Deductable Limits on Welfare Benefit Trusts
What is the limit on the amount an employer may deduct for contributions to a welfare benefit fund to provide disability, medical, death and other benefits to employees and independent contractors?
Qualified Cost
An amount, otherwise deductible, contributed by an employer to a welfare benefit fund may be deducted up to the fund's "qualified cost" for the taxable year of the fund that ends with or within the employer's taxable year. IRC Secs. 419(a), 419(b); Temp. Treas. Regs. §§1.419-1T, A-1, 1.419-1T, A-4. A fund's qualified cost for any taxable year generally is its (1) "qualified direct cost" for that taxable year, plus (2) any additions to a "qualified asset account" for that taxable year to the extent such additions do not cause the account to exceed its "account limit" for the taxable year, minus (3) the fund's after-tax income for the taxable year. IRC Secs. 419(c)(1), 419(c)(2), 419A(b); Temp. Treas. Reg. §1.419-1T, A-5(a). However, the deductible amount may be further reduced by additional rules. See Temp. Treas. Reg. §1.419-1T, A-5(b).
In determining whether a company's contributions to a proposed trust to fund postretirement medical benefits for union retirees under a plan would be treated as not exceeding the trust's "qualified cost" under IRC §419(b) and IRC §419(c), and would be deductible without regard to the limits of IRC §419A(b) and IRC §419A (c), the Service determined that if the amount of the contribution satisfies the requirements of IRC §419, the deduction of such amount is generally not limited by IRC §162. However, if the contribution is such that the assets exceed the amount needed to provide postretirement benefits to all current and future retirees (from current active employees)(i.e., the present value of future benefits), then the contribution would fail to satisfy the requirements of IRC §162. Let. Rul. 199945066.
When the taxable year of a fund is different from the taxable year of the employer, special rules determine the deduction limit for the taxable year of the employer in which the fund is established and for the employer's next taxable year. See Temp. Treas. Reg. §1.419-1T, A-7. Special rules also require contributions made after the close of a fund's taxable year but during the employer's taxable year to be treated as an amount in the fund as of the last taxable year of the fund that relates to the taxable year of the employer. See Temp Treas. Reg. §1.419-1T, A-5(b). Accordingly, an employer with a differing tax year than its welfare benefit trust cannot accelerate its deduction for its contribution to the trust to an earlier tax year by making its contribution after the end of the trust's tax year but before the end of the employer's tax year and, therefore, prefunding the trust for benefits to be provided in the following tax year. Square D Co. v. Comm., 109 TC 200 (1997).
A fund's "qualified direct cost" for a taxable year is generally the amount (including administrative expenses) a cash basis employer with the same taxable year as the fund could deduct had it provided the benefits directly instead of through an intermediary fund. Any rules limiting the deduction for benefits provided directly by the employer apply even though the benefits are provided through a fund. The benefit is considered provided in the year the benefit is includable in income by the employee (or would be includable except for Code provisions excluding the benefit from income). IRC §419(c)(3); Temp. Treas. Regs. §§1.419-1T, A-6(a), 1.419-1T, A-6(c).
A "qualified asset account" is an account consisting of assets set aside to provide for the payment of disability benefits, medical benefits, supplemental unemployment benefits (SUB), severance pay benefits, or life insurance benefits (including any other death benefits). IRC §419A(a). The "account limit" on a qualified asset account for a taxable year is generally the amount reasonably and actuarially necessary to fund claims incurred but unpaid (as of the close of the fund's taxable year) for such benefits, as well as the administrative costs with respect to those claims. IRC §419A (c)(1).
In one case, the Tax Court concluded that assets must actually be set aside for the payment of future long-term disability benefits that were incurred but unpaid; thus, an employer could not deduct contributions for such benefits where the employer had failed to accumulate the necessary assets in the VEBA trust. However, the Sixth Circuit Court of Appeals determined that the Tax Court had erroneously "interpreted the term 'set aside' in IRC §419A(a) as having the same meaning as the term 'reserve' in IRC §419A(c)(2)." The Sixth Circuit held that an employer has "set aside" assets for purposes of IRC §419A(a) when it has made an irrevocable contribution to a welfare benefit fund providing those benefits specified in IRC §419A(a). Parker-Hannifin Corp. v. Comm., TC Memo 1996-337, affirmed in part, reversed in part, 139 F.3d 1090 (Sixth Circuit 1998). In other words, "set aside" with respect to an account for disability, medical, supplemental unemployment, severance, or life insurance benefits under IRC §419A(a) has a different, less restrictive meaning than "reserve" as it applies to an account for postretirement medical or life insurance benefits. Internal Revenue Service Exempt Organizations Continuing Professional Education Text for Fiscal Year 1999, Chapter F, Voluntary Employees' Beneficiary Associations. (Apparently, the amount reasonably and actuarially necessary to fund incurred but unpaid claims in a fully insured plan is zero. See Let. Rul. 9325050.)
Under certain circumstances, the account limit may also include an amount to fund (over their working lives) postretirement medical or life insurance benefits (including any other death benefit) to be provided to covered employees. See IRC Secs. 419A(c)(2), 419A(e)(1). Such a reserve may not be included in the account limit, though, unless such a reserve is actually established and funded—that is, unless assets are actually accumulated in the fund to cover postretirement obligations. General Signal Corp. v. Comm., 103 TC 216 (1994), affirmed, 142 F.3d 546 (Second Circuit 1998); Parker-Hannifin Corp. v. Comm., TC Memo 1996-337, affirmed in part, reversed in part, 139 F.3d 1090 (Sixth Circuit 1998). See also Square D Co. v. Comm., 109 TC 200 (1997). The present value of projected postretirement medical benefits for employees who are retired at the time the reserve is created may be deducted in the year the reserve is created (approving the use of the individual level premium cost method to compute the reserve and rejecting the use of the aggregate cost method). Wells Fargo v. Comm., 120 TC 69 (2003). The IRS privately ruled that where a company's VEBA intended to purchase a retiree health insurance policy to fund retiree benefits under the VEBA: (1) the VEBA would not be taxed on any income from the policy; (2) the company would not be required to recognize any income on the amount of the policy; and (3) the benefit payments under the policy to the VEBA would be excluded from the VEBA's gross income. Let. Rul. 200404055.
Whether deductions may be claimed under IRC §419A(c)(2) turns on the intent of the employer at the time that the reserve is established. General Signal Corp. v. Comm., 142 F.3d 546 (Second Circuit 1998). A reserve for postretirement benefits is not required to be segregated from the general assets of the fund into a separate account. See General Signal Corp. v. Comm., 103 TC 216 (1994) (agreeing in dicta with Service attorneys' argument that a postretirement reserve need not be maintained in a separate account), affirmed, 142 F.3d 546 (Second Circuit 1998); Parker-Hannifin Corp. v. Comm., 139 F.3d 1090 (Sixth Circuit 1998).
One special rule provides that certain employee pay-all VEBAs have no account limits. IRC §419A(f)(5)(B). Another special rule provides that welfare benefit funds under collective bargaining agreements have no account limits. IRC §419A(f)(5)(A); see Temp. Treas. Reg. §1.419A-2T, A-2. (Certain arrangements purportedly qualifying as collectively-bargained welfare benefit funds excepted from the account limits of IRC §419 and 419A have been identified as "listed transactions." Notice 2003-24, 2003-18 IRB 853. See Q 493 for the rules applicable to listed transactions.) The Department of Labor has released criteria for determining when a plan is established and maintained under a collective bargaining agreement for purposes of the exception from the multiple employer welfare arrangement (MEWA) rules under ERISA. See Labor Reg. §2510.3-40; 68 Fed. Reg. 17471 (4-9-2003).
Maintenance of a separate welfare benefit fund for union employees is required. A fund for union employees must not only be separate from the employer and its creditors, but it must also be "distinct and apart from any funds provided for non-collectively bargained employees." Parker-Hannifin Corp. v. Comm., 139 F.3d 1090 (Sixth Circuit 1998). But see Let. Ruls. 200137066, 199945066.
A fund's after-tax income is generally the fund's gross income, including employee contributions, but excluding employer contributions, reduced by allowable deductions directly connected with production of gross income and by the tax on the income. IRC §419(c)(4).
Employer contributions that are not deductible in one year because they exceed the limit on allowable deductions are carried over and treated as contributed in the next year. IRC §419(d).
If a welfare benefit fund is part of a 10 or more employer plan, see Q 493.
Account Limit
Claims incurred but unpaid. "Claims are incurred only when an event entitling the employee to benefits, such as a medical expense, a separation, a disability, or a death actually occurs. The allowable reserve includes amounts for claims estimated to have been incurred but which have not yet been reported, as well as those claims [that] have been reported but have not yet been paid." H.R. Conf. Rep. 861 (TRA '84), 98th Cong., 2d Sess. 1156, reprinted in 1984-3 CB (vol. 2)
410. Incurred but unpaid claims would include the present value of a future stream of payments under a long-term disability or death claim, using reasonable actuarial assumptions, according to that conference report. See id. The report of the Senate committee (TRA '86) notes that no more than 12 months of disability benefits may be deemed incurred with respect to a short-term disability expected to last more than five months. S. Rep. No. 313, 99th Cong., 2d Sess. 1006, reprinted in 1986-3 CB (vol. 3) 1006.
The account limit to fund for disability claims incurred but unpaid may not take into account disability benefits to the extent they are payable at an annual rate in excess of the lower of 75% of the individual's average high 3-years' compensation or the dollar limit on an annual benefit of a defined benefit plan ($165,000 in 2004, $160,000 in 2003). IRC §419A(c)(4)(A); Notice 2003-73, 2003-45 IRB 1017. In applying this limit, all welfare benefit funds of the employer are treated as one fund. IRC §419A(h)(1)(A).
The account limit with respect to reserves set aside to provide postretirement medical or life insurance benefits may not take into account life insurance benefits in excess of $50,000, except to the extent a higher amount may be provided tax free under grandfathering provisions of §79 for certain individuals. IRC §419A(e)(2); TRA '86, §1851 (a)(3)(B), as amended by TAMRA '88, §1018(t)(2)(D). For this purpose, all welfare benefit funds of the employer are treated as one. IRC §419A(h). In funding for postretirement medical benefits, current cost assumptions must be used; future inflation may not be assumed. IRC §419A(c)(2).
Furthermore, the account limit generally may not include a reserve to provide postretirement medical or death benefits under a plan that fails to meet the nondiscriminatory benefit requirements discussed in Q 490. See IRC §419A(e)(1); TRA '86, §1851(a)(3)(B), as amended by TAMRA '88, §1018(t)(2)(D). If postretirement benefits are provided for key employees, see Q 489.
Unless there is an actuarial certification of the account limit by a qualified actuary, the account limit for a taxable year may not exceed certain "safe harbor limits." See IRC §419A(c)(5)(A); H.R. Conf. Rep. 861 (TRA '84), above, reprinted in 1984-3 CB (vol. 2) 412. The Code's reference to safe harbor limits here is potentially confusing because these limits are not true safe harbors. See General Signal Corp. v. Comm., 103 TC 216 (1994), affirmed, 142 F.3d 546 (Second Circuit 1998); Square D Co. v. Comm., 109 TC 200 (1997); TAMs 9818001, 9446002, 9334002. That is, the safe harbor limits do not establish a minimal reserve level (or, account limit) that an employer can automatically fund on a currently deductible basis. An employer claiming an account limit equal to or less than the applicable safe harbor limit(s) must still show that its claimed reserve satisfies the generally applicable restrictions of IRC §419A. That is, the claimed reserve must still be reasonably and actuarially necessary to pay incurred but unpaid claims (plus administrative costs). See, e.g., Let. Rul. 9818001. Any reserve for postretirement medical or life insurance benefits must be actuarially determined on a level basis to fund the postretirement benefits over the working lives of the covered employees. Claiming an account limit at or below the applicable safe harbor limit(s) simply relieves the employer of the obligation to obtain an actuarial certification justifying its reserve computations. See General Signal, above; Square D Co., above; H.R. Conf. Rep. No. 861, above, reprinted in 1984-3 CB (vol. 2) 412. Actuarial valuation reports do not constitute an actuarial certification for purposes of IRC §419A. Let. Rul. 9818001.
The "safe harbor limit" for any taxable year for short-term disability claims is 17.5% of the "qualified direct costs" (other than insurance premiums) for short-term disability benefits for the immediately preceding taxable year. IRC §419A(c)(5)(B)(i).
The "safe harbor limit" for any taxable year for long-term disability or life insurance benefits is to be prescribed by regulations. IRC §419A(c)(5)(B)(iv).
The "safe harbor limit" for any taxable year for medical claims is 35% of the "qualified direct costs" (other than insurance premiums) for medical benefits for the immediately preceding taxable year. IRC §419A(c)(5)(B)(ii). The TRA '84 conference report explains that insurance premiums may not be taken into account because the conferees did not intend that a fund be used as a vehicle for prepayment of insurance premiums for current benefits. H.R. Conf. Rep. 861, above, reprinted in 1984-3 CB (vol. 2) 412.
In determining the employer's deduction, no item may be taken into account more than once. IRC §419(c)(5).
Supplemental Unemployment Compensation (SUB) and Severance Pay Benefits
Where contributions are made to the fund to provide supplemental unemployment compensation (SUB) or severance pay benefits, the account limit for SUB or severance pay benefits is 75% of the average "qualified direct costs" for any two of the immediately preceding seven taxable years (as selected by the fund). IRC §419A(c)(3)(A). If the benefit to any individual is payable at an annual rate in excess of 150% of the IRC §415 dollar limit on contributions to defined contribution plans, the excess cannot be taken into account in determining the account limit. IRC §419A(c)(4) (B). In applying this latter limit, all welfare benefit funds of the employer are treated as one fund. IRC §419A(h)(1) (A). Treasury regulations are to provide an interim limit for new SUB or severance pay plans that do not cover key employees. IRC §419A(c)(3)(B).
The "safe harbor limit" for SUB or severance pay benefits is the amount as determined above. IRC §419A(c)(5) (B)(iii).
Aggregation Rules
An employer must treat all of its welfare benefit funds as one fund for certain purposes. IRC §419A(h)(1)(A). For other purposes, an employer may elect to treat two or more of its funds as one. IRC §419A(h)(1)(B). An election to aggregate must be consistent for deduction and nondiscrimination purposes (see Q 490, Q 494 for a discussion of nondiscrimination rules applicable to certain welfare benefit funds), the conference report to TRA '84 notes. H.R. Conf. Rep. 861, above, reprinted in 1984-3 CB (vol. 2) 413. Aggregation rules similar to those of IRC §414 (controlled groups of corporations, employers under common control, affiliated service groups) and rules similar to the employee leasing rules apply. IRC §419A(h)(2). ASRS, §66, ¶¶620, 680.