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Guest Article

Deloitte logo

(From the April 13, 2009 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Change in Accounting Method Issues Arising from VEBA Terminations and IBNR Deductions


This article addresses the accounting method issues that arise in two scenarios. In the first scenario, an employer terminates a welfare benefit fund, such as voluntary employees' beneficiary association (VEBA). In the second scenario, an employer without a VEBA begins taking deductions under IRC § 162(a)(1) for medical claims that are incurred but not reported (IBNR) as of the end of the employer's tax year.

Background on Deduction Timing

An accrual basis taxpayer generally is entitled to deduct expenses in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. Reg. § 1.461-1(a)(2)(i). For liabilities arising out of services provided to the taxpayer by another person, economic performance generally occurs as the services are provided. Reg. § 1.461-4(d)(2)(i). The economic performance requirement is automatically satisfied, however, to the extent expenses are otherwise deductible under IRC § 419 (discussed in the next section).

In United States v. General Dynamics, 481 U.S. 239 (1987), the Supreme Court held that the all events test was not satisfied with respect to medical benefits provided during a taxable year to employees who did not file claims before year-end, because the filing of claims by employees was necessary as a matter of law to create the employer's liability. Where the employer instead has a liability to pay a third party for medical services provided to its employees, however, the IRS takes the position that the liability arises in the taxable year in which medical services are provided. See Rev. Proc. 2008-52, § 19.01(1)(A)(i)(B).

Background on Welfare Benefit Funds, Including VEBAs

Some employers fund welfare benefits through welfare benefit funds. In general, IRC § 419 limits deductions for contributions to a welfare benefit fund. Under IRC § 419(e), the term "welfare benefit fund" means any "fund" that is part of an employer plan through which the employer provides "welfare benefits" to employees or their beneficiaries. The term "welfare benefit" is defined under IRC § 419(e)(2) as any benefit to which IRC §§ 83(h), 404, and 404A do not apply. Thus, welfare benefits are generally defined as any benefits paid to an employee or independent contractor other than property transfers or payments or accruals to a deferred compensation plan. The term "fund" is defined in IRC § 419(e)(3) as any organization described in paragraph (7), (9), (17), or (20) of IRC § 501(c); any trust, corporation, or other organization not exempt from the tax imposed by Chapter 1 of the Code; and, to the extent provided in regulations, any account held for an employer by any person. Thus, a fund, inter alia, may be a tax exempt VEBA or a taxable trust.

Together, IRC §§ 419 and 419A, limit an employer's deduction for contributions to a welfare benefit fund. Such contributions must be made to the fund before the end of the employer's tax year. An employer's deduction is limited to the welfare benefit fund's qualified cost for the taxable year. IRC § 419(b). /1/ The fund's qualified cost for a taxable year is the sum of its qualified direct cost and any addition to a qualified asset account for that year. IRC § 419(c)(1). The fund's qualified direct cost is the aggregate amount (including administrative expenses) that the employer would be eligible to deduct for the benefit payments if it provided the benefits directly to employees (or in the case of an insured amount, if it paid a premium to the insurance company) and used the cash receipts and disbursements method of accounting. IRC 419(c)(3). A qualified asset account consists of assets set aside to provide for the payment of disability, medical, SUB or severance, or life insurance benefits. IRC § 419A(a). The general limitation on additions to any qualified asset account for a taxable year is the amount reasonably and actuarially necessary to fund claims incurred but unpaid, plus applicable administrative expenses. IRC § 419A(c)(1). In addition, the account limit may include a reserve funded over the working lives of the covered employees and actuarially determined on a level basis (using assumptions that are reasonable in the aggregate) as are necessary for post-retirement medical benefits and postretirement life insurance benefits. IRC § 419A(c)(2).

A VEBA is an association of employees, with voluntary membership, that provides for the payment of life, sick, accident or other benefits to the association's members, their dependents or their beneficiaries no part of whose net earnings inures, except through payment of permissible benefits, to the benefit of any private shareholder or individual. IRC § 501(c)(9); Reg. § 1.501(c)(9)-1, -2. Generally, a VEBA will include a trust to which contributions are made and from which permissible benefits are paid. See Reg. § 1.501(c)(9)-2(c)(2). VEBAs are exempt from tax pursuant to IRC § 501(a) except to the extent that they are subject to unrelated business income tax pursuant to IRC § 511.

For various reasons, an employer that has adopted a welfare benefit fund might decide to terminate it. With respect to benefits for active employees (as opposed to the accumulation of amounts to fund postretirement medical or life insurance benefits) the deductible reserve permitted without a welfare benefit fund would be essentially equivalent to the permitted funding of an IBNR reserve under IRC § 419A(c)(1). Thus, accelerated deductions for welfare benefits paid in a future year do not depend on the existence of a fund. Rather, an accrual basis taxpayer can deduct amounts for medical expenses already incurred that will not be paid until a future year.

Background on Changes in Accounting Methods

When a taxpayer changes its treatment of the timing of an item's inclusion in income or deductibility, a change in accounting method often occurs. An accounting method generally is adopted when an item is treated the same way in determining gross income or deductions in two or more consecutively filed federal income tax returns -- even if the method is impermissible -- or if a taxpayer treats an item properly in the first return that reflects the item, even if the taxpayer does not treat the item consistently in two or more consecutive returns. Correcting mathematical errors or errors in the computation of tax liability is not considered a change in accounting method.

Once a taxpayer has adopted an accounting method, the taxpayer may not change the method simply by amending its income tax return -- the consent of the Commissioner is generally required. Consent is normally requested by filing a Form 3115, Application for Change in Accounting Method, during the taxable year in which the taxpayer wants to make the change. Unless specifically authorized by the Commissioner, retroactive changes in accounting method are not permitted, even if the change is from an impermissible method to a permissible method.

There are two basic types of accounting method change requests: automatic and advance consent (commonly referred to as "manual"). Automatic change requests generally must be filed in duplicate. The original must be attached to the timely filed (including extensions) federal income tax return for the year of change, and a copy must be filed with the national office between the first day of the year of change and the date on which the federal income tax return for the year of change is filed. Manual change requests must be filed during the year for which the change is requested and generally cannot be taken into account in the taxpayer's federal income tax return until the taxpayer receives a favorable letter ruling from the IRS and signs and returns the consent agreement copy.

If a change in accounting method would cause the item to be included in income or deducted more than once or not at all, section 481(a) generally requires that adjustments be made to prevent that result. For voluntary changes with a net positive section 481(a) adjustment (e.g., when the item would be deducted twice), the adjustment generally is spread over four taxable years. For involuntary changes and voluntary changes with a net negative section 481(a) adjustment (e.g., when a deduction is accelerated as a result of the change) the adjustment generally must be taken into account completely in the year of change. In some cases, however, the change in accounting method is made on a cut-off basis, and only expenses that arise prospectively are accounted for under the new method. In those cases, no section 481(a) adjustment is necessary.

Rev. Proc. 2008-52 provides the exclusive procedure for a taxpayer within its scope to obtain consent to change its method of accounting. Among the changes of accounting within the scope of Rev. Proc. 2008-52 is a change in the method of accounting for self-insured liabilities relating to employee medical expenses that are not paid from a welfare benefit fund. If the taxpayer has a liability to pay employees for their medical expenses, then the taxpayer must treat the liability as incurred in the taxable year in which the employee files the claim with the employer. If the taxpayer has a liability to pay a third party for these expenses, then the taxpayer must treat the liability as incurred in the taxable year in which the medical services are provided to the employee. Rev. Proc. 2008-52, § 19.01(a).

Scenario 1: VEBA Termination

Suppose that many years ago an employer provided welfare benefits without using a VEBA and took deductions for these expenses under IRC § 162(a)(1). Then, several years ago, the employer funded a VEBA and began taking deductions under IRC § 419 for its contributions to the VEBA. Now the employer is contemplating terminating its VEBA and taking future deductions under IRC § 162(a)(1).

The informal position of the IRS National Office is that if an employer has ever taken a deduction under IRC § 162(a)(1) for providing welfare benefits, then the termination of the employer's VEBA gives rise to a change in accounting method. In addition, the IRS National Office invokes the IRC § 481 rules in situations in which the VEBA is terminated with assets remaining (something that very rarely happens due to the inability for the employer to get a reversion of assets) such that the same medical expense was considered in funding the VEBA and in creating a current IRC § 162(a)(1) deduction for current expenses and an IBNR reserve. In all other situations, the vast majority of the cases, contributions to a VEBA or welfare benefit fund can be treated as a different item than employee benefit payments to employees or third parties for employees' medical expenses and thus not involve a change in accounting method.

The employer under this scenario has several alternatives:

First, the employer can take the position that there is no change in accounting method and simply begin taking deductions under IRC § 162(a)(1) instead of IRC § 419. Alternatively, the employer can take the position that there is a change in accounting method for which an automatic change is permitted under Rev. Proc. 2008-52.

Finally, the employer can take the position that there is a change in accounting method for which a manual change is required. This position will require the filing of an accounting method change before the end of the taxable year and the payment of a user fee.

Scenario 2: IBNR Deductions

Suppose that an employer that provides welfare benefits without using a welfare benefit fund deducts these expenses under IRC § 162(a)(1) but does not deduct any amount for IBNR.

If the employer begins deducting an amount for IBNR, this will give rise to a change in accounting method. The employer can take the position that an automatic change is permitted under Rev. Proc. 2008-52.

It should be noted that the IRS has recently changed its position regarding whether IBNR amounts must be spent within 2? months after year end to be deductible in a given tax year. PLR 200846021 (July 23, 2008). This is because the liability arises when the employee receives medical treatment -- not at the time of reimbursement. The compensation the employee receives from the employer is the rendering of medical services pursuant to the employer's plan, and even if the employee quit immediately after receiving medical benefits, the employer would be liable for the paying the expenses, even if the employee had paid for the medical services received (in which case the employer's liability would be to the employee rather than the provider of the medical benefits).

/1/ Where the employer's tax year and the fund's year are not identical, the deduction limit is based on the fund year that ends with or within the employer's tax year.


Deloitte logoThe information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2009, Deloitte.


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