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Guest EMM118

Exemption Letter not Issued ... What are Available Options?

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Guest EMM118

An employer established a presumed VEBA three years ago. At the time, I had not read the IRS Memo on Processing VEBA exemption applications and was unaware of the increased review on these smaller VEBA's. The employer made three annual contributions of $100,000. Amounts were invested in mutual funds that are now valued at $250,000. After more than two years, the IRS has indicated that an exemption letter will not be issued. All participants are owner-employees and their parents (HCEs through stock attribution rules). We can challenge the initial ruling or withdraw the exemption application.

If we withdraw application, can we take the $250,000 and put into an insurance product with no tax conseqiences? Amounts will be held in a non-VEBA trust. Are there also no current adverse tax consequences since assets have decreased in value?

Any thoughts on this matter would be greatly appreciated.

Thanks. Ed

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Guest jims

I'm no expert, but if the IRS won't issue tax exemption letter then your run up from $100k to $250k during the earlier years would need to be reported as income. Those earlier years would have positive income, and more recent would have negative.

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A VEBA is only a VEBA when it has been approved by the IRS. See IRC section 505. Short of that it is likely a taxable grantor welfare benefits trust.

Contributions to VEBAs are not inherently tax deductible, and contributions to welfare benefits trusts are not inherently non-deductible. The rules relative to tax deductions are found in IRC section 419 and 419A.

The only advantages to being a VEBA are: (i) The trust is "tax-exempt" and (ii) The IRS has reviewed and approved the trust. However, the tax-exemption is not worth much because medical accumulations are subject to UBIT in any event. And other benefits are generally disposed of during the current plan year. The benefit of being tax-exempt is illusory.

For all plan years you should be filing IRS form 1041 for the trust. Losses on investments will not be taxed in any event.

All welfare benefit plans are subject to nondiscrimination rules. cf, IRC section 79, section 105, section 505, section 414, etc.

You mention life insurance and this brings up additional issues. Review IRS Notice 2007-83 and 84 along with Rev Rul 2007-65 for guidance that may apply to such arrangements. Generally, life insurance plans for owners are not tax-deductible as provided in IRC section 264.

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VEBAGuru,

Could you expand a bit on the illusory nature of the tax exemption for VEBAs and where the UBTI generally kicks in on medical accumulations?

We just saw a VEBA established for a self-insured MEWA that is required to accumulate and hold certain minimum cash reserves per state insurance rules in excess of participants' claims / health care expenses. Is tax-exempt status of a VEBA in that sort of situation likely illusory or could they argue that the income earned on the accumulated reserves / funds required by law should be exempt from taxation?

In this case, client just showed up with a trust set up many years ago with typical VEBA language but they never sought tax-exemption for the trust and apparently were told they did not have to by another advisor. In addition, they have apparently never paid any taxes or made any tax filings with respect t the trust's income. Under their facts (reliance on bad or misinterpreted advice), I suppose they might possibly have a shot at getting an extension on the Form 1024 application to obtain retroactive tax-exempt status but I think that is a long shot and it sounds like that may not be worth the time and effort even if possible.

Have you had any experience is similar situations and/or thoughts on whether it might be possible for them to resolve prior issues by forgetting about pursuit of tax-exempt status and simply filing the last 3 years (6 years?) of returns and letting the prior years go even though the trust never filed any returns in any years?

Many thanks.

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Guest On Hiatus
VEBAGuru,

Could you expand a bit on the illusory nature of the tax exemption for VEBAs and where the UBTI generally kicks in on medical accumulations?

We just saw a VEBA established for a self-insured MEWA that is required to accumulate and hold certain minimum cash reserves per state insurance rules in excess of participants' claims / health care expenses. Is tax-exempt status of a VEBA in that sort of situation likely illusory or could they argue that the income earned on the accumulated reserves / funds required by law should be exempt from taxation?

In this case, client just showed up with a trust set up many years ago with typical VEBA language but they never sought tax-exemption for the trust and apparently were told they did not have to by another advisor. In addition, they have apparently never paid any taxes or made any tax filings with respect t the trust's income. Under their facts (reliance on bad or misinterpreted advice), I suppose they might possibly have a shot at getting an extension on the Form 1024 application to obtain retroactive tax-exempt status but I think that is a long shot and it sounds like that may not be worth the time and effort even if possible.

Have you had any experience is similar situations and/or thoughts on whether it might be possible for them to resolve prior issues by forgetting about pursuit of tax-exempt status and simply filing the last 3 years (6 years?) of returns and letting the prior years go even though the trust never filed any returns in any years?

Many thanks.

401 chaos, welcome to 419 chaos.

As an initial thought, if the amount of reserve assigned to each "employer" in the MEWA is less than IBNR as of the end of each taxable year, then you probably do not have an issue with unrelated business income in that trust. I would assume there is no retiree medical in this trust. Right?

As a second thought -- with respect to any 1041s that might be due -- I would think you would have to go back 6 years. Did this "trust" ever file any 990s, during the period when it thought it was a VEBA?

Since this is a MEWA, I am assuming there are multiple employers involved, and deductions these employers took for payments made to the MEWA might be affected. My hunch is that these may not be material, but the facts of this seem truly ugly.

Does the state law in question require establishment of a VEBA, per se, or just a trust?

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Hiatus,

Thanks for your post.

There is no retiree medical. At this stage I am not sure how the reserves are allocated--there are multiple employers so it may be that each has been allocated a portion of the reserve. In any event, the "reserves" are not that great so hopefully they don't have real UBIT issues. This was a small MEWA / trust with amounts going through the trust pulled from both employer and employee (premium) contributions with the whole idea being to try and keep the premiums as low as possible so its not really a situation where any particular employer or group tried to over fund or accumulate excess amounts--they basically paid premiums in at the rate the actuary told them to charge / pay so they could comply with state insurance rules. The MEWA is not a sham and has had a solid history of paying claims, etc.--they were just set up by a group of relatively unsophisticated members of a particular industry and have been rocking along with issue. They however apparently have not ever filed a Form 990 or any other tax returns related to the trust. The state MEWA rules do require creation of a trust structured along the VEBA rules but they do not appear to require the trust to actually have tax-exempt status under 501©(9) which I think helped lead to their confusion on not seeking an exemption originally.

I'm not sure what to think of the deduction issue other than yes it would be a big mess if they had to go back and adjust members' prior returns, etc. Again, the emploeyrs in this case were simply paying all or some of the premiums set by the MEWA so there really was no intent to accrue or accumulate more benefits than required.

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We have been dealing with a similar issue for a trust set up many years ago that thought it was tax-exempt but apparently never applied for a determination from the IRS. In addition, it has filed no trust tax returns of any kind. Based on our additional research, I wanted to post back and post a cite to an excellent (albeit a bit dated) article I found on the subject of the illusory nature of tax exempt status. The article is entitled "The Unimportance of Being a VEBA: Tax Attributes of Nonexempt Welfare Benefit Plans" by Andrew W. Stumpff. It can be found at 47 Tax Law 113 (1993-94).

The article basically notes as did VEBAGuru above, that in many cases if the trust involved is covering benefits for active employees and so paying out a lot more in benefits than the trust is making in investment income, there is a good argument that the trust should be treated as a taxable nongrantor trust and the contributions treated as additions to principal. I think what that generally means is that in typical arrangements there should be no regular taxable income for the trust even though it is not tax exempt as a VEBA under 501©(9). The disadvantages of that approach, however, seem to be somewhat less certainty about the tax treatment of the arrangement although I have found nothing so far to suggest the IRS disagrees with the nongrantor trust classification and different / additional compliance concerns. In particular, as noted above the taxable trust would be required to file a Form 1041 each year and it also appears provide each participant in the plan a Form K-1 reflecting the amount of benefits paid out each year. The penalties for the missed Form 1041 in a case where there was no taxable income seem to be manageable but the penalties for missed K-1s could add up if you are dealing with a large number of participants over many years is the case in our matter. Guess you could try for a waiver of those penalties on some reasonable cause ground but not sure of the likelihood of success of that. As a general matter, having to give K-1s seems a bit strange to me in this context and a bit difficult to communicate to participants. That seems especially strange though

Alternatively, it is possible to attempt to seek a VEBA determination on a retroactive basis beyond the initial VEBA application deadline if you can make a "reasonable action and good faith" argument pursuant to Treas. Reg. Section 301.9100-3. I've never tried that before in a VEBA context so not sure the likelihood of receiving a retroactive exemption but would welcome any thoughts others may have. Even if they do get retroactive approval, however, the trust should have still presumably been filing Form 990s for each year it thought it was tax-exempt. The penalties for failure to timely file a Form 990 appear very expensive--$20 per day not to exceed the lesser of $10,000 or 5% of gross receipts. In our case, I think we are looking at the $10,000 cap for a number of years. Suppose we could also try for a waiver of those penalties as well but just preparing the application and retroactive exemption request plus also preparing the Form 990s is going to be pretty expensive.

Bottom line seems to be that there are some possible alternatives available for those with trusts that thought they were or maybe tried to be VEBAs but did not have an exemption letter. Both alternatives, however, seem to carry some risks and uncertainties and are potentially very costly if there are a large number of years involved.

Glad for any additional thoughts or suggestions.

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