Regulations released in December 2019 finalize the guidance on how voluntary employees’ beneficiary associations must calculate unrelated business taxable income. Wondering how this might affect you?
Background on VEBAs
Although VEBAs are generally exempt from income tax under IRC Section 501(c)(9), they may generate UBTI, or taxable income, from carrying on activities other than their exempt function. Exempt function income includes amounts paid by members as consideration for the benefits received. In the context of VEBAs, this is typically made up of contributions from employees and employers that are used to provide health and welfare benefits to employees and their dependents. Importantly, investment income isn’t considered exempt-function income and can thus generate UBTI. For purposes of this discussion, we’ll refer to nonexempt function income as “investment income,” as that is the most common source of this income.
IRC Section 512 and the regulations thereunder describe an exception to the imposition of UBTI for investment income that is set aside for the payment of life, sick, accident, or other benefits, or for reasonable costs of administration directly connected with these purposes. The Code imposes a limit on the amount of income that may be set aside, and Section 512 requires VEBAs to treat investment income as UBTI to the extent of the lesser of:
- The investment income for the taxable year.
- The excess (if any) of:
- The total amount of the assets of the VEBA as of the close of the taxable year, over
- The applicable account limit for the year.
The “applicable account limit” for the year is determined under the rules of IRC Sections 419A(c) and 419A(f)(7), but does not include reserves for post-retirement medical benefits.
These limitations on the set-aside amount are generally not applicable to VEBAs that cover employees who are subject to a collective bargaining agreement. In addition, these limits do not apply if substantially all of the contributions to the VEBA are made by employers who were tax-exempt throughout the five-year taxable period ending with the taxable year in which the contributions were made.
Since the issuance of the 1986 regulations under Section 512, the interpretation of the set-aside rules has been the subject of numerous court cases, with differing results. In the Sixth Circuit, a 2003 decision (Sherwin-Williams Co. Employee Health Plan Trust v. Comm’r, 330 F.3d 449) held that investment income earmarked and spent prior to year-end on reasonable costs of administration wasn’t subject to the Section 512 set-aside limit. The court held that the Section 512 set-aside limit applied only to investment income that is accumulated and remains at the close of the year. In similar fact patterns, other appellate circuits rejected this argument, stating that the language of the statute was clear and unambiguous, i.e. that a VEBAs cannot avoid the set-aside limitations merely by allocating investment income toward the payment of welfare benefits. These appellate circuits reasoned that the Section 512 set-aside limit applied to the total investment income set aside for the taxable year and not just the “accumulated” remainder after the payment of appropriate administrative costs during the year. As a result, the IRS issued a notice of nonacquiescence to the Sherwin-Williams decision in 2005. Some taxpayers in the Sixth Circuit have continued to follow the Sherwin-Williams decision due to its authority in that circuit.
Regulatory changes for VEBAs
In 2014, proposed regulations were issued indicating that the IRS would no longer allow the Sherwin-Williams case to be used as authority by VEBAs. The final regulations generally mirror the proposed regulations, but do provide for a prospective effective date. Going forward, all investment income earned during the year should be considered in the set-aside limitation analysis, not just the amount remaining after amounts are allocated and spent on reasonable costs of administration. For tax years beginning after Dec. 10, 2019 (the date the final regulations were published), VEBAs must adopt the rationale of these regulations.
As a result, many VEBAs that have previously not incurred UBTI must now assess their applicable account limits to determine if they will generate UBTI from their investment income. If gross UBTI exceeds $1,000 in any year, Form 990-T must be filed to report the income and pay the applicable tax at rates up to 37%. If tax exceeds $500 in any year, quarterly estimated tax payments are required to be made in order to avoid penalties for underpayment of tax. In addition, a number of states impose tax on all or a portion of federally taxable UBTI.
Since these regulations will apply for calendar year 2020 and future taxable years, VEBAs should begin now to assess their situation and determine whether they need to begin filing tax returns and paying tax.