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Grantor Trust Treated Like a VEBA Trust for Tax Purposes

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Would welcome any thoughts or prior experience in dealing with this situation. Client was interested in setting up a VEBA to fund self-insured health plan several years ago. Client got some bad advice or misinterpreted the advice it received (or both) and thought it could set up a grantor trust to segregate funds but still get tax benefits of a VEBA. Client established simple, plain-vanilla grantor trust and began setting aside and taking deductions on amounts in excess of its health plan expenses for the year. Accountants apparently went along with all of this. The excess amounts are not enormous but significant and there are several open years at issue. It seems to me they are likely looking at having to amend their taxes as a result but just curious if anybody had ever dealt with something like this or had thoughts on resolving. Thanks.

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They may be o.k. See Q&A-3 of 1.419-1T.

Q-3: What is a "welfare benefit fund" under section 419?

A-3: (a) A "welfare benefit fund" is any fund which is part of a plan, or method or arrangement, of an employer and through which the employer provides welfare benefits to employees or their beneficiaries. For purposes of this section, the term "welfare benefit" includes any benefit other than a benefit with respect to which the employer's deduction is governed by section 83(h), section 404 (determined without regard to section 404(b)(2)), section 404A, or section 463.

(b) Under section 419(e)(3)(A) and (B), the term "fund" includes any organization described in section 501©(7), (9), (17) or (20), and any trust, corporation, or other organization not exempt from tax imposed by chapter 1, subtitle A, of the Internal Revenue Code. Thus, a taxable trust or taxable corporation that is maintained for the purpose or providing welfare benefits to an employer's employees is a "welfare benefit fund."

© Section 419(e)(3)© also provides that the term "fund" includes, to the extent provided in regulations, any account held for an employer by any person. Pending the issuance of further guidance, only the following accounts, and arrangements that effectively constitute accounts, as described below, are "funds" within section 419(e)(3)©. A retired lives reserve or a premium stabilization reserve maintained by an insurance company is a "fund," or part of a "fund," if it is maintained for a particular employer and the employer has the right to have any amount in the reserve applied against its future years' benefit costs or insurance premiums. Also, if an employer makes a payment to an insurance company under an "administrative services only" arrangement with respect to which the life insurance company maintains a separate account to provide benefits, then the arrangement would be considered to be a "fund." Finally, an insurance or premium arrangement between an employer and an insurance company is a "fund" if, under the arrangement, the employer has a right to a refund, credit, or additional benefits (including upon termination of the arrangement) based on the benefit or claims experience, administrative cost experience, or investment experience attributable to such employer. However, an arrangement with an insurance company is not a "fund" under the previous sentence merely because the employer's premium for a renewal year reflects the employer's own experience for an earlier year if the arrangement is both cancellable by the insurance company and cancellable by the employer as of the end of any policy year and, upon cancellation by either of the parties, neither of the parties can receive a refund or additional amounts or benefits and neither of the parties can incur a residual liability beyond the end of the policy year (other than, in the case of the insurer, to provide benefits with respect to claims incurred before cancellation). The determination whether either of the parties can receive a refund or additional amounts or benefits or can incur a residual liability upon cancellation of an arrangement will be made by examining both the contractual rights and obligations of the parties under the arrangement and the actual practice of the insurance company (and other insurance companies) with resepct to other employers upon cancellation of similar arrangements. Similarly, a disability income policy does not constitute a "fund" under the preceding provisions merely because, under the policy, an employer pays an annual premium so that employees who became disabled in such year may receive benefit payments for the duration of the disability.

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QDROphile:

Thanks for providing those 2 PlRs.

In PLR 9522017, it states "Sec. 419A(b) provides no addition to any qualified asset account may be taken into account under Sec. 419©(1) to the extent such addition results in the amount of such account exceeding the account limit."

Do you read that to mean that if the amount is not deductible, it cannot be added to the account limit?

Or, that there is no account limit for non deductible contributions?

Don Levit

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Sorry, I just dug these out of an old file because they spoke to the issue and I don't have time to refresh myself on the specifics. Each of the two rulings has another similar ruling of about the same vintage if you want more words to consider.

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vebaguru:

Thanks for your reply.

Are you saying that the maximum that can be set aside is strictly for tax purposes?

Can you cite any rulings or regulations which state that explicitly?

Are you suggesting that a VEBA can have an unlimited amount of UBIT, without losing its tax exempt status?

Don Levit

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Setting funds aside for future welfare benefits is not a bad thing. However, to avoid abuses, Congress has enacted Section 419A of the IRC for the purpose of preventing such welfare benefit arrangements to be used to shelter an excessive amount of income from current taxes. The amount that is not considered to be abusive is termed "qualified additions" to a "qualified asset account". With qualified retirement plans, excise taxes are imposed on excess contributions. However, no such limitation is imposed under 419A. That is because: (1) Congress did not want to bar companies from funding welfare benefits when they were able; and (2) excess income inside the trust is taxable anyway.

The answer to your question is actually within the statutes and the committee reports that accompanied the passage of IRC 419 & 419A.

There has been no mention of UBIT on this thread, so your question is unexpected. Did you confuse non-deductible employer contributions with taxable income inside the trust?

Despite the confusion, you have asked an interesting question: how much UBIT can a VEBA have without losing it's exempt status? Or, what is the purpose of a tax-exempt trust is you're using it for taxable transactions?

I could easily argue both sides here (pro): the amount of UBIT is irrelevant to the tax-exempt status since the UBIT issue is self-correcting. A trust which secures income which is not tax exempt pays the price of it (UBIT). The extent of the income doesn't matter because IRS is perfectly happy to collect taxes from a tax-exempt trust.

(con): A VEBA exists to provide certain benefits and must invest consistent with its purposes. Occasional incursion of UBIT is common, particularly in connection with debt financing of real estate. However, it is inconsistent with a VEBA's purposes to be engaging in a trade or business or other forms of UBTI activities. Once the investments become the issue rather than the benefits to be provided, the trust has lost its identity as a VEBA and should lose its tax-exempt status.

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vebaguru:

Thanks for your thoughtful reply.

Is there any way you could E-mail to me the pertinant parts of the statutes and committee reports you mentioned?

Is the only penalty for "abusive" funding of a VEBA the loss of the tax deduction for excessive contributions?

I have not seen in the regulations any excise taxes for excessive contributions, as you mentioned.

I do believe there will be UBIT on excessive contributions, but this involves taxing excessive income at the trust tax rates, with no additional penalty taxes.

In addition, it would seem that the benefits would still be tax-free, even for "abusive" contributions.

In short, the only drawbacks for abusive contributions, seems to be what would normally occur in a taxable trust, other than the non-deductibility of contributions.

If correct, that raises the issue of what are the advantages of a taxable welfare benefit trust over a tax-exempt trust?

I believe a VEBA offers unique advantages as a tax-exempt 501©(9) trust, in addition to the tax advantages.

That is because a VEBA can be more than just a tax-advantaged way to contribute, accumulate, and distribute benefits.

It also is a non commercial insurer, which, according to the VEBA regs, is intended to provide products that are not available to the public.

This provides a wonderful opportunity for creative plan design, similar to what Blue Cross and Blue Shield used to accomplish.

In addition, as an insurer, the VEBA has strict fiduciary responsibilities to the participants.

One of those responsibilities is to maximize the benefits and maintain reasonable costs.

Excessive UBIT could violate this particular fiduciary responsibility.

In addition, excessive reserves means higher premiums would be required, which would also violate the fiduciary responsibilities of a VEBA to maintain reasonable costs to the participants.

Thus, I believe the tax-exempt status could be threatened.

If correct, the advantages of the VEBA as a unique insurer could be terminated as well.

Don Levit

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Guest mjb

While excess contributions may be carried over and deducted in a future tax year, excess contributions made to a tax exempt trust will have the effect of imposing/increasing the UBIT which is 35% on taxable income of about $10,600. In addition fund income attributable to after tax contributions will reduce the deductible contributions that can be made by the employer.

UBIT does not affect the tax exempt status of a VEBA trust. It just reduces the funds in the trust by the amount of the tax.

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mjb:

Thanks for providing the additional information on UBIT.

Don't you think that repeated, excess UBIT could be a potential threat to a VEBA's tax status?

You don't think "too much" excess reserves would violate the fiduciary responsibilitry of the trustees to keep costs reasonable to the participants?

I trust you are aware of this type of problem in the insurance industry.

Don Levit

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Guest mjb
mjb:

Thanks for providing the additional information on UBIT.

Don't you think that repeated, excess UBIT could be a potential threat to a VEBA's tax status?

You don't think "too much" excess reserves would violate the fiduciary responsibilitry of the trustees to keep costs reasonable to the participants?

I trust you are aware of this type of problem in the insurance industry.

Don Levit

The only penalty for UBIT in the IRC is payment of taxes at a rate of up to 35%.

I dont have any opinion on the fiduciary issues of VEBAS you raised because there are vey few VEBA fiduciary cases. I avoid non retirement plans because the arcane rules require too much time to research.

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[W]hat are the advantages of a taxable welfare benefit trust over a tax-exempt trust?

There are many advantages:

1. Not nearly so many rules to live by;

2. Compliance work is easier;

3. No UBIT;

4. More flexible;

5. Can cover an industry and all states with one trust;

I believe a VEBA offers unique advantages as a tax-exempt 501©(9) trust, in addition to the tax advantages. That is because a VEBA can be more than just a tax-advantaged way to contribute, accumulate, and distribute benefits. It also is a non commercial insurer, which, according to the VEBA regs, is intended to provide products that are not available to the public. This provides a wonderful opportunity for creative plan design, similar to what Blue Cross and Blue Shield used to accomplish.

There is no advantage to a VEBA besides the exclusion of current investment from income taxation. A VEBA is not a "non commercial insurer" any more than a taxable trust is. Either must comply with insurance laws, especially if they intend to "provide products that are not available to the public". The Blues quit offering "creative plan design" in 1961.

In addition, as an insurer, the VEBA has strict fiduciary responsibilities to the participants.

The duties of an ERISA trustee are the same for a taxable trust as they are for a VEBA.

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vebaguru:

Thanks for your reply.

One of the advantages you cited in using a taxable over a non taxable trust was that the taxable trust could cover an entire industry and all states within one trust.

As you know, a VEBA cannot have the attributes of a commercial insurer.

A major way to avoid being in the commercial insurance business is to operate in all 50 states.

Thus, the IRS regulations provide that the VEBA cannot operate in more than three contiguous states.

By limiting the VEBA to this "geographic locale," the VEBA sustains the employer-employee relationship, and avoids the insurance company-customer relationship.

Nationwide participation would violate the intimacy required to qualify as a VEBA, for the arrangement is more akin to a commercial insurer than a not-for-profit VEBA.

You wrote that there is no advantage to the VEBA, other than the exclusion of current investment income from income taxation.

You seem to be focusing on the tax benefits, and exclude the VEBA as a non commercial insurer.

Why would you limit the advantages of a VEBA to merely tax advantages, and exclude the unique products it can offer, to help maintain those tax advantages?

You say the duties of an ERISA trustee are the same for a taxable trust as they are for a VEBA.

That is correct, if the VEBA is fully insured. In that case, the insurer and the trust are 2 distinct parties.

However, if the VEBA is self-funded, it is not an entity independent of the employment relationship, as a commercial insurer is. A self-funded VEBA still maintains the employer-employee relationship, so that the insurer and the participants are seen more like one unit.

Thus, the fiduciary responsibilities of the insurer are very similar to the fiduciary responsibilities of ERISA trustees.

A commercial insurer, on the other hand, has no fiduciary responsibilities to the plan participants, simply for issuing the policy.

Don Levit

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You wrote that there is no advantage to the VEBA, other than the exclusion of current investment income from income taxation.

You seem to be focusing on the tax benefits, and exclude the VEBA as a non commercial insurer.

Why would you limit the advantages of a VEBA to merely tax advantages, and exclude the unique products it can offer, to help maintain those tax advantages?

Because no such advantages exist. If a VEBA acts like a "non commercial insurer", it must be licensed as an insurance company. Why would a VEBA licensed as an insurance company be any more creative than any other insurance company? It is likely to be considerably less efficient because of its size.

That is correct, if the VEBA is fully insured.

Why would it matter whether the plan is insured? Does an ERISA fiduciary have fewer duties or more when insurance policies are involved? I believe the answer is more because the fiduciary must (in addition to other duties) select the insurance company, oversee the insurance contracts, etc.

However, if the VEBA is self-funded, it is not an entity independent of the employment relationship, as a commercial insurer is. A self-funded VEBA still maintains the employer-employee relationship, so that the insurer and the participants are seen more like one unit.

The Employer is also an ERISA fiduciary, but that doesn't relieve the VEBA trustee from its liability simply because the Employer is a co-fiduciary.

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vebaguru:

Thanks for your reply.

It would be great for others to share their thoughts as well.

You are correct that a self-funded VEBA of 2 or more employers must be licensed as an insurer.

However, it is my contention that the spirit of the law is to license self-funded VEBAs, of 2 or more employers, as an insurer that is not "in the business of insurance."

That is to say, an insurer that is not-for-profit that provides products that are not available to the public.

The IRS explains the distinctions between commercial and non commercial insurers very well in General Counsel Memorandum 39817.

Of course, the way the law is actually written which allows states to regulate MEWAs, is that states can apply any and all laws to do so.

There is a distinction, however, between power and wisdom.

While states have the authority to regulate a VEBA, as if it was United Health Group, where is the logic in doing so?

The purpose for having the same standards for different entities, is when standardization among the entities is desired, such as with McDonald's.

The public desires each McDonald's to be very similar; thus, the similar standards.

VEBAs are intended to be unique from commercial insurers.

Why regulate them similarly?

It is ironic, in my opinion, that states want freedom from the federal government and ERISA preemption to try innovative approaches.

They were given such freedom back in 1983, when they were provided the authority to regulate self-funded MEWAs.

In regards to the fiduciary duties of trustees, they would be similar regardless of how the plan is funded.

I am stating that if the plan is self-funded, then the insurer and the plan are more intimately related, than if the insurer was, say, United Health Group.

This increased intimacy is heightened even more, when you consider that the self-funded plan is in the "business of insurance" for one client, the VEBA itself.

Don Levit

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Hi, Don,

I think the reason that ERISA preempts state law when there are benefits, even insurance like coverage, provided by a single employer to its employees is that because the underlying relationship (employer-employee) is a matter of regulation of state law, and because that relationship is continuing, the employees are better able to monitor and sense what is happening at the employer level than if the relationship did not exist. When this is coupled with the desire to allow companies with employees in more than one state to deal with just a single, uniform law/regulations, ERISA preempts States' benefit laws from applying.

Whenever a plan is maintained by two or more unrelated employers, a MEWA, the employees only have that proximity of relationship with one participating employer. That one participating employer does not have the control over the MEWA that such employer would over a single employer plan, albeit the employer may participate along with other employers sponsoring the MEWA in its funding and administration.

In a MEWA situation, an employee only has that proximity of relationship with one of the group of decision makers regarding the MEWA. There, the situation between the covered employee and the MEWA is more akin to a relationship between the covered individual and an unrelated insurer--which states do find the need to regulate. When a state regulates a MEWA the same as a commercial insurer, the state is providing the covered individual some protection against underfunding and other mischief. This type of regulation is more needed where the coverage is self-funded by the MEWA than where insurance is involved, because the insurance is provided by a commercial insurer subject to the state's regulation.

Of course, the concept of extending ERISA's preemption to association health plans has been debated much in recent years. To date, no legislation has been adopted to so extend the reach of ERISA preemption.

I do agree with vebaguru's comment that from an ERISA fiduciary's point of view, there are more duties when insurance is involved. When self-funded, the fiduciaries must be concerned about the adequacy of the funding to meet the promised benefits obligations. When insurance is involved, the fiduciaries must select and monitor the insurance carrier to be used, and likely need to drill down to consider the insurance company's ratings, history and funding level. Even though the insurance company must meet certain funding standards set by the state, it might yet not be prudent to select an insurance company that does not have capital in excess of that required by the state.

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John:

I agree with you that when 2 or more employers are involved that state regulation is needed (and is mandated).

Why do you think that, say, a 10-employer MEWA of 500 participants, should require the same surplus as a United Health Group that has, say, 1 million participants in a particular state?

In addition, if the multiple employer VEBA has stop-loss insurance, the surplus required would be even lower to ensure that benefits are paid in a timely fashion.

When I mentioned that the self-funded VEBA has fiduciary obligations as an insurer that a fully insured plan does not have, I am referring to the inefficiencies that would result that vebaguru referred to.

For example, by requiring surplus that simply is unnecessary to pay claims, participants are paying more in premiums than is necessary.

In addition, having unnecessary surplus reduces the benefits available to the participants.

Wouldn't this scenario violate fiduciary responsibilities of maintaining reasonable expenses and maximizing benefits, while ensuring the safety of those benefits?

Don Levit

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Hi again, Don,

When at the state regulatory level, does one size fit all? Probably not, but many states don't differentiate or have levels of compliance for health insurers, the full regulatory scheme would apply to all, including surplus levels.

If the MEWA gives discretion to the VEBA trustees to self-fund or fund through insurance contracts, the impact on benefits that would go along with different VEBA funding levels would need to be taken into account by those VEBA trustees in making a prudent decision.

However, most VEBAs that I've seen specify self-funding or insurance in the trust document. That would be a settlor decision by the sponsoring employer, and as a settlor function generally would not implicate fiduciary duty.

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John:

I am not disputing whether state departments of insurance can or cannot impose the same surplus levels on all health insurers.

I believe they can do so.

The question I have is why do so?

Why not decide appropriate surplus on a case-by-case basis?

In the event of a not-for-profit insurer, the possibility of excessive surplus may be damaging to its tax-exempt status.

As I understand, Blue Cross has a standard of maintaining a surplus between three and six months of the expected year's claims in reserves.

So, in the event a one-size fits all would apply to a VEBA that has stop-loss insurance, the surplus required to ensure claims are paid in a timely manner may be, for example, 12-18 months of the current year's expected claims.

Don Levit

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Several states have MEWA laws with reduced capitalization requirements. Other states apply the requirements applicable to insurers to MEWAs.

For most states there is an exception in the laws for self-funded health and welfare benefits of an employer or of a controlled group of corporations. Other states administratively grant such an exception based on the facts of the case.

I know of no state that exempts VEBAs which are also MEWAs from registration, filing and capitalization requirements applicable to insurance companies. Almost every state has had its citizens burned by so-called ERISA health plans (MEWAs) which were undercapitalized and underregulated.

Rather than pining for the good old days before the Secretary of Labor made it clear that he would not apply ERISA pre-emption, you should be looking for creative solutions within currently permissible legal structures. I am involved with creating a captive insurance company for funding welfare benefits for a MEWA, for example. This permits creative designs and yet is subject to sufficient oversight and capitalization requirements as to protect the public.

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Vvbaguru:

I am glad that you are explorting creative ways to fund health benefits.

A captive insurer can certainly be an effective way to do so.

What is needed, as you seem to endorse, are innovative approaches.

The traditional way of funding health care expenses will provide traditional results.

You seem to believe there is something inherently flawed about MEWAs.

If that was the case, there would be no success stories.

The flaws lay in the people operating these entities, rather than the form itself.

What is ironic about ERISA preemption, is that the states had the freedom in 1983 to really provide the atmosphere for innovative financing of health benefits through MEWAs, that they are now asking for, in requesting ERISA waivers.

The states do not have a good track record in encouraging financially solvent self-funded MEWAs to flourish.

Until they show some accountability with the 1983 freedom, why should they be given more?

Don Levit

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Don

I am aware of very very few MEWA success stories but know of many failures etc.

Would you care to list a few of these success stories ? And while you are looking them up, keep an eye out for the failures and catastrophies. As far as I have seen the failures so dwarf the successes that the successes are not worth relying on. But I am curious to see what causes your support.

Ia lso would like to know more about states "requesting ERISA waivers".

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As G Burns, I also am unfamiliar with such "success stories" but too familiar with frauds perpetrated in many states by several MEWAs who sought to avoid state regulation.

It is my understanding that the only state that has obtained an ERISA waiver was Hawaii (in 1984?), and that the door is now closed for additional waivers to be granted.

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vebaguru and George:

I have heard of the many failures as well.

Fortunately, I have read and talked to several people who have successfully run these ventures for many years.

To find a list of MEWAs that are licensed, go to:

http://askebsa.dol.gov/epds/.

The reason that many of these MEWAs have failed are numerous, I am sure.

However, the thread that seems to be consistent is that these ventures have been unlicensed, and have attempted to shield themselves from state regulation.

For those states that have reasonable requirements to license as a non commercial insurer, the rationale for not being licensed is hard to explain.

For those many states who require a non commercial insurer to have the same surplus as a CIGNA, it is not hard to understand why there are few, if any, licensed MEWAs.

In regards to ERISA exemption, vebaguru is correct about Hawaii.

I was referring to states already having a similar exemption in regards to regulating MEWAs.

The federal government is pretty much out of the picture here.

Have the states created the type of atmosphere to encourage MEWAs to form?

MEWAs are not the only way that innovative plans can come to fruition.

However, the arrangement does give small employers the alternative to secure more participants, and thus, obtain the proper pooling to do some creative financing.

Don Levit

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