distributions involving transfers of stock or other property and coordination of repayment with adjustments to withholding.

Taxpayers may rely on Notice 2010-6 for tax years beginning on or after January 1, 2009. The modifications to Notice 2008-113 are effective for service provider tax years beginning on or after January 1, 2010, but may be relied upon for service provider tax years beginning before this date.

In particular, if a plan is eligible for correction under this notice and is corrected on or before December 31, 2010, the plan may be treated as having been corrected on January 1, 2009, and any income inclusion that would otherwise be required is waived, provided that any payment made before December 31, 2010, that would not have been made under the amended provision (or any payment not made before December 31, 2010, that would have been made under the amended provision) is treated as an operational failure and fully corrected in compliance with all the requirements of Notice 2008-113 on or before December 31, 2010.

The modifications to Notice 2008-115 are generally effective for service provider tax years beginning on or after January 1, 2009, provided that the modifications to Notice 2008-115 that are due to changes to Notice 2008-113 are effective for service provider tax years beginning on or after January 1, 2010, but may be relied upon for service provider tax years beginning before that date.

In order to be eligible for relief under Notice 2010-6, the taxpayer must satisfy general eligibility requirements, requirements for a particular correction method, and information and reporting requirements of the notice. The taxpayer has the burden of demonstrating eligibility for relief and that each of the requirements of the notice has been satisfied. A taxpayer's eligibility for relief is subject to IRS examination. In addition to the general requirements, the notice addresses issues such as coordination of multiple failures and how to measure the amount of income to be included, to the extent required.

Notice 2010-6 does not provide relief for stock rights or plans where the time and form of payment under an NQDC plan are linked to one or more other NQDC plans or one or more qualified plans. Certain relief for discounted stock rights is set forth in Notice 2008-113. The notice provides transition relief for corrections made on or before December 31, 2011, with respect to linked NQDC plans and payment schedules determined by the timing of payments received by the service recipient. Generally, if any amounts have been paid under the plans under the pre-amendment provisions since January 1, 2009, or have failed to be paid consistent with the amended provisions, these amounts must be treated as operational failures and corrected under Notice 2008-113.

Notice 2010-6 provides significant relief for potential document failures by allowing correction in one year to address failures in prior years. This notice and Notice 2008-113 give taxpayers many opportunities to address noncompliance. While the notice provides welcome relief, it does require significant income inclusion in some cases based on post-amendment events, which may affect service providers with similar issues differently for reasons outside the control of the service provider. Similarly, the notice imposes requirements on the service recipient, such as consistency in corrections, which are outside the control of the service provider.

Many taxpayers do not appreciate the required notification and thus use other approaches to resolve Sec. 409A issues. In many cases this includes prospective clarification in conjunction with carefully constructed legal arguments for determining compliance under the old document.

Final Employee Stock Purchase Plan Regs.

On November 16, 2009, Treasury issued final regulations relating to employee stock purchase plans...