In an attempt to boost returns and increase portfolio diversification, many benefit plan sponsors are capitalizing on various alternative investments. However, some plan sponsors and advisors are often unaware of the fact that many of these investments are producing unrelated business taxable income (UBTI) which can cause otherwise tax-exempt trusts to be taxable. Additionally, welfare benefit plan trusts that have both collectively and non-collectively bargained participants, may be producing UBTI.
While qualified retirement plans do generally benefit from a federal income tax exemption, they remain subject to taxation for all UBTI (less deductions) in excess of $1,000. Internal Revenue Code (IRC) section 511 imposes a tax on any gross income derived from certain unrelated business activities. Determining what is considered UBTI can often be difficult; however, in the case of trusts associated with a retirement plan, the determination is somewhat straightforward. IRC 513(b) explicitly lays out that for a trust (retirement plan), any trade or business regularly carried on by such trust is to be considered UBTI.
Plan sponsors or advisors who have identified UBTI within their plan must file an IRS Form 990-T Exempt Organization Business Income Tax Return annually. UBTI is then taxed according to the federal tax rate schedule for trusts, which can quickly reach as high as 39.6%. Both retirement plan sponsors and advisors need to evaluate their plan’s investments to identify any potential UBTI and the financial implications of this tax.
Although not as common, UBTI related to the types of investments described above is a concern for welfare plans. In addition, there is a specific provision related to funding limits associated with welfare plans that can generate UBTI. UBTI for Voluntary Employee Beneficiary Associations (VEBAs) and Supplemental Unemployment Benefit Plans (SUBs) is the lesser of the amount of excess funding or the amount of investment earnings. Under IRC 419A, residual welfare plan funding is limited to the amount reasonably necessary to fund claims incurred but unpaid, the administrative costs associated with such claims, and an additional reserve for post-retirement medical, if applicable. Some Plans have used a Sherwin Williams approach to by-pass the 419 and 419A funding limits; however, upon finalization of proposed treasury regulations, the IRS anticipates that this methodology will be eliminated.
There is an exception to these funding limits for collectively bargained plans, but only to the portion that encompasses the collectively bargained participants. All collectively bargained welfare trusts that have funding in excess of the 419 and 419A limits and have non-collectively bargained participants, will have to perform UBTI calculations. Treasury Regulation § 1.419A-2T requires that at least 90% of the employees eligible to receive benefits under the fund must be covered by the collective bargaining agreement, unless grandfathered. Although the IRS proposed regulations may provide further guidance, at this time there are no operational details concerning how to allocate the portion of a fund attributable to the employees covered by a collective bargaining agreement.
In anticipation of these regulations being finalized, a mock computation should be performed to help assess the data gathering requirements, computation assumptions, UBTI magnitude, and alternative methods to prorate between collectively bargained employees and plan participants who are non-collectively bargained, as well as differentiating among the special rules related to different components of investment income.