Editor: Mark Heroux, J.D.
The voluntary employees' beneficiary association (VEBA), a vehicle tax-exempt under Sec. 501(c)(9), has seen its heyday come and go. Created to provide for employees' various insurance needs (life, health, dental, etc.), these entities were popular for years until legislation reduced their attractiveness. Certain employers had discovered that VEBAs seemed to be the perfect place to put assets available only to them and a small coterie of executives. Assets such as second homes, airplanes, and assorted other luxury items found their way into the VEBA's protection. The Deficit Reduction Act of 1984, P.L. 98-369, sought to curb these abuses and strengthened anti-discriminatory language.
While nowhere nearly as common as they once were, VEBAs still represent a distinct avenue by which employers can provide for their employees. VEBAs need to follow general rules similar to those of other tax-exempt organizations to retain their not-for-profit status, such as ensuring that no part of their net earnings inure to private individuals. Likewise, a VEBA's activities must substantially revolve around its mission of providing beneficiaries with whatever benefits the VEBA designates. Beneficiaries must be either members (employees with some employment-related bond), their dependents, or designated beneficiaries.
What makes VEBAs sometimes less than desirable are rules surrounding unrelated business income (UBI). VEBAs may set aside income to pay benefits to members and reasonable administrative costs. This income can be considered "exempt function" income, which is considered not taxable. This exempt function income in the VEBA context is defined in Sec. 512(a)(3)(B) as gross income from dues, fees, charges, or similar amounts paid by members of the organization in furtherance of the purpose for which the organization exists. This definition then excludes income that is not specifically to be used for the provision of life, sickness, accident, or other benefits, including reasonable administrative costs. One key aspect of this income, referred to as set-aside income, is that it must not exceed the amount necessary to pay future claims and administrative costs related to those claims.
Sec. 419(a) establishes the general rule that contributions to a welfare benefit fund cannot be deductible unless otherwise deductible in the tax year when paid. Sec. 419(b) goes on to explain that income must not exceed the organization's "qualified cost" for the year, which is defined under Sec. 419(c)(3) as the total amount of expenses an employer would be allowed to deduct with respect to benefits under the cash method of accounting. However, the "qualified cost" also includes any amounts added to a "qualified asset" account, limited to unpaid claims at the close of the year and the administrative costs of those claims. Thus, VEBAs may consider any income above and beyond exempt function income that is calculated on an actuarial basis to be designated necessary for future claims as exempt from UBI.
There is a substantial exception to these rules. Retiree health care benefit plans do not enjoy the same exemption from UBI as other VEBAs. Retiree health care benefit plans have been singled out as having to report all of their investment income as UBI unless the plan is based upon a collective bargaining agreement. The Deficit Reduction Act of 1984 essentially stated that the qualified asset accounts for retiree health care benefit plans are zero, leaving all investment income generated by these plans to be fully taxable. Regs. Sec. 1.512(a)-5(c)(2)(v) clarifies the earlier legislation by stating that the limits calculated under Secs. 419A(c) and 419A(f)(7) do not include reserves for post-retirement medical benefits, except for special rules regarding plans covered under collective bargaining agreements.
Various court challenges, including in Sherwin-Williams Co. Employee Health Plan Trust, 330 F.3d 449 (6th Cir. 2003), have contradicted one another and what appeared to be the original intent of earlier legislation. The court in Sherwin-Williams held that investment income could be considered set-aside income and only taken into account as UBI after all payments for the year had been expended. Subsequent cases, such as CNG Transmission Management VEBA,588 F.3d 1376 (Fed. Cir. 2009), supported the IRS's assertion that investment income not initially considered to be exempt function income could not be reduced by exempt function deductions (i.e., payments of benefits and administrative costs).
In factoring their UBI to report for the year, VEBAs must follow the same rules for UBI as any other tax-exempt organization. Debt-financed rental income will be considered UBI, but interest income from state and local municipalities will not. Carefully planning an investment strategy that takes into consideration the taxability of the plan investments may be a prudent option to preserve the plan's principal for future needs.
VEBAs, like many tax-oriented strategies, may at first seem simple and straightforward. However, as often happens, burrowing into the detail of the VEBA rules and regulations reveals nuances that are profoundly necessary to understand to take full advantage of the capabilities that VEBAs may provide employers.
Mark Heroux, J.D., is a tax principal and leader of the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly US, LLP.