Proposed Regulations on Section 162(m); Upcoming Fiduciary and Participant Disclosures; Comments on Annual Fees Upon Employers and Insurers; Rules for Claims and Appeals and External Reviews; New Guidance Announces End to Annual Limit Waiver Program

Focus On Employee Benefits

Executive Compensation: Newly Proposed Regulations Seek to Clarify the Application of Section 162(m) in the Equity Context

Anne Batter and Anthony Provenzano

The Treasury on June 24, 2011, proposed regulations aimed at clarifying two issues that have arisen over the years regarding how certain exceptions from the deduction disallowance under Code section 162(m) apply in the equity context. 76 F.R. at 37036. The first clarification addressed in the proposed regulations is the need for an equity plan to contain, not only an overall share limit, but also an individual per employee, per period limit on the shares available for grant as stock options and stock appreciation rights. In addition, the proposed regulations clarify that restricted stock units ("RSUs") are not eligible for the special transition rules otherwise applicable in the case of options and restricted stock when a private company becomes public.

Individual Share Limit Issue. As a general matter, compensation that qualifies as "performance-based compensation" is not subject to the deduction disallowance under Code section 162(m), and compensation attributable to stock options issued with a fair market value exercise price can be treated as performance-based compensation that is exempt from deduction disallowance under section 162(m). The current final regulations under section 162(m) provide (at Treas. Reg. § 1.162-27(e)(2)(vi) and 1.162-27(e)(4)(iv)) that options and SARs are deemed to qualify for the performance-based compensation exception if the following requirements are met: (1) the option is granted by a compensation committee comprised of at least two outside directors, (2) the plan is approved by shareholders following disclosure of the plan's material terms, (3) the plan under which the option is granted states "the maximum number of shares with respect to which options or rights may be granted during a specified period to any employee," and (4) the option is granted with an exercise price equal to the fair market value on the date of grant so that the amount of compensation the employee could receive is based solely on an increase in the stock's price.

The proposed regulations clarify that the plan and shareholder disclosures must specify "the maximum number of shares with respect to which options or rights may be granted during a specified period to any individual employee." In the past, some taxpayers have argued that there is no need for an individual limit, in addition to the overall share limit, because the overall share limit serves as a per employee, per period limit since all the shares available under the plan could be granted to one individual as options in any period. The newly proposed regulations would appear to be issued in response to this position that no individual share limit is required, although the proposed regulation does not give clear guidance as to how an individual share limit should be structured to comply with the proposed regulation. For example, we understand that it would be acceptable to rely on the overall share limit if the plan clearly states that all the shares authorized can be granted to one employee during a specified period. Similarly, we have been told that the individual per person, per period, limit can apply to RSUs, restricted stock, etc. in addition to stock options and SARs. Taxpayers may wish to submit comments seeking further guidance on the issue of how to structure the individual share limit required by the proposed regulations.

The proposed regulations propose to make this clarifying change regarding individual share limits effective on or after June 24, 2011, the date the proposed regulations were published in the Federal Register. This would appear to mean that compensation relating to outstanding options granted under a plan that does not contain the requisite individual share limit would not be deductible when the options are exercised if the current proposal is made final even if the option/SAR were granted prior to June 24, 2011.

Application of IPO Transition Rules to RSUs. The proposed regulations also override, on a prospective basis, the conclusions of two private letter rulings (PLR 200449012 (December 3, 2004) and PLR 200406026 (February 6, 2004)) allowing restricted stock units ("RSUs") the same beneficial treatment applicable to stock options, stock appreciation rights, and restricted stock in the context of a company going public. The current final regulations (at Treas. Reg. § 1.162-27(f)) contain transition rules for private companies that become publicly traded. Under these transition rules, the deduction disallowance under section 162(m) generally would not apply to amounts paid under plans and agreements that were in place when the company was private during a reliance period generally lasting about three years after the company becomes public (shorter, if the company goes public without an IPO).

An even more beneficial rule applies to stock options, stock appreciation rights, and restricted stock under Treas. Reg. § 1.162-27(f)(3). Under this special rule, section 162(m) does not apply if the grant, rather than the payment, occurs during the reliance period. Thus, an option granted in the year after an IPO potentially can be deductible eight or ten years later, when the option is exercised, notwithstanding that the option does not otherwise meet the requirement for qualifying as performance-based compensation, as discussed above. Notwithstanding this proposed clarification, the position in the private letter rulings giving RSUs the same beneficial treatment as restricted stock on the basis that RSUs are economically equivalent to restricted stock would appear to be the more sensible view. Further, the same issues that make it difficult for employers to amend options and restricted stock before payment in order to make them compliant with section 162(m) would appear to exist for RSUs.

The proposed effective date for this clarification to the regulations is on or after the date of publication of the regulations in the Federal Register. We take it this more prospective effective date stems from the Service's recognition that taxpayers had relied on the private letter rulings treating restricted stock units the same as restricted stock for purposes of the transition rules for taxpayers going public. Additionally, at least some government representatives may be sympathetic to the argument that RSUs are economically and process-wise the same as restricted stock so that the same rules should apply to both.

Comments. The Service has requested comments by September 22, 2011. Taxpayers who would be adversely impacted by the changes described above should consider submitting comments, if not directly, then through a trade group or counsel. Potential comments might address the need for more generous effective dates, covering equity grants outstanding as of June 24, 2011, since already outstanding grants and the plans under which they were granted, cannot easily be amended to be made deductible under these new rules. Another possible area for comment would be on the substantive and process similarities between RSUs and the types of equity that do receive the benefit of the equity compensation provision in the going public context. We would be happy to discuss with you any comments that you might be interested in submitting.


Qualified Plans: Reminder Concerning Upcoming Fiduciary and Participant-Level Disclosures

Anthony Provenzano

It is very important for employers maintaining defined contribution and defined benefit plans to ensure that they are coming into compliance with the new DOL regulations regarding fiduciary and participant-level disclosure. In 2010, the DOL released final regulations under ERISA section 408(b)(2) requiring an entity providing certain services to a defined contribution or defined benefit plan (a "covered service provider") to provide extensive information to the plan's fiduciaries regarding the fees charged by the covered service provider and the services provided. Absent this disclosure, the transaction between the plan and the covered service provider could be considered a "prohibited transaction" under ERISA triggering excise taxes--even if the fees charged were otherwise reasonable and the services necessary. The DOL also finalized in 2010 regulations requiring fiduciaries of a defined contribution plan to disclose to participants greater detail regarding the fees charged against participant accounts.

The DOL recently delayed the effective date of the fiduciary-level disclosure until April 1, 2012 meaning that covered service providers have until that date to provide to plan fiduciaries the required information with respect to then existing arrangements. With respect to arrangements entered into after April 1, 2012, the required disclosures generally must be provided to plan fiduciaries before the new arrangement becomes effective. To meet the April 1, 2012 effective date, an employer must begin the compliance process immediately by identifying any plan vendor that could qualify as a "covered service provider" and confirming that any such covered service provider will provide the required disclosures.

The participant-level disclosures requiring the plan fiduciaries to disclose fee information to defined contribution plans will become effective for plan years beginning on and after November 1, 2011. However, the DOL has extended the transition period during which the initial disclosure must be provided to the later of (1) 60 days after the first day of the plan year beginning on or after November 1, 2011, or (2) 60 days after the effective date of the fiduciary-level disclosure rule (i.e., 60 days after April 1, 2012). As extended, a calendar year plan will be required to furnish the initial disclosures by May 31, 2012, and the disclosures of the quarterly statement of fees/expenses actually deducted by August 14, 2012 (i.e., 45 days after the end of the quarter in which the initial disclosures are required to be furnished). In order to meet these deadlines, employers should already be working with their recordkeepers, advisors, and brokers to gather the necessary information and to review the potential expenses.


Health and Welfare: IRS Requests Comments on Annual Fees to be Imposed Upon Employers and Insurers under Health Care Reform

Garrett Fenton

The IRS recently issued a Request for Comments regarding the annual fees to be imposed upon health insurers and employers who sponsor self-funded group health plans -- under the Patient Protection and Affordable Care Act, as amended -- to fund the new "Patient-Centered Outcomes Research Trust Fund." These fees will be imposed for plan and policy years ending on or after October 1, 2012 (generally, plan and policy years beginning on or after October 2, 2011). IRS Notice 2011-35, 2011-25 I.R.B. 879 (June 20, 2011), requests comments on how the fees should be determined and paid, in an effort to "inform the development" of forthcoming proposed regulations. Although the Notice generally does not provide any substantive guidance, it describes (and seeks comments on) potential guidance that the U.S. Department of the Treasury and IRS expect to propose. Comments are due by September 6, 2011.

For example, the IRS and Treasury are considering whether to permit certain "safe harbors" in counting the "average number of lives covered" by a group health plan or health insurance coverage -- the number upon which the annual fees will be based. With respect to self-funded plans, the IRS and Treasury are requesting comments on whether plan sponsors should be allowed to calculate the average number of lives covered using a formula based on the number of employee/participants, as well as other factors that account for covered dependents without requiring them to be individually counted. With respect to health insurers that report their total number of covered lives on the National Association of Insurance Commissioners' Supplemental Health Care Exhibit ("Exhibit"), filed with their Annual Statements, the IRS and Treasury are considering a safe harbor that would allow the annual fee to be calculated based on the number of lives reported on the most recently-filed Exhibit, or perhaps the average number of lives reported on the two most recently-filed Exhibits.

In addition, Notice 2011-35 invites comments on the potential application of (or exemption from) the annual fee provisions for certain types of health flexible spending arrangements and employer-funded health reimbursement arrangements. The IRS and Treasury are also considering whether the fees should be reported and paid on an annual versus quarterly basis, and perhaps on the same calendar date for all plans and policies (regardless of their individual plan or policy years).

The notice seeks comments on potential "transition rules" that could apply for the first plan or policy year for which the fees are imposed (again, generally plan and policy years beginning on or after October 2, 2011). Other issues for which the notice seeks comments include whether (1) guidance is needed concerning the definition of "policy year" or "plan year" for purposes of the annual fees, (2) regulations should address circumstances where an insurer or employer/sponsor of a self-funded group health plan might not know whether a covered individual resides in the United States, (3) all entities treated as a single employer under the Internal Revenue Code's employer aggregation rules should be treated as a single employer for purposes of determining the "plan sponsor" of a self-insured health plan, and (4) guidance is needed regarding the ability of a self-funded plan's third party administrator to act on behalf of the plan sponsor in complying with the annual fee provisions.


Health and Welfare: Agencies Modify Rules for Internal Claims and Appeals and External Reviews

Garrett Fenton

The U.S. Departments of Labor, Treasury, and Health and Human Services recently issued an amendment to the Interim Final Rule ("IFR") for Internal Claims and Appeals and External Review that was originally published in July 2010, pursuant to the Patient Protection and Affordable Care Act ("PPACA"). We had been expecting this amendment to the IFR, as reported in our April 27, 2011 newsletter. The Department of Labor also recently issued Technical Release 2011-02, which revises previous guidance relating to the requirements for external review processes.

The amendment to the IFR and Technical Release 2011-02 generally relax some of the requirements imposed upon employer-sponsored group health plans and health insurers, in connection with claims, appeals, and external review procedures. These changes have generally been applauded as welcome relief by both employers and health insurers. Specifically, the new guidance, in part:

  1. Restores the 72-hour maximum time frame to notify claimants of benefit determinations for claims involving urgent care, consistent with the DOL's (pre-PPACA) claims procedure regulations. The IFR had initially shortened this time frame to a maximum of 24 hours.
  2. Relaxes the IFR's notice requirements, by providing that diagnosis and treatment codes must merely be made available upon request, rather than automatically provided in adverse benefit determination notices.
  3. Relaxes the "deemed exhaustion" rule by providing that, in certain cases, minor failures to comply with all of the procedural requirements of the IFR will not automatically entitle a claimant to seek immediate external review or court action.
  4. Modifies and standardizes requirements for "culturally and linguistically appropriate" notices provided to claimants.
  5. Provides an updated model notice of adverse benefit determination, final internal adverse benefit determination, and final external adverse benefit determination.
  6. Extends the transition period through December 31, 2011, for state external review processes -- to which insured group health coverage, as well as self-insured nonfederal governmental plans and church plans, are subject in most states -- to be deemed compliant with the IFR. This transition period had previously been set to expire for the first plan or policy year beginning on or after July 1, 2011. Accordingly, the extension will have no practical effect for plans and policies that are operated on a calendar year basis.
  7. Establishes temporary minimum consumer protection standards for "NAIC-similar processes," with which state-administered external review processes (applicable to insured group health coverage and self-insured nonfederal governmental plans) may comply, until January 1, 2014. Beginning January 1, 2014, these state-administered external review processes will need to be fully compliant with the "NAIC-parallel processes" that were initially outlined in the July 2010 IFR.1
  8. Provides that if HHS determines that a state external review process does not comply with either the "NAIC-parallel processes" (outlined in the July 2010 IFR) or the "NAIC-similar processes" (outlined in the new guidance) as of January 1, 2012,2 then insured group health coverage and self-insured nonfederal governmental plans in that state will need to elect to either (1) follow the federal external review process administered by HHS3 or (2) engage in the private accredited Independent Review Organization ("IRO") process applicable to self-insured, private sector group health plans. HHS has issued instructions on how to make this election.
  9. Temporarily narrows the scope of claims that are eligible for external review, under either the HHS-administered federal external review process or the private accredited IRO process, to those involving medical judgment or rescissions of coverage. The agencies have indicated that they expect to move to a much broader scope of claims eligible for external review, by January 1, 2014. In any event, future guidance will clarify the permanent scope of external review, and provide "sufficient notice" to give affected parties enough time to ensure their compliance.
  10. Temporarily modifies the "enforcement safe harbor" regarding the number of IROs with which a self-insured group health plan (or health insurer that elects to engage in the private accredited IRO process, as described above) must contract for external reviews. The enforcement safe harbor had previously required plans to contract with at least three accredited IROs, but last September the agencies issued FAQs that provided that for plans that did not comply with this enforcement safe harbor, compliance would be determined on a case-by-case basis. In view of developments, though, the modified safe harbor now specifically requires plans to contract with at least two IROs by January 1, 2012, and at least three IROs by July 1, 2012.
  11. Clarifies that although the external review decision of an IRO is "binding" on all relevant parties, a group health plan or health insurer is free to pay a claim or provide benefits at any time, including after the IRO renders a decision upholding a denial of the claim or benefits (or otherwise fails to require the payment or provision of benefits).

With respect to the IFR provisions (as amended) to which the agencies' "enforcement grace periods" currently apply -- see our April 27, 2011 newsletter -- the agencies have formally indicated their commitment to enforcing the relevant requirements as soon as the applicable grace periods expire.


Health and Welfare: New Guidance Updates and Announces End to the Annual Limit Waiver Program

Garrett Fenton

On June 17, 2011, the U.S. Department of Health and Human Services' ("HHS") Center for Medicare and Medicaid Services ("CMS") issued new guidance regarding the process for obtaining temporary waivers from the restrictions on annual dollar limits for "essential health benefits" imposed pursuant to the Patient Protection and Affordable Care Act, as amended ("PPACA"). HHS also issued a "Fact Sheet" describing the new guidance.

By way of background, all group health plans and group health insurance policies (as well as non-"grandfathered" individual health insurance policies) will be prohibited from imposing any annual dollar limits on so-called essential health benefits, for plan or policy years beginning on or after January 1, 2014. In the meantime, certain "restricted" annual dollar limits may be imposed -- i.e., a minimum of $750,000, $1.25 million, and $2 million, respectively, for plan or policy years beginning on or after September 23, 2010, September 23, 2011, and September 23, 2012. CMS's Center for Consumer Information and Insurance Oversight ("CCIIO") previously issued a series of guidance, in the Fall and Winter of 2010, describing a process that was available for group health plans and health insurance issuers offering certain types of coverage (such as limited benefit, or "mini-med," plans) to apply for a one-year waiver from these "restricted" minimum annual limit requirements, if they could show that complying with the requirements would result in a significant decrease in access to benefits or a significant increase in premiums.

The new CMS guidance sets forth a "waiver extension process," whereby plans and issuers that already received a waiver from the initial $750,000 minimum annual limit restriction may elect to extend that waiver until the first plan or policy year beginning on or after January 1, 2014. To obtain an extension, a completed waiver extension election must be submitted by September 22, 2011, and certain "annual limit update" information will need to be re-submitted by December 31, 2012 and December 31, 2013, respectively.

The new guidance also describes an updated process for new applicants to apply for waivers from the annual limit restrictions, and notes that any new waiver approvals will be granted for all plan years beginning before January 1, 2014 (rather than the "one-year" approach previously utilized). Similar to the waiver extension elections, new applications for waivers must be submitted by September 22, 2011, and certain "annual limit update" information will need to be re-submitted by December 31, 2012 and December 31, 2013, respectively. No waiver extension elections or new waiver applications will be accepted after September 22, 2011.

Finally, the guidance provides updated model language that must be "prominently displayed" on the front of any summary plan description, or other materials that describe the terms of coverage, for each plan or policy year for which a waiver that was granted (or extended) after June 17, 2011 applies.

It is important to emphasize that no waivers will be available for plan or policy years beginning on or after January 1, 2014, when annual dollar limits on essential health benefits will be completely prohibited. In addition, the HHS Fact Sheet, referenced above, notes that a plan that has a current annual limit greater than $750,000 -- and thus did not need to apply for a waiver from the initial $750,000 annual limit restriction for the plan or policy year beginning on or after September 23, 2010 -- will be unlikely to qualify for a waiver for any future year, leading up to 2014, because "actuarial analysis" indicates that annual limit increases from $750,000 to $1.25 million, and $1.25 million to $2 million, respectively, will generally require "minimal premium increases." The HHS Fact Sheet, though, does not prohibit such a plan from applying for a waiver based on its specific circumstances.

Finally, the guidance indicates that existing waivers are not intended to permit new, non-compliant insurance coverage to be offered. Waivers are intended to be granted solely for the purpose of maintaining coverage that was offered before September 23, 2010, except in the case of state-mandated policies, as provided in December 9, 2010 CCIIO supplemental guidance, and except as to new participants or beneficiaries in an existing group health plan.

1 The "NAIC" refers to the National Association of Insurance Commissioners. "NAIC-parallel processes" is a reference to state external review processes that incorporate certain minimum protections from the NAIC Uniform Health Carrier External Review Model Act, as specified in the IFR.

2 HHS has stated that it will make initial determinations by July 31, 2011 -- and final determinations, if necessary, by October 1, 2011 -- as to whether each state’s external review process meets the requirements of either the "NAIC-parallel" or "NAIC-similar" processes.

3 This HHS-administered, federal external review process currently applies to health insurance coverage and self-insured nonfederal government plans in states and U.S. territories that do not have an existing external review process in place, i.e., Alabama, Nebraska, Mississippi, the U.S. Virgin Islands, Guam, American Samoa, and the Northern Mariana Islands.

For more information, please contact:

Anthony Provenzano,, 202-626-1463

Garrett Fenton,, 202-626-5562

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