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July 06, 2015 Article 4 min read

Executive summary:

In February 2014, proposed Treasury regulations were issued which, when finalized, will change the way in which most VEBA’s in the 6th Circuit (Michigan, Ohio, Kentucky and Tennessee) are taxed. Essentially, these funds’ investment income will be subject to tax except to the extent that the fund covers participants who are included in a collective bargaining agreement. VEBA’s that are substantially funded by tax-exempt employers are also exempt from the impact of the new regulations.

Each plan’s status should be reviewed as soon as possible in light of this upcoming change to determine the applicability of the changes to the plan, the potential tax cost to the plan, and any action that may be warranted to prepare for the change. Unless a plan covers only collectively bargained participants, or is funded substantially by tax-exempt employers, action may be required to calculate and plan for this tax and reporting responsibility.

Issue and Discussion:

Although they are generally tax-exempt entities, VEBA’s are subject to unrelated business income tax (UBIT) on income that is other than “exempt function income.” Exempt function income is generally defined as any fees, dues, and other charges received in exchange for the provision of the VEBA benefits to the members or their dependents. Hence, investment income is potentially taxable, subject to several additional rules that are specific to VEBA’s.

The UBIT definition is driven by the VEBA funding limits under Internal Revenue Code (IRC) Sections 419 and 419A, as well as by the existence of collectively bargained employees within the fund’s members. The Tax Reform Act of 1984 created limits on the amount of funding allowed for VEBA’s under IRC Sections 419 and 419A. This funding limit is roughly equal to claims paid, plus certain administrative expenses, plus the amount of claims that are incurred but not reported (IBNR). There is an exception to these funding limits for arrangements that include collectively bargained participants, but only to the extent of the portion that encompasses the collectively bargained participants. In addition, if substantially all of the contributions to a VEBA are made by tax-exempt employers, the funding arrangement may meet an exception to these rules.

Unrelated business taxable income (UBTI) for VEBA’s is defined as the lesser of (1) the amount of funding that is set-aside and is in excess of the 419/419A amounts (generally, IBNR), or (2) the fund’s investment earnings. In most cases the investment earnings will be the lesser amount, and for purposes of this discussion this will be the presumed result. UBTI is taxed at the trust tax rates, which allow for favorable rates for qualified dividends and long-term capital gains, but subject ordinary income to a very steep graduated rate scale, with the highest rate being 39.6%. It is worth noting, in today’s investment environment, that the federal income tax exemption for income from municipal bonds is applicable to UBTI as well.

In 2003, in Sherwin Williams Co. Employee Health Plan Trust v. Commissioner, the 6th Circuit Court of Appeals ruled that to the extent that investment earnings were used to pay claims or administrative expenses, such amounts would never have been “set aside,” and therefore, there would be no taxable investment earnings. The IRS disagreed, and has announced that they would limit the applicability of the 6th Circuit’s ruling to the aforementioned states. The U.S. Supreme Court has since declined a request from another Circuit to address this issue.

In February 2014, the IRS re-proposed regulations to clarify their position, and have indicated that, once the regulations are finalized, the IRS will no longer respect the 6th Circuit’s Sherwin Williams decision, and UBTI will be taxable to the extent it is attributable to non-collectively bargained participants unless the arrangement is substantially funded by tax-exempt employers. Although we do not know when the IRS might finalize the regulations, it does seem that there is heightened interest in this subject and funded welfare arrangements should prepare now for the impact of this change.

Action Needed:

Welfare benefit trusts that have funding in excess of the 419/419A limits, have non-collectively bargained participants, and do not meet an exception for arrangements funded substantially by tax-exempt employers, will be required to perform UBTI calculations and file a Form 990-T to report the income and the resulting tax. Estimated taxes must be paid on a quarterly basis throughout the fund’s tax year. State tax issues must also be addressed.

Steps should be taken now to review each plan’s status relative to its funding levels and the presence or absence of collectively bargained participants. Where arrangements cover both collectively bargained and non-collectively bargained participants, a reasonable methodology will need to be determined for identifying the amount of gross income and allocable expenses that are attributable to non-collectively bargained participants and thus required to be reported on Form 990-T. We strongly encourage VEBA’s to begin gathering this data now for the current tax year, and to prepare a mock tax calculation to assess the potential future tax liability. If you have questions about this issue, or would like any assistance in preparing for the finalization of the regulations, please don’t hesitate to contact us using the web form on this page.