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CHIPping away at deductions on employee compensation
On 1 April 2013, the IRS issued proposed regulations providing guidance on the US$500,000 deduction limitation for compensation paid by covered health insurance providers (CHIPs) to employees. Don't think you're a CHIP? Taxand USA discusses how the net cast by the IRS is likely to snag some companies not in the health insurance industry.
According to the statute and the proposed regulations, a CHIP is any health insurance issuer that receives at least 25% of its health insurance premiums from providing "minimum essential coverage." If one entity of an aggregated group is considered a CHIP, the parent and all members of the aggregated group are also considered CHIPs, unless a de minimis exception is satisfied. To meet the de minimis exception, premiums received related to providing "minimum essential coverage" must be less than 2% of the gross revenues of the aggregated group. CHIP status is determined on a year-by-year basis.
So who, besides health insurance companies, will be affected? The preamble to the proposed regulations makes it clear that the Treasury Department and the IRS believe that a captive insurance company (better known simply as a captive) is a CHIP if it otherwise meets the definition of a health insurance issuer under Section 162(m)(6)(C). Therefore, a captive (and its entire aggregated group) may be treated as a CHIP if it is licensed to engage in the business of insurance in a state and is subject to state law that regulates insurance.
To illustrate how a company might find itself in a surprising situation, consider this example:
The Jackson Company (Jackson) provides technology consulting services to the energy industry. Jackson has established a captive insurance company (Captive) to insure the risks associated with the medical benefits provided to employees of Jackson. Captive, which is subject to state regulation, receives premiums from Jackson (funded in part by Jackson and in part via employee payroll deductions) during the year of $5 million, all of which relate to providing minimum essential coverage. In the ordinary course of its consulting business, Jackson produces $195 million of revenue during the year. Assume that Jackson and Captive are the only 2 entities in the aggregated group.
Because the premiums received by Captive ($5 million) represent 2.5% (more than the 2% de minimis threshold) of the gross revenues of the aggregated group (US$200 million - US$195 million from Jackson and US$5 million from Captive), the de minimis exception cannot be invoked. In addition, since more than 25% (100%) of Captive's revenue is attributable to providing minimum essential coverage, Jackson and Captive are both treated as CHIPs. Therefore, compensation paid to any employee of Jackson or Captive is not deductible to the extent it exceeds US$500,000.
It should be noted that the proposed regulations include a 1-year grace period related to the de minimis exception. For example, if Jackson was not treated as a CHIP in year 1 solely because it invoked the de minimis exception, it will not be treated as a CHIP in year 2 if it fails to meet the de minimis exception the subsequent year.
Proposed Section 162(m) regulations applicable to covered health insurance providers - CHIPs - bring many complexities to the forefront for tax, human resource and accounting professionals. Of note, companies should immediately consider:
- Whether or not the proposed regulations will affect them. For companies that are not health insurance issuers, consideration should be given to whether the presence of a captive insurance company that insures minimum essential benefits would cause all members of the aggregated group to be treated as covered health insurance providers. If a captive is expected to cause the aggregated group to be treated as CHIPs, consideration should be given to self-insuring employees' medical benefits
- Performing sensitivity analyses within the tax department to determine the approximate value of the deduction that will be lost as a result of the proposed rules, as well as updating forecasts
- Whether there are appropriate systems and processes in place to track which compensation is deductible vs. non-deductible. Certain elements of compensation may be "earned" across many years. Further, the year in which the compensation is potentially deductible may occur many years following the year in which the compensation is "earned." Therefore, it is of utmost importance to have procedures and controls in place to track compensation
- Whether the proposed regulations warrant examining and adjusting the overall compensation strategy and philosophy of the organisation