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Steelerfan

VEBA to fund severance

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Does anyone have any opinions, tips, experience, etc. regarding the pros and cons of funding severance payments through a VEBA. I know this is very open ended, just looking for general opinions.

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The use of a VEBA is an excellent idea for collective bargaining groups. It gets the funds out of the hands of the employer, increasing the probability that the funds will invested wisely and not dissipated, it separately accounts for the funds required and available for the severance plan, etc. DOL has primary jurisdiction over these plans.

In a non-collective bargaining situation, where IRS has primary jurisdiction, severance benefits are considered to be a form of deferred compensation subject to the reqiurements of IRC 409A. Therefore, the type of trust to be used likely will be a "Rabbi Trust" rather than a VEBA. No trust is required at all and no advance deductions are available other than a modest amount set aside as "qualified additions" to a "qualified asset account".

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This would be noncollectively bargained. I didn't expect to here that.

The idea would be to take advantage of 419A pre-funding and accelerate the deduction. With rabbi trust there seems to be little benefit, I never thought of doing that or that you could prefund a rabbi trust.

We would obviously operate the VEBA within the confines of 409A's potential application. We would possibly also pay LTD benefits through the trust (which is in place already) and possibly fund for other health benefits.

Are you saying VEBAs in the non collective bargained context are dead or useless?

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I am simply saying that, court decisions under prior law notwithstanding, IRS has always argued that severance pay plans are deferred compensation. Now that IRC 409A is law, any plan that does anything beyond short-term deferrals must comply with 409A.

If you choose to impose the additional requirements of IRC 501©(9) on top of such a plan, fine.

Please note that 419A(a)(4) permits tax deductions for supplemental unemployment and and severance pay benefits. That section also provides a safe harbor deduction limitation equal to 75% of the qualified direct costs (under IRC 419) for any 2 of the prior 7 years. So if the employer paid out $1,000,000 in severance benefits in 2 of the past 7 years, they could obtain a tax deduction for up to $750,000 so long as such contributions would "otherwise be deductible" (IRC 419(a)).

What is now in question is whether such amounts are now otherwise deductible, or if they are now barred from deduction under 409A. Whether or not such amounts are part of a "separation pay plan" is based on a facts and circumstances test as described in the Final Regs.

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So which are you saying, that he can't use a VEBA anymore or just that 409A makes it much more complicated?

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One way around that problem would be to limit individual severance payments under the VEBA to the lesser of the 401(a)(17) limit or 2X prior pay. Any amounts remaining in the trust could be used to pay other VEBA benefits. Additional severance could then be paid out to higher compensated employees outside the VEBA.

I guess the real question is whether using a VEBA provides any additional economic benefit, considering this potential payout limit and potential UBIT.

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Guest Harry O
Please note that 419A(a)(4) permits tax deductions for supplemental unemployment and and severance pay benefits. That section also provides a safe harbor deduction limitation equal to 75% of the qualified direct costs (under IRC 419) for any 2 of the prior 7 years. So if the employer paid out $1,000,000 in severance benefits in 2 of the past 7 years, they could obtain a tax deduction for up to $750,000 so long as such contributions would "otherwise be deductible" (IRC 419(a)).

What is now in question is whether such amounts are now otherwise deductible, or if they are now barred from deduction under 409A.

I'm no expert on the types of VEBAs being discussed here, but Section 409A has no impact on an employer's deduction.

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I think the issue is that if the amounts are deferred compensation, you have this fundamental conflict between the "up front" deduction upon contribution to a VEBA and the later deduction for NQDC. Since a NQDC plan can't have both up front deduction and be deferred compensation, 409A could theoretically "ruin" the deduction for the VEBA (up to the exemption amounts). It's a shame that Congress didn't exempt benefits payable from VEBAs' from the definition of deferred compensation.

A similar issue arises with employers who have sought to deduct pre-contributions to severance plans as welfare benefit plans, only to lose in court on the theory that the plan is really deferred comp subject to 404(a) deduciton timing rules (inclusion in GI). Except I would think that the comprehensive rules on deductibility for VEBAs should take the benefit out of the realm of 404(a) and into the deduction rules applicable to VEBAs.

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Steelerfan:

You bring up some excellent, conflicting points.

Can someone take a gander at explaining the difference between deferred compensation and severance benefits?

Severance benefits are allowed in VEBAs.

Don Levit

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Guest mjb

Reg. 1.501©(9)-3(f) specifically prohibits the payment of deferred comp from a VEBA and allows severance as a permissible benefit under 1.501©(9)-3(e) if the plan is a welfare plan under ERISA 2510.3-2(b). Unlike NQDC under 404(a)(5), The employer's deduction under 419A©(4)(B) for contributions are not contingent on when the employee is taxed on the payment. There is nothing in 409A that affects the employer's deduction to a VEBA b/c the benefits paid under a VEBA are not NQDC but are benefits that protect against a contingency that interrupts earning power. see 1.501©(9)-3(e).

The plans that lose the 419A deduction are those that are thinly disguised deferred comp, e.g., plan will pay severance to the owner of the business if he as president fires himself as an employee.

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There is nothing in 409A that affects the employer's deduction to a VEBA b/c the benefits paid under a VEBA are not NQDC but are benefits that protect against a contingency that interrupts earning power. see 1.501©(9)-3(e).

The plans that lose the 419A deduction are those that are thinly disguised deferred comp, e.g., plan will pay severance to the owner of the business if he as president fires himself as an employee.

But there is no clear delineation in the tax world. Tax courts ignore the definition in ERISA and will rule that most severance is deferred comp for tax purposes because, unless the plan is mere insurance (as opposed to a guarantee of payment), severance always looks, smells and feels like a pension. Besides, if I recall properly, the definition in ERISA of severance that is welfare benefit is similar to the 409A 2X/2 year exemption. Would you agree that VEBA severance benefits should be limited by that 409A exemption?

Where would you draw the line?

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Guest mjb
But there is no clear delineation in the tax world. Tax courts ignore the definition in ERISA and will rule that most severance is deferred comp for tax purposes because, unless the plan is mere insurance (as opposed to a guarantee of payment), severance always looks, smells and feels like a pension. Besides, if I recall properly, the definition in ERISA of severance that is welfare benefit is similar to the 409A 2X/2 year exemption. Would you agree that VEBA severance benefits should be limited by that 409A exemption?

Where would you draw the line?

You have any citations for your statement that severance pay because of a loss of employment is a pension? I dont know of any case where severance paid by a publicly held corp was determined to be deferred comp. The 24 month rule for severance benefits under ERISA is only a safe harbor not a maximum. I dont understand how the distinction between insurance as opposed to a guarantee of payment for the loss of a job determines whether the payment is severance since severance is paid for a finite period not for life which is the definition of a pension under ERISA.

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Severance is payment on an involuntary termination of employment for a limited period of time. If the payment is made even if the employee voluntarily terminates, it's not a welfare benefit but a retirement benefit. If it is paid over an extended period of time, it is not a welfare benefit but a retirement benefit.

Under ERISA a pension is a benefit (other than a welfare benefit) that commences following termination of employment that is not a severance benefit (see above).

It gets complicated in the VEBA context when severance is set up by business owners. They will call it a severance benefit all day long, but in the end it is highly unlikely that the owner will give up the assets held in the VEBA - the owner will either consider himself terminated and eligible for the benefit, or he will terminate the plan and pay out the benefits to employees (namely the owner).

I can see how the IRS would assume a severance plan was deferred compensation unless the company can prove otherwise. That proof is certainly there in the union context, and perhaps in a big company with a written ERISA severance plan, but in the small business context - doubtful.

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Folks:

Excellent points by mjb and Locust.

To add my 2 cents (there is no "cents" sign on the keyboard, right), in Grant-Jacoby v. Commissioner, the court stated that "it is more significant to look to whether the plan is for the benefit of the owners; when the benefits are restricted to the owners, there is reason for requiring that the deduction be deferred until the distributions are made from the plan."

Provision of benefits only for key employees is a strong indicator that deferred compensation is involved.

In other words, context is key.

There is a big difference between finding a bee in the garden and finding a bee in your bedroom.

Don Levit

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You have any citations for your statement that severance pay because of a loss of employment is a pension? I dont know of any case where severance paid by a publicly held corp was determined to be deferred comp. I dont understand how the distinction between insurance as opposed to a guarantee of payment for the loss of a job determines whether the payment is severance since severance is paid for a finite period not for life which is the definition of a pension under ERISA.

Wellons v Commissioner, 31 f3d 569 (7th Cir 1994).

This was not a public company, but I don't see that as necessarily relevant. The court addressed VEBAs in a footnote that suggests (to me) that if this had been a VEBA, the doctor would have gotten his deduction upon contribution to the trust at issue (obviously not a VEBA).

I don't think I'd normally have much to worry about since payment would not be made unless there is an involuntary termination. But now we have a tax law that says that amounts in excess of 2X/2 years are deferred compensation even if paid upon involuntary termination, so the only real issue is whether VEBA payments for severance can exeed the 409A limit. I don't think so. Anyone disagree?

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Guest mjb

I thought under the facts in Wellons the "severance" benefits were based on the passage of time and not an unanticipated event e.g., the benefits were paid only for participants who had 5 yrs of service, benefits were based on compensation and length of service and could be paid upon almost any termination of service. Therefore it was a penson and not a severance benefit.

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I thought under the facts in Wellons the "severance" benefits were based on the passage of time and not an unanticipated event e.g., the benefits were paid only for participants who had 5 yrs of service, benefits were based on compensation and length of service and could be paid upon almost any termination of service. Therefore it was a penson and not a severance benefit.

That's true, but severance packages predominently have an element of service and compensation built into the formula (as does the plan where I work). The vesting schedule is a little strange, but only relevant to the "guaranteed" portion of the analysis. there is no legal reason why a severance plan as welfare benefit couldn't have a vesting requirement. The only necessarily "offensive" term is that the plan would have paid out on voluntary termination--that bodes bad for severance as welfare benefit.

But the significance of this case to me is that the court wouldn't have anything to do with ERISA's definition of severance and didn't care if it met the definition of "welfare benefit plan". And also that it seemed to suggest in the footnote that a VEBA would have been ok.

Post 409A, my concern for a VEBA is not just whether meeting ERISA's definition is enough--but also whether I have to be congnizant of the 409A limit on severance?

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Guest mjb

I have never seen a vesting provison in any severance plan b/c the employer wants to get a wavier of all claims (age & sex discrimination, etc) from each separated employee which is not possible if a minimim period of service is required to be eligible for severance benefits. What many employer do is provide a minimum amount of payment, e.g., 6 weeks pay to all severed employees and then an additional amount prorated on yrs of service if the employee signs a waiver of all rights which is required to be a valid waiver under ADEA. In all cases the benefit is paid only upon a contingent event, i.e, a reduction in force, not terminaton of employment

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A severance plan that only pays on RIF, that stinks! I guess some industries have different standards

Do you have any final opinion on the 409A limit applying to VEBA severance?

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