Voluntary Employee Benefit Associations (“VEBAs”) have been in the news recently as tax-favored vehicles for pre-funding employee and retiree health care. In 2007, the United Auto Workers agreed to establish VEBAs at Ford, General Motors and Chrysler to assume liability for union retirees’ medical care, allowing the companies to remove more than $100 billion in liabilities from their balance sheets under Financial Accounting Board Standard 106.
State and local government bodies also have been considering VEBAs (or Section 115 trusts) in response to Government Accounting Board Standard 45, which now requires public sector employers to report their retiree health liabilities to taxpayers. Public employers who pre-fund retiree liabilities in a VEBA or other Code Section 115 trust may use higher long-term interest rates in calculating their liabilities, leading in theory to a lower liability figure on the books.
Tax Advantages of VEBAs
According to the Internal Revenue Service, more than 12,000 VEBAs exist today. VEBAs properly designed and administered under Section 501(c)(9) of the Code have several tax advantages:
- Contributions are generally not taxable to employees.
- Investments in the VEBA accumulate tax-free.
- Payments from the VEBA are tax-free so long as they are used for qualified welfare benefits, such as health benefits.
- Under Code Section 419A(f)(5)(A), there is no “account limit” on the deductibility of employer contributions to VEBAs maintained under collective bargaining agreements.
Unfortunately, VEBAs of non-union, non-public employers do not receive the favorable income tax treatment available to collectively bargained VEBAs. Under the “account limit” rules of Code Section 419 and 419A, non-union employers may only deduct a years’ worth of employee benefit claims and expenses. Congress added these restrictions in the mid 1980s to prevent abuse of VEBAs as tax shelters. These limits on annual deductions can create “unrelated business taxable income” (“UBTI”) for VEBAs and have made prefunding of medical expenses through VEBAs much less attractive for non-union employers.
Unrelated Business Taxable Income of VEBAs
Although VEBAs established under § 501(c)(9) are tax-exempt, they must pay tax on UBTI. Under Code § 512(a)(3)(A), UBTI is any gross income that is not “exempt function” income. Exempt function income includes income from dues, fees, charges or similar amounts contributed by VEBA members “in furtherance of the purposes constituting the basis for” the VEBA’s tax-exempt status. § 512(a)(3)(A). Exempt function income also includes income set aside “to provide for the payment of life, sick, accident, or other benefits.” § 512 (a)(3)(B).
However, the exemption for set-aside funds exists only to the extent that the income does not exceed the Section 419A account limit for the taxable year. The excess over the Section 419A “account limit” is not exempt function income and results in UBTI. Because VEBAs of non-union, private sector employers will have an “account limit,” these employers should pay close attention to a growing dispute among courts and the Internal Revenue Service regarding how to apply the Code’s account limit.
Calculating a VEBA’s Unrelated Business Income
In 2003, the Court of Appeals for the Sixth Circuit interpreted the Section 419A “account limit” rules to permit a somewhat larger deduction of employer contributions. In Sherwin-Williams Co. Employee Health Plan Trust v. Commissioner, 330 F.3d 449 (6th Cir. 2003), the Court interpreted the “account limit” as applying only to the amount of income that the VEBA accumulated during the taxable year and did not spend on qualified benefits and administrative expenses.
Sherwin-Williams established its VEBA in 1988 to provide health care benefits for its non-union employees, retirees and their families. An IRS audit concluded that the Sherwin-Williams VEBA deducted nearly $3.5 million in administrative expenses over and above its “account limit” in 1991 and 1992. The IRS filed a notice of deficiency alleging that the VEBA owed over $800,000 in UBTI tax. The VEBA challenged the IRS’ position in court, arguing that the “account limit” did not apply to amounts actually spent on qualified benefits and administrative expenses, but only to the “accumulated” income – i.e., the amount of income remaining in the VEBA at the end of the year after payments for benefits and reasonable expenses.
Over the objections of the IRS, the Sixth Circuit ruled in favor of the VEBA, holding that the Section 419A account limit “does not apply to income that was set aside and spent on the reasonable costs of administering health care benefits.” In response to the decision, the IRS issued a formal Opinion disagreeing with the Sixth Circuit and stating that it will not follow this interpretation of Section 419A outside the jurisdiction of the Sixth Circuit (Tennessee, Kentucky, Ohio and Michigan). 2005-35 I.R.B. 422.
In a recent decision, the Court of Federal Claims rejected the Sixth Circuit’s interpretation of the Code’s account limits. In CNG Transmission Management VEBA v. United States, No. 06-541 (Ct. Fed. Cl. 2008), the VEBA’s investment income exceeded its yearly account limit by $2.6 million, which excess amount was spent by the VEBA on health benefits during the same year. The VEBA sought to deduct this excess amount, relying on the Sixth Circuit’s ruling in Sherwin-Williams that amounts spent during the year and not accumulated were not subject to the Section 419A account limit. In response, the IRS argued that the Section 419A account limit applies to all the VEBA’s investment income, “even where the VEBA spends more money on program benefits than the investment income it earns.”
Although the Court of Claims found the Code was ambiguous on this point, the Court agreed with the IRS interpretation, relying on Treasury Regulation § 1.512(a)-5T, which in the Court’s view interpreted “exempt function income” in a manner “inconsistent with the narrow focus on year-end ‘accumulated’ funds adopted by the Sixth Circuit.”
Under the recent IRS interpretation, as upheld by the Court of Federal Claims, a VEBA can exclude investment income from UBTI only to the extent that its investment income does not exceed its “account limit” under Section 419A. In other words, the VEBA always pays tax on the lesser of its investment income or the excess of investment income over the VEBA’s account limit. The IRS will apply this interpretation in all jurisdictions outside the Sixth Circuit.