Recent guidance from the IRS suggests that it will be helpful to segregate funding for retiree health benefits from funding for all other welfare benefits (such as retiree life insurance, disability benefits, and health benefits for active employees) in order to minimize tax liabilities.  A proposed regulation issued earlier this year indicates that segregating the retiree health assets in a separate trust might reduce the unrelated business income tax on the trust’s investment income.  (As we explain below, this tax issue is limited to benefits that are not collectively-bargained.)

Excess Assets Result in Taxable Income

A voluntary employees’ beneficiary association, or “VEBA,” is a tax-exempt entity (usually a trust) that provides health, life, disability, and other welfare benefits to current and former employees and their spouses and dependents.  Different types of benefits are subject to different limits that restrict the amount of assets the VEBA can accumulate on a tax-advantaged basis.  The sum of these limits for the different benefits provided under the VEBA is the VEBA’s “account limit.”

The VEBA’s investment earnings are tax-exempt only to the extent that the VEBA’s assets at year-end do not exceed the account limit.  For example, if a VEBA earns $600,000 of investment income during the year, and at year-end the value of the assets set aside in the VEBA exceed its account limit by $200,000, only $400,000 of the VEBA’s investment income will be exempt from tax: the remaining $200,000 will be taxed as unrelated business income.

Do Retiree Health Reserves “Taint” Income on Other Reserves?

Assets set aside in a VEBA to provide retiree health benefits are subject to an especially unfavorable rule.  The account limit used in calculating the VEBA’s unrelated business taxable income does not include any allowance for a retiree health reserve.  As a result, the assets set aside to provide retiree health benefits automatically exceed the account limit (which is deemed to be zero), and all of the VEBA’s investment earnings attributable to the retiree health reserve generally are taxed as unrelated business income.

The unfavorable treatment of retiree health reserves raises a question: if an employer accumulates assets in a single VEBA to fund both retiree health benefits and other types of benefits, will the retiree health reserve “taint” the investment earnings of the other reserves, causing them to be taxable as well?  To illustrate this problem, assume that a single VEBA has two reserves: one for retiree health benefits, and the other for retiree life insurance.  At year-end, the value of the assets set aside to provide retiree health benefits is $50 million, and these assets have earned $3 million in investment income during the year.  The value of the assets set aside to provide retiree life insurance is $18 million, and these assets have earned $1 million in investment income.  The VEBA’s account limit (attributable solely to the retiree life insurance reserve) is $20 million.

Because the account limit for retiree health benefits is deemed to be zero for purposes of the unrelated business taxable income calculation, the $50 million reserve for retiree health benefits in our example far exceeds the account limit, and all $3 million of investment income generated by the retiree health reserve is taxable.  But what about the retiree life insurance reserve?  The assets set aside at year-end to provide retiree life insurance are below the $20 million account limit for the retiree life insurance reserve.  If the retiree life insurance reserve is considered separately, the $1 million of investment income generated by the reserve will be exempt from tax.  In contrast, if the employer must compare the VEBA’s total assets at year-end ($68 million) with its total allowable account limit ($20 million), the assets will exceed the account limit by $48 million, and all of the VEBA’s $4 million of investment income—including the income generated by the retiree life insurance reserve—will be taxable as unrelated business income.

The New Proposed Regulation Answers the Question Unfavorably

When the unrelated business income tax rules for VEBAs first became effective in 1986, many employers established separate VEBAs to hold reserves for retiree health benefits, so that they would not run the risk of exposing the investment earnings generated by other reserves to unrelated business income tax.   Maintaining separate VEBAs was expensive and burdensome, however, and it was not clear that this precaution was necessary.  Employers argued (and some senior IRS officials informally agreed) that requiring a separate trust for retiree health reserves elevated form over substance, and that employers could achieve the result Congress had intended by accounting separately for the earnings on a retiree health reserve maintained with other reserves in a single VEBA.

Proposed and temporary regulations issued in 1986 adopted a separate-accounting procedure for income on certain grandfathered reserves held in the VEBA, but did not address this issue for future reserves.  The new proposed regulation replaces the 1986 proposed regulation and, when finalized, will replace the temporary regulation.

Unfortunately, examples in the new proposed regulation indicate that a VEBA must aggregate retiree health reserves with other reserves held in the same VEBA, and must calculate unrelated business taxable income for the aggregated reserves.  As a result, a large retiree health reserve is likely to expose the income generated by other reserves in the same VEBA to unrelated business income tax, even though this income would not be taxable if the reserves were held in a separate VEBA.

Collectively-Bargained VEBAs Remain Exempt From Tax

Collectively-bargained VEBAs are not subject to the account limits that apply to non-bargained VEBAs.  The IRS has issued a number of private letter rulings confirming that earnings generated by reserves (including retiree health reserves) held in collectively-bargained VEBAs are not subject to unrelated business income tax calculated by reference to the VEBAs’ year-end asset values.

The new proposed regulation does not address collectively-bargained VEBAs.  The preamble explains that the Treasury Department and IRS intend to deal with these VEBAs in a separate regulation project.  At least for the present, however, it appears that collectively-bargained VEBAs will continue to be exempt from unrelated business income tax attributable to excess reserves.  (Like non-bargained VEBAs and other exempt organizations, collectively-bargained VEBAs might earn taxable income if they actually engage in unrelated business activities.)

What Steps Should Employers Take?

Retiree health reserves are not the focus of the new proposed regulation.  Instead, the IRS published the proposed regulation to repudiate the Sixth Circuit’s decision in Sherwin-Williams Co. Employee Health Plan Trust v. Commissioner, which held that a VEBA’s investment income would not be subject to unrelated business income tax if it was spent during the year for a permissible purpose.  Nevertheless, the new proposed regulation appears to reflect the IRS’s current view concerning the treatment of income generated by retiree health reserves, and it is unlikely that this view will change before the proposed regulation is finalized.

Employers might wish to review the structure of their non-collectively-bargained VEBAs to determine whether there are steps they can take to reduce the VEBA’s potential taxable income.  Among the possibilities are (1) establishing a separate VEBA for retiree health reserves, (2) establishing a sub-trust for retiree health reserves under an existing VEBA (although it is not clear that this technique will have the desired result), (3) investing VEBA assets in trust-owned life insurance or other investments designed to shelter income from tax, (4) permissively aggregating underfunded VEBAs with VEBAs that hold excess reserves, and (5) expanding the universe of welfare benefits funded through the VEBA in order to increase the account limit.

Each of these techniques raises its own issues and complications.  The proposed regulation states that it will be effective for taxable years ending on or after the date when a final regulation is published.  Accordingly, employers that do not currently maintain separate VEBAs for retiree health reserves might wish to give this issue early attention.

Email this postTweet this postLike this postShare this post on LinkedIn
Photo of Amy N. Moore Amy N. Moore

Amy Moore advises public and private companies and tax exempt organizations on a wide range of tax, ERISA, and employment law issues concerning all types of benefit programs.  Ms. Moore counsels some of the world’s largest multinational companies on the design and implementation…

Amy Moore advises public and private companies and tax exempt organizations on a wide range of tax, ERISA, and employment law issues concerning all types of benefit programs.  Ms. Moore counsels some of the world’s largest multinational companies on the design and implementation of innovative benefit strategies, including the restructuring of retirement programs to meet the needs of the modern work force; the use of surplus pension and insurance assets to provide non-traditional benefits; and the establishment of funding and security arrangements for welfare plans and executive compensation.  She represents clients in connection with pension fund investments in private equity funds, hedge funds, group trusts, and derivatives.  She also advises on benefits and compensation issues in acquisitions and divestitures, debt finance, joint ventures, and other corporate transactions.  Ms. Moore represents companies in audits and contested agency proceedings involving benefit plans and advises clients on employee benefits issues that arise in connection with ERISA litigation and settlements.  She also counsels employers on issues of plan administration and the correction of operational problems under government-sponsored remedial programs.