New Proposed Rules Determine UBTI of Certain Exempt Employee Benefit Organizations

The IRS on Wednesday issued proposed regulations to implement Sec. 512(a)(3)(E), which limits the amount of exempt function income that can be set aside when calculating the unrelated business taxable income (UBTI) of Sec. 501(c)(9) voluntary employee beneficiary associations (VEBAs) and Sec. 501(c)(17) supplemental unemployment benefit trusts (SUBs) (REG-143874-10). This new proposed rule will replace existing Temp. Regs. Sec. 1.512(a)-5T (which was issued in 1986 shortly after Sec. 512(a)(3)(E) was added to the Code), which will continue to apply until it is removed by final regulations.

According to the IRS, the UBTI of a “covered entity” (a VEBA or SUB subject to the UBTI computation rules of Sec. 512(a)(3)) is the lesser of (1) the entity’s investment income or (2) the excess of the amounts set aside as of the close of the tax year over the qualified asset account limit under Sec. 419A. The IRS believes that this rule means that UBTI is calculated based on the extent to which the entity’s assets at the end of the year exceed the Sec. 512(a)(3)(E) limitation, without regard to whether income was allocated to pay VEBA or SUB benefits during the year.

The IRS explained that its position was upheld in several recent cases in the Federal Circuit, including CNG Transmission Management VEBA, 588 F.3d 1376 (Fed. Cir. 2009), which held that a VEBA cannot avoid the limit on exempt function income by allocating investment income to pay welfare benefits during the year. It noted that the Sixth Circuit has held otherwise in Sherwin-Williams Co. Employee Health Plan Trust, 330 F.3d 449 (6th Cir. 2003), and announced its intention not to follow the Sherwin-Williams decision in that circuit if the new proposed regulation is adopted as final.

The new proposed regulation, which is in question-and-answer format, retains the formula for calculating the UBTI of a covered entity from the original proposed regulations. However, it makes a few other changes, including clarifying that the Sec. 512(a)(3)(E) rule does not apply if substantially all the contributions to the entity were made by employers that were tax-exempt throughout the five-year period ending with the tax year in which the contributions were made.