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has not been revoked;14 and (3) were tax exempt for the last taxable year beginning before January 1, 1987, provided that no material change occurs in the structure or operations of the organization after August 16, 1986, and before the close of 1986 or any subsequent taxable year. Congress intends that the following principles will be applied by the Secretary in determining whether or not a material change in operations or structure has occurred.
Material change in operations or structure
First, the merger or split up of 1 or more existing Blue Cross/ Blue Shield organizations, or the conversion to a mutual company status under local law, will not constitute a material change in operation or structure.
Second, if an existing Blue Cross/Blue Shield organization acquires a new line of business or is acquired by another business (other than a health business), the acquisition does not, by itself, constitute a material change in operations or structure of the organization if (1) the assets of the other business are a de minimis percentage (i.e., less than 10 percent) of the assets of the existing Blue Cross/Blue Shield organization at the time of the acquisition, or (2) the taxpayer can demonstrate to the Secretary of the Treasury that, based on all the facts and circumstances, the acquisition does not constitute a material change in operations or structure of the existing Blue Cross/Blue Shield organization.
Third, a material change in operations occurs if an existing Blue Cross/Blue Shield organization drops its high risk coverage or substantially changes the terms and conditions under which high risk coverage is offered by the organization from the terms and conditions in effect as of August 16, 1986. A change in high risk coverage is considered substantial if the effect of the change is to defeat the purpose of high risk coverage. High risk coverage for this purpose generally means the coverage of individuals and small groups to the extent the organization (1) provides such coverage under specified terms and conditions as of August 16, 1986, or (2) meets the statutory minimum definition of high risk coverage for new organizations. A material change in operations does not occur if an existing organization alters its operations to provide high risk coverage that meets the minimum standards under the Act for new Blue Cross/Blue Shield organizations.
For example, if an existing Blue Cross/Blue Shield organization provides open enrollment to all individuals and small groups of less than 5 individuals, the organization could redefine a small group for purposes of this coverage to mean the lesser of 15 individuals or the minimum number of individuals required for a small group under State law. Such a redefinition of a small group (from 5 to 15 individuals) would not be considered a material change in operations because the organization would meet the minimum standard for a new organization with respect to small group coverage.
A material change in operations occurs if the effect is to eliminate coverage for a significant high-risk segment of the plan's busi
14 Congress intends that, to the extent such determinations of tax exemption for any taxable year beginning before 1987 were not under audit or in litigation before August 16, 1986, the Internal Revenue Service will not seek to revoke such determinations.
ness. Whether a change in operations constitutes a material change in operations depends on all of the facts and circumstances. A material change is presumed to occur if an organization, on or after August 16, 1986, ceases to offer coverage for individuals or small groups or conversion coverage for those individuals who leave an employment-based group because of termination of employment. A material change generally occurs if an organization, which on August 16, 1986, offered individual coverage that allowed enrollment regardless of medical condition, modifies enrollment practices for that coverage to exclude certain individuals because of a preexisting medical problem.
A material change in operations does not occur if the plan increases its premium rates to reflect increases in health care costs or makes normal changes in products or services to respond to changes and developments generally in the health care environ-2 ment. Thus, this material change in operations rule is not intended to prevent a plan from making normal adjustments in their business practices, such as adjustments to reflect new trends in cost containment or adding new coverages.
Any change in business practice that either eliminates coverage of high-risk individuals or small groups or that has the effect of eliminating such coverage, however, is a material change in structure or operation. For example, a premium increase that reflects normal increases in medical costs is not itself treated as a material change. On the other hand, a premium increase that has the effect of making high-risk coverage unavailable because of the cost of such coverage is treated as a material change.
Similarly, a material change generally will occur if an organization after August 16, 1986, ceases offering individual or small group coverage in a defined geographic area due to a concentration of high risk individuals in that area. In addition, a material change generally will occur if an organization institutes, subsequent to August 16, 1986, a procedure to identify particular individuals within the pool of individual enrollment, reassess their individual risk due to excessive utilization, and cancel their coverage.
The material change rule is not intended to prevent existing Blue Cross and Blue Shield organizations from changing their high risk coverage to respond better to the needs of that population. For example, a material change would not occur if the organization introduced a preferred provider arrangement or a managed care product for individual high risk coverage that included financial incentives or requirements to use more cost effective providers or benefits (e.g., home health or hospice care rather than hospitalization). The material change rule also is not intended to prevent existing Blue Cross and Blue Shield organizations from establishing special coverages that recognize health lifestyles. For example, a material change would not occur if smokers were charged a higher premium than non-smokers.
A special deduction is provided to such organizations with re spect to their health business equal to 25 percent of the claims and expenses incurred during the taxable year less the adjusted surplus at the beginning of the year. This deduction is calculated by com
puting surplus, taxable income, claims incurred, expenses incurred, tax-exempt income, net operating loss carryovers, etc., attributable to health business. Claims incurred also include claims under costplus contracts. Thus, the deduction is not allowable with respect to such items attributable to, for example, life insurance business. The expenses attributable to health business are those incurred during the taxable year in connection with the administration, adjustment or settlement of claims under health business. The deduction may not exceed taxable income attributable to health business for the year (calculated without regard to this deduction).
For organizations eligible for this deduction in the first taxable year beginning after December 31, 1986, the amount of the adjusted surplus to be applied in the first year for which the deduction is allowable is the surplus reported on the organization's annual statement (i.e., the annual statement approved by the National Association of Insurance Commissioners) at the close of the preceding year, adjusted by not taking into account distributions (such as distributions to shareholders, or contributions or loans to affiliates that reduce surplus, but not including ordinary and necessary expenses or deductible policyholder dividends) after the date of conference action (August 16, 1986). For organizations that first become eligible for the provision in a later taxable year, the amount of the adjusted surplus for the first year of the deduction is the surplus reported on the annual statement at the close of the preceding year.
The initial surplus amount is adjusted under the provision at the close of each taxable year by adding the taxable income or loss 15 of the organization for the year (determined without regard to net operating loss carryovers and without regard to the deduction under this provision), plus net tax-exempt income for the year. Net taxexempt income means dividends to the extent a dividends received deduction was allowed, and interest that is tax-exempt, less the expenses of earning the tax-exempt interest that were disallowed under sec. 265, and less the adjustment that was made for proration of tax-exempt income under sec. 805(a) or sec. 832(b)(5) (as amended by the Act). If an organization eligible for the deduction under this provision does not take the deduction in any year, adjusted surplus must be calculated for the intervening years between the last year the organization took the deduction and the next year in which it takes the deduction, so as to take account properly of the calculation of the deduction in the later year.
For example, assume a calendar year Blue Cross organization engaged only in health business, the State law surplus (as adjusted) of which was $100 million on January 1, 1987. In 1987, the organization has health claims and expenses incurred of $880 million and adjusted taxable income of $160 million (including net tax-exempt income of $10 million). In 1987, the organization would be entitled to a special deduction of $120 million, that is, the excess of $220
15 As under present and prior law, insurance loss reserves must be reasonable (see title X; part C.1., below). Generally, it is intended that the loss reserves of organizations eligible for the deduction under this provision also be reasonable, and that they be comparable to the historical loss reserves of the organization in relation to its claims and expenses.
million (25 percent of the 1987 claims and expenses paid) over $100 million (the 1987 opening surplus).
As a further example, assume that in 1988, the organization has health claims and expenses incurred of $1.2 billion. Its special deduction for 1988 would be $40 million, that is, the excess of $300 million (25 percent of the 1988 health claims and expenses incurred) over the opening 1988 adjusted surplus balance of $260 million. The opening 1988 surplus is calculated by taking the sum of (a) 1987 opening surplus of $100 million, plus (b) 1987 adjusted taxable income of $160 million (including 1987 net tax-exempt income of $10 million).
The deduction applies only for regular tax purposes. Therefore, the deduction is treated as a preference item for purposes of the corporate minimum tax.
In addition to this special deduction, such organizations are given a fresh start with respect to changes in accounting methods resulting from the change from tax-exempt to taxable status. No adjustment is made under section 481 on account of an accounting method change.
Existing Blue Cross/Blue Shield organizations are required to compute their ending 1986 loss reserves without artificial changes that would reduce 1987 income. This rule as to reserve weakening is to be applied so that the incurred-but-not-paid claims reserve at the end of 1986 will be redetermined using actual paid claims data for 1987. That amount will be used for purposes of determining both the surplus at December 31, 1986, and the opening loss reserve at January 1, 1987. Use of actual experience to determine those amounts will eliminate potential controversy over the proper amount of the surpluses and reserves for 1987 tax purposes. The loss reserve then will be adjusted, as appropriate, by the rules of section 1023 of the Act requiring the discounting of unpaid losses.
Unearned premium reserves
Such organizations are not subject to the treatment of unearned premium reserves generally applicable to property and casualty insurance companies under the Act. Congress determined that during the period such organizations were tax exempt, any mismatching of currently deductible premium acquisition expenses and deferred premiums (resulting from the unearned premium reserve deduction) had no significant tax impact, and therefore it is not appropriate to require these organizations to include in income a portion of the outstanding balance of the unearned premium reserve. To ease the transition from tax-exempt to taxable status, Congress determined that it is appropriate to give such organizations relief from the requirement that 20 percent of the increase in unearned premium reserves be included in income.
Basis of assets
Finally, the basis of assets of such organizations is equal, for purposes of determining gain or loss, to the amount of the assets' fair market value on the first day of the organization's taxable year beginning after December 31, 1986. Thus, for formerly tax-exempt or
ganizations utilizing a calendar period of accounting and whose first taxable year commences January 1, 1987, the basis of each asset of such organization is equal to the amount of its fair market value on January 1, 1987. The basis adjustment is provided solely for purposes of determining gain or loss upon sale or exchange of the assets, not for purposes of determining amounts of depreciation or for other purposes. The basis adjustment is provided because Congress concluded that such formerly tax-exempt organizations should not be taxed on unrealized appreciation or depreciation that accrued during the period the organization was not generally subject to income taxation.
The foregoing special provisions apply to existing tax-exempt Blue Cross and Blue Shield organizations and to those other organizations that satisfy the additional criteria described below.
Other organizations substantially all of whose activities are providing health insurance, in order to receive the treatment under the provisions described above, must meet certain requirements. First, at least 10 percent of the health insurance (determined as a percentage of the total number of individuals covered annually) provided by the organization must be provided to individuals and small groups (disregarding Medicare supplemental coverage). A small group is defined as the lesser of 15 individuals or the number of individuals required for a small group under the State law where the covered groups are located.
Second, the organization is required to provide continuous fullyear open enrollment for individuals and small groups. Open enrollment is intended to include conversions from group to individual coverage (for example, upon separation from service with an employer who provides group coverage), without a lapse in coverage, provided the individual seeking to convert from group to individual coverage notifies the organization providing group coverage of his conversion request by the date of his separation from service. Conversion includes any change in the type of coverage (e.g., from one type of group to another).
Third, any individual seeking health insurance is required to be offered coverage which includes coverage of pre-existing conditions, and the coverage becomes effective within a reasonable waiting period after the time such coverage is sought. A reasonable waiting period is intended to be not more than three months. Further, health insurance coverage must be provided without regard to the age, income, or employment status of persons under age 65.
Fourth, at least 35 percent of the organization's health insurance premiums are determined on a community-rated basis. This percentage is determined as a percentage of the total number of persons covered on an annual basis. Community rating means that premiums are determined on the basis of the average annual cost of health insurance over the population in the community.
Fifth, the organization must be organized and operated in a manner such that no part of the net earnings inures to the benefit of any private shareholder or individual.