Crowell & Moring

The Treasury Department and the Internal Revenue Service released a final regulation providing guidance to Blue Cross and Blue Shield (and other qualifying healthcare organizations) on computing and applying the medical loss ratio (MLR) under Code Section 833(c)(5), which is effective as of January 7, 2013 and applies to tax years beginning after December 31, 2013. Under Code Section 833(c)(5), qualifying organizations (including Blue Cross and Blue Shield organizations) are provided with favorable income tax treatment, including: (1) treatment as stock insurance companies, (2) a special deduction under Code Section 833(b), and (3) the computation of unearned premium reserves based on 100 percent of unearned premiums under Code Section 832(b)(4). However, the Patient Protection and Affordable Care Act (ACA) added a provision to the Code, requiring that a qualifying organization must  have a medical loss ratio (MLR) of at least 85 percent to get favorable income tax treatment under Code Section 833(c)(5). For purposes of Code Section 833, an organization’s MLR is its percentage of total premium revenue expended on reimbursement for clinical services provided to enrollees under its policies during such taxable year (as reported under Section 2718 of the Public Health Service Act (PHSA)).

The final regulation defines how organizations calculate their MLR. Under the final regulation, the MLR numerator is defined as the “total premium revenue expended on reimbursement for clinical services provided to enrollees.” This definition of the MLR numerator retains the proposed regulation’s exclusion of “activities that improve health care quality.” Under the final regulation, the MLR denominator is the “total premium revenue for the tax year,” excluding Federal and State taxes, licensing and regulatory fees, and payments and receipts for risk adjustment, risk corridors, and reinsurance.

Additionally, the final regulation clarifies the time frame from which organizations compute their expenses and total premium revenue. The final regulation retains the three-year rule that is applied under Code Section 2718(b)(1)(B)(ii) of the PHSA (i.e., it uses amounts reported under PHSA Section 2718 for the taxable year and the prior two taxable years, subject to adjustment), but it creates a transitional rule for the first two years of implementation, beginning after December 31, 2013. Specifically, for the first taxable year beginning after December 31, 2013, an organization’s MLR is computed based on its total premium revenue expended on reimbursement for clinical services provided to enrollees and its total premium revenue for the first taxable year beginning after December 31, 2013. For the second taxable year beginning after December 31, 2013, and organization’s MLR is computed based on the sum of its total premium revenue expended on reimbursement for clinical services provided to enrollees and its total premium revenue for the first taxable year beginning after December 31, 2013 and the first taxable year beginning after December 31, 2014. For the third taxable year beginning after December 31, 2013 and all proceeding tax years, the MLR will be computed based on the sum of the amounts in that taxable year and the two preceding years.

If an organization fails to have a MLR of at least 85 percent, the final regulation provides that the organization loses favorable income tax benefits under Code Section 833(c)(5) for that year; specifically, the organization (1) loses its treatment as a stock insurance company (although it may be taxable as an insurance company if it meets certain requirements), (2) loses the special deduction under Code Section 833(b), and (3) must take into account 80 percent, rather than 100 percent, of its unearned premiums under Code Section 832(b)(4) (if it qualifies as an insurance company). Although the regulators did not adopt the commenters’ suggestions for a lessened penalty, they are still considering how to handle de minims failures under Code Section 833(c)(5).

The regulation provides that an organization’s change in eligibility under Code Section 833(c)(5) does not qualify as a “material change” in the organization’s operations or in its structure under Code Section 833(c)2(C). In addition, the final regulation does not supersede any of the procedures for an organization to obtain automatic consent to change its method of accounting for unearned premiums because of the application of Code Section 833(c)(5), as set out in Notice 2011-4 (2011-2 IRB 282 (December 29, 2013)) and Rev. Proc. 2011-14 (2011-4 IRB 330 (January 11, 2011)).

The final regulation was published in the January 7, 2014 Federal Register and is available here.