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Final regs detail computation of medical loss ratio & effect of failure to meet threshold

T.D. 9772, 06/21/2016; Reg. § 1.833-1

IRS has issued final regs that provide guidance to Blue Cross/Blue Shield organizations, as well as certain other health care organizations, on computing and applying Code Sec. 833(c)(5)’s medical loss ratio (MLR) and the consequences for not meeting the MLR threshold. The final regs reflect the enactment of technical corrections to Code Sec. 833(c)(5) by the Consolidated and Further Continuing Appropriations Act of 2015 (P.L. 113-235, 12/16/2014).

Background. Under Code Sec. 833, special rules apply to certain eligible health insurance organizations. They are (1) Blue Cross/Blue Shield organizations existing on Aug. 16, ’86, which have not experienced a material change in structure or operations since that date, and (2) other organizations that meet certain community-service-related requirements and substantially all of whose activities involve providing health insurance.

Under Code Sec. 833, eligible organizations that meet these requirements are generally entitled to the following “Code Sec. 833 benefits”:

1. Treatment as stock insurance companies under Code Sec. 833(a)(1)—meaning that they are taxed on their taxable income at regular corporate rates. Taxable income is gross income (i.e., investment income, underwriting income, gains from sales or other dispositions of property, and all other items constituting gross income for corporations) reduced by deductions. Gross income is then reduced by losses and expenses incurred, plus certain other deductions.
2. A “special deduction” under Code Sec. 833(b) equal to the excess (if any) of: (a) 25% of the sum of (i) the claims incurred during the tax year, and liabilities incurred during the year under cost-plus contracts, and (ii) expenses incurred during the tax year for the adjustment, administration, and settlement of claims, or in connection with the administration of cost-plus contracts; over (b) the “adjusted surplus” at the beginning of the tax year.
3. Computation of unearned premium reserves under Code Sec. 833(a)(3) based on 100%, and not 80%, of unearned premiums under Code Sec. 832(b)(4) (which essentially entitles an eligible organization to a larger deduction than it would otherwise receive).

Code Sec. 833(c)(5) was added to the Code by the Affordable Care Act. It provides that, for tax years beginning after Dec. 31, 2009, health organizations whose MLR is below 85% cannot take advantage of the Code Sec. 833 benefits discussed above.

An organization’s MLR is equal to the amount expended on reimbursement for clinical services provided to enrollees under its policies during the tax year, as reported under §2718 of the Public Health Service Act (PHSA) (the MLR numerator), divided by the organization’s total premium revenue (the MLR denominator). In December of 2010, the Department of Health and Human Services (HHS) issued interim final regs implementing PHSA §2718.

Prior guidance and transitional relief. Late in 2010, IRS issued Notice 2010-79, 2010-49 IRB 809 (see Weekly Alert ¶  5  11/24/2010), which provided interim guidance and transitional relief on (1) the computation of a taxpayer’s MLR for purposes of Code Sec. 833(c)(5); (2) the consequences of nonapplication of Code Sec. 833 if Code Sec. 833(c)(5) wasn’t satisfied; and (3) changes in accounting method because of the application or nonapplication of Code Sec. 833. The interim guidance applied to the first tax year beginning after Dec. 31, 2009. In general, it provided that an organization wouldn’t be treated by IRS as losing its status as a stock insurance company by reason of Code Sec. 833(c)(5) if certain conditions were met.

In June of 2011, IRS issued Notice 2011-51, 2011-27 IRB 36, which extended the interim guidance and transitional relief in Notice 2010-79 to the first tax year beginning after Dec. 31, 2010.

In December of 2011, HHS issued final regs implementing the reporting requirements under PHSA §2718, effective Jan. 3, 2012, with the first reporting under PHSA §2718 due in June 2012.

In Notice 2012-37, 2012-24 IRB 1014, IRS again extended the interim guidance and transitional relief in Notice 2010-79 and Notice 2011-51 through the first tax year beginning after Dec. 31, 2012, and indicated that it would issue proposed regs under Code Sec. 833(c)(5) shortly. (See Weekly Alert ¶  37  05/31/2012.)

In May of 2013, IRS issued proposed regs on computing and applying the MLR under Code Sec. 833(c)(5). (See Weekly Alert ¶  2  05/16/2013.) In January of 2014, IRS issued final regs which included transition rules to phase in the same 3-year period used under PHSA §2718(b) to compute the MLR for a tax year. Under the final regs, for the first tax year beginning after Dec. 31, 2013, an organization’s MLR is computed on a 1-year basis. For the first tax year beginning after Dec. 31, 2014, an organization’s MLR is computed on a 2-year basis. Finally, for the first tax year beginning after Dec. 31, 2015, and for all succeeding tax years, the final regs provide that an organization’s MLR is determined based on amounts reported under PHSA §2718 for that tax year and the two preceding tax years, subject to the same adjustments that apply for purposes of PHSA §2718. The final regs applied to tax years beginning after Dec. 31, 2013.

The Consolidated and Further Continuing Appropriations Act, 2015 (the Appropriations Act) made a technical correction to Code Sec. 833(c)(5). Effective for tax years beginning after Dec. 31, 2009, the technical correction provided that in calculating its MLR numerator, an organization includes both the cost of reimbursement for clinical services and amounts expended for activities that improve health care quality. Prior to the technical correction, the existing final regs only included in the MLR numerator an organization’s total premium revenue expended on reimbursement for clinical services provided to enrollees. In addition, the technical corrections provide that the consequences for not meeting the MLR threshold are only that Code Sec. 833(a)(2) and Code Sec. 833(a)(23) do not apply. Therefore, an organization with an insufficient MLR is treated as if it were a stock insurance company under Code Sec. 833(a)(1).

New final regs. In order to avoid any confusion caused by the effect of the technical correction on the existing final regs, IRS has published the existing final regs, as revised by the technical correction, in their entirety.

Consistent with the technical correction in the Appropriations Act, Code Sec. 1.833-1(c)(1)(i) describes an organization’s MLR numerator as the total premium revenue the organization expended on reimbursement for clinical services and activities that improve health care quality provided to enrollees under its policies for the tax year. For purposes of Code Sec. 833(c)(5), the final regs define the term “activities that improve health care quality” to have the same meaning as the term has in PHSA §2718 and its regs (see 45 CFR 158.150). In addition, consistent with the technical correction, the transition rules for computation of the MLR in Reg. § 1.833-1(c)(2)(i) and Reg. § 1.833-1(c)(2)(ii) include the premium revenue expended on activities that improve health care quality.

Consistent with the technical correction, the final regs provide that the consequences for an organization described in Code Sec. 833(c) that has an MLR of less than 85% are the following: (1) the organization is not allowed the special deduction set out in Code Sec. 833(b); and (2) it must take into account 80%, rather than 100%, of its unearned premiums under Code Sec. 832(b)(4). Unlike under the rule in the existing final regs, an organization that has an MLR of less than 85% does not lose its eligibility to be treated as a stock insurance company under Code Sec. 833(a)(1).

Effective/applicability date. The final regs apply to tax years beginning after Dec. 31, 2016, but taxpayers may rely on the final regs for tax years beginning after Dec. 31, 2009.

References: For taxation of qualifying health insurance providers, see FTC 2d/FIN ¶  E-5624; United States Tax Reporter ¶  8334.

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