IRS issues final regulations on sec. 162(m) (6) deduction disallowance.

• Author: Dell, Michael

The IRS issued final regulations (TD. 9694) under Sec. 162(m)(6), which imposes a $500,000 federal income tax deduction limitation for compensation paid by a covered health insurance provider (CHIP). These regulations apply in determining when any entity in a controlled group that includes a health insurer is subject to the $500,000 annual limit. These regulations also provide rules for determining how the $500,000 annual limit is allocated to years of service for various types of compensa-tion--including equity and deferred compensation. The deduction limitation under Sec. 162(m)(6) took effect for tax years beginning in 2013. This item summarizes the key provisions of the regulations, highlights the changes from the proposed regulations, and discusses implications for taxpayers.

Sec. 162(m)(6)

Sec. 162(m)(6), added by the Patient Protection and Affordable Care Act (PPACA), P.L. 111-148, imposes a $500,000 limit on the federal income tax deduction for compensation that is otherwise deductible by CHIPs for tax years beginning after Dec. 31, 2012. The key concept under Sec. 162(m)(6) is that an annual $500,000 limit applies for each individual who is providing services to the CHIP. To determine whether the $500,000 limit is exceeded, compensation for an individual is allocated to the year in which the relevant services are performed. Thus, salary is allocated to the year for which it is paid, and other types of compensation, including deferred compensation and equity compensation, are allocated to the years over which the compensation is earned. (As discussed below, the final regulations provide methods for this allocation that differ from those contained in the proposed regulations.)

When the CHIP is entitled to the deduction for compensation (which generally will be when it is paid), it must determine to what extent any of the compensation is allocable to a year in which the $500,000 limit is exceeded and, therefore, the deduction is limited. The first year for which the $500,000 limit applies to deferred compensation is the tax year beginning-after Dec. 31,2009. Thus, CHIPs must track the $500,000 limit for compensation that is earned beginning in 2010 and later years. Because Sec. 162(m)(6) applies only to amounts that are otherwise deductible in 2013 or later years, however, any compensation exceeding the $500,000 limit that is deductible in a tax year beginning before Jan. 1, 2013, is not subject to the $500,000 limit.

Sec. 162(m)(6) applies only to CHIPs, but this includes any entity that is in the controlled group with a CHIP, as determined under Sec. 414 (but disregarding the brother-sister and combined group rules). Thus, any entities in a controlled group (under this definition) with a CHIP, regardless of the entity's line of business, are also subject to the deduction limit for all their individual service providers with compensation over $500,000.

Definition of a CHIP

Sec. 162(m)(6) includes two definitions of a CHIP--one that applies for tax years beginning before Jan. 1, 2013, and one that applies for tax years beginning in 2013 and thereafter. In Notice 2011-2, the IRS issued guidance providing that an entity will not be treated as a CHIP for any year unless it meets the definition of a CHIP applicable to 2013 and later years. That definition treats any insurer (and its affiliates under Sec. 414) as a CHIP if 25% or more of its gross premiums from health insurance are from the sale of "minimum essential coverage," as stated in the formula in the exhibit on the previous page.

Minimum essential coverage is defined in Sec. 5000A(f) and generally applies to health insurance coverage that individuals must maintain under PPACA to avoid incurring tax penalties. The provisions in PPACA generally would include in minimum essential coverage those policies sold in the state-sponsored insurance exchanges and employer-provided health insurance.

In addition, Notice 2011-2 included a de minimis rule under which an entity will not be considered a CHIP for any tax year beginning after Dec. 31,2009, and before Jan. 1, 2013, if the employer's premium revenue from minimum essential coverage for the year is less than 2% of the employer's gross revenue for the year (referred to as the 2% de minimis rule).

Final Regulations

Like Notice 2011-2 and the proposed regulations, the final regulations include a 2% de minimis rule (subject to certain clarifications discussed below). The final regulations also clarify whether certain coverage is treated as health insurance for purposes of determining whether an insurer is a CHIP. For those entities meeting the definition of a CHIP, the proposed regulations set forth allocation methods for determining the $500,000 limit. An overview of the key provisions of the final regulations follows.

Aggregated groups: Commenters to the proposed regulations asked the IRS to provide relief from the controlled-group rule. Because the rule is statutory, the IRS concluded...