IRS Warns Taxpayers About Certain Trust Arrangements Sold As Welfare Benefit Funds

[Guest Ric Joyner]

WASHINGTON – The Internal Revenue Service and the Treasury Department cautioned taxpayers about participating in certain trust arrangements being sold to professional corporations and other small businesses as welfare benefit funds and identified some of the arrangements as listed transactions.

There are many legitimate welfare benefit funds that provide benefits, such as health insurance and life insurance, to employees and retirees. However, the arrangements the IRS is cautioning employers about primarily benefit the owners or other key employees of businesses, sometimes in the form of distributions of cash, loans, or life insurance policies.

“The guidance targets specific abuses involving a limited group of arrangements that claim to be welfare benefit funds,” said Donald L. Korb, Chief Counsel for the IRS. “Today’s action sends a strong signal that these abusive schemes must stop.”

The guidance explains that, depending on the facts and circumstances, a particular arrangement could be providing dividends to the owners of a business that are includible in the owners’ income and not deductible by the business. The arrangement could also be a plan of nonqualified deferred compensation. Even some arrangements providing welfare benefits may have tax consequences different than what is claimed.

In Notice 2007-83, the IRS identified certain trust arrangements involving cash value life insurance policies, and substantially similar arrangements, as listed transactions. If a transaction is designated as a listed transaction, affected persons have disclosure obligations and may be subject to applicable penalties. Taxpayers who otherwise would be required to file a disclosure statement prior to Jan. 15, 2008, as a result of Notice 2007-83 have until Jan. 15, 2008, to make the disclosure.

In Notice 2007-84, the IRS cautioned taxpayers that the tax treatment of trusts that, in form, provide post-retirement medical and life insurance benefits to owners and other key employees may vary from the treatment claimed. The IRS may issue further guidance to address these arrangements, and taxpayers should not assume that the guidance will be applied prospectively only.

Today, the IRS also issued related Revenue Ruling 2007-65 to address situations where an arrangement is considered a welfare benefit fund but the employer’s deduction for its contributions to the fund is denied in whole or part for premiums paid by the trust on cash value life insurance policies.

Related Items:

Revenue Ruling 2007-65

Notice 2007-83

Notice 2007-84

[Guest TCP]

I have become aware of a transaction that seems to fit this description.

In 2007, a LLC (taxed as a partnership) adopted and made substantial payments to a 419(e) Welfare Benefit Trust. The LLC has no employees and has no earned income (Income is from rental real estate and interest income). They have been advised by the company who sold this product that the LLC can deduct the payments as "employee benefits".

This of course raises additional red flags to accompany those from IRS 10/17/07 issued guidance on perceived abuses and IRS Notice 2007-83 listed transaction identification. Even without all the concerns about the guidance and the Notice, it seems highly improbable that an LLC with no employees, and no earned income could adopt such a plan and take a current deduction for payments as "employee benefits".

The plan is set up under the "Grist Mill Trust" (www.gristmilltrust.com).

I would appreciate any comments on the situation or the vehicle being used and what course of action seems appropriate for the LLC.

Thanks

[Don Levit]

TCP:

I went to the Grist Mill web site, but had to be a registered member.

Can you provide any other information regarding your concerns?

I noticed their plans are not ERISA plans.

Does that mean their expertise can be used for non employees?

Don Levit

[Guest TCP]

Don,

My primary concern is that they have been advised that substantial payments to a 419(e) plan are deductible, for a company that has no employees and whose LLC members report only rental real estate income and interest income on their partnership return. Is it in any way possilbe for that LLC to be able to take a tax deduction for "employee benefits", when it has no employees ?

[masteff]

1) Sometimes Google search can be a wonderful thing, here's a brochure on the product: http://www.benefitplanadvisors.com/pubs/GMTQA.pdf

At least on the third page they say the limit on the current tax deduction is based on something that sounds like life insurance premium rates.

2) To your point that the LLC has no employees, 419(e)(1)(B) says: "through which the employer provides welfare benefits to employees or their beneficiaries." So I'd agree there would need to actually be some employees.

However, as it's an LLC, it's conceivable that an individual owner-member could be construed to be an employee for these purposes; I just don't know. But in that case, Notice 2007-84 warns (emphasis added):

The IRS may challenge the claimed tax benefits for the above-described arrangements for various reasons. Depending on the facts and circumstances of a particular arrangement, contributions to a purported welfare benefit arrangement on behalf of an employee who is an owner may properly be characterized as dividends or as non-qualified deferred compensation subject to § 404(a)(5) or 409A (or both), or the arrangement may be subject to the rules for split-dollar life insurance arrangements.

Oh, Don, on your "can it be used for non-employees" question. 419(g) does say it can be used for independent contractors. If that's what you meant.

[Ron Snyder]

The Grist Mill Trust claims to be a welfare benefit plan for some purposes and not one for other purposes. Grist Mill also erroneously claims that they are not subject to ERISA because they are a top-hat plan. While they may be a top-hat plan by discriminating against non-HCEs, any contributions under IRC 419A would not be deductible, and contributions under 419 are limited to current term insurance costs. However, GM does not comply with the split dollar regulations and is one of the plans IRS was aiming at when they released the Notices and Revenue Ruling last October.

Your concerns about providing benefits to non-employees are well considered. The rule that permits inclusion of contract workers in welfare benefit plans is just that: an inclusion. In order for the plan to be established it must cover at least one employee. It optionally may also cover independent contractors.

The company should refile their tax return without claiming the deduction, pay their taxes due (with penalties and interest), and then sue Grist Mill, the salesman, the insurance company, the Administrator. Several of these suits that have begun since the Notices came out. There are several attorneys contacting companies in similar situations to handle the lawsuits for them.

[Guest TCP]

Update - Informed client that based on the information provided to us, the 419(e) deduction was very questionable at best and we were not inclined to take the deduction on his behalf. I understand that his salesman has offered to find someone who will prepare and sign the return using the deduction. That of course does not let the taxpayer off the hook. We have advised him otherwise, but taxpayer is currently of the mind that if the person who sold him on this is so certain that a deduction is warranted and can get someone to sign the return, then, (to paraphrase Satchel Paige)..."I've already paids my money, so I'll takes my chances".

Thanks for everyones input. It was a big help.

[Don Levit]

TCP:

Thanks for the update.

In your opinion, if the deduction is unavailable, does that mean that no funding is allowed, even after-tax employer contributions?

Don Levit

[Guest TCP]

TCP:

Thanks for the update.

In your opinion, if the deduction is unavailable, does that mean that no funding is allowed, even after-tax employer contributions?

Don Levit

Don:

In this situation, it's an LLC owned by husband and wife. With their being no employees and no earned income in the LLC, my opinion is that it would treat as an LLC member distribution and consider it a personal "investment" with the disbursements within the plan treated as if they had been made directly by the individuals. On the other hand, a regular C Corp would have dividend or compensation issues to deal with.

[Steelerfan]

TCP:

Thanks for the update.

In your opinion, if the deduction is unavailable, does that mean that no funding is allowed, even after-tax employer contributions?

Don Levit

Don:

The way I read section 419 is that it creates no tax deduction, but rather states that an amount must be otherwise deductible, so it seems you could fund even if not deductible. I'd have to think this would be a rare situation since most employers are more concerned with tax breaks than protecting welfare benefit assets from creditors.

[Ron Snyder]

TCP-

Unfortunately for your client, failure to take a deduction doesn't really save them from Notice 2007-84. They are still participants in a purported welfare benefit plan and may be subject to alternative taxation rules upon distribution of assets from such plan. They should insist that policies be retroactively titled in their personal names and not in the name of the WBT to avoid such awful consequences (potential 100% excise tax under 4976, 20% excise tax under 409A, etc.).

[Don Levit]

Steelerfan:

I agree with you.

There are many IRS papers on UBIT, so, apparently, this is an important area they look at very closely.

If there is continuous overfunding to a large extent, I assume the entity may lose its tax-exempt status.

Don Levit

[GBurns]

Why would overfunding, to any extent, cause a loss of tax exempt status?

[Guest TCP]

TCP-

Unfortunately for your client, failure to take a deduction doesn't really save them from Notice 2007-84. They are still participants in a purported welfare benefit plan and may be subject to alternative taxation rules upon distribution of assets from such plan. They should insist that policies be retroactively titled in their personal names and not in the name of the WBT to avoid such awful consequences (potential 100% excise tax under 4976, 20% excise tax under 409A, etc.).

Good point and I agree.

[Don Levit]

George:

Overfunding to an unreasonable extent could be viewed as tax avoidance.

In addition, having excess reserves can be viewed as providing insurance far above the cost.

Don Levit

[GBurns]

If overfunding is not deductible, How can it be tax avoidance ? Even then, What's wrong with tax avoidance? Isn't that the purpose of tax planning and a major reason for most of these machinations?

But, as you do so often with other things, you could be confusing "tax avoidance" with "tax evasion".

What does excess reserves have to do with providing insurance or anything else?

[Don Levit]

George:

Thanks for pointing out my confusion on avoidance v. evasion.

While the contributions are not deductible, I wonder if the growth of those contributions would be taxable.

If the growth is taxable, then there would not be tax evasion.

The purpose of limiting deductions and UBIT for excessive contributions, is to deal with excessive reserves.

It is clear from the specific limitations that the IRS wishes to discourage unreasonable tax-advantaged accumulations.

In addition, the amount set aside must have a substantial relationship to the purposes of the organization's reason for eiostence.

Unreasonable reserves defeats that purpose.

Don Levit

[GBurns]

While the facts and circumstances of each case has to be considered for a rational opinion, in general, growth (and I assume this is interest or investment related) would probably be UBTI and subject to some sort of taxation.

The purpose of the limitations etc is not to deal with excessive reserves. They are there for abusive reserves, whether excessive or not. There could be a business reason for accumulating reserves that have nothing to do with "reason for existence" but have to do with ability to continue operations. For example, Would it be prudent for a VEBA to accumulate funds with the purpose of using these funds to purchase a building in which to house its Operations Center etc because the current premises are sub-leased from the employer who possibly will soon give up the lease as part of a corporate downsizing effort?

The limits were set so as to restrict abuse, not to stop accumulations for valid business reasons. A VEBA like all trusts are business entities also, and must operate in a profitable and "business" like manner in order to have continuity. The law allows this.

[Steelerfan]

I also think an excessive reserves could be corporate waste, remember that assets can't revert back to the employer, so you don't want too much in there.

[Don Levit]

Steelerfan:

Excellent point.

The same holds true for individual savings accounts that are dedicated to one of the qualified benefits, such as medical expenses.

This is why any unused balance in one's individual medical account must be returned to the VEBA at the participant's death.

Using these accounts for anything other than medical expenses prohibits the 105(b) exclusion, as well as violates the VEBA regulations.

George:

I agree with you on the amount of reserves issue.

The building is seen as an important asset, just like the reserves, in order to carry out the VEBA's mission.

One clarification: a VEBA is not only a trust, and a business entity; it is also a non commercial insurer.

As a non commercial insurer, it has the opportunity of providing innovative plans and operations to set itself apart from commercial insurers.

Don Levit

[GBurns]

Don

What VEBA regulation would be affected by using these accounts for other than medical expenses?

Where do you get this non-commercial insurer hang up from?

Also which VEBAs have these "innovative plans and operations" that you keep alluding to ?

[Don Levit]

George:

In regards to the VEBA regulation which disallows dual purpose funding for other than medical benefits, I refer to the 1999 IRS paper.

It can be found ar http://www.irs.gov/pub/irs-tege/eotopicf99.pdf.

On p. 3, it states, "Although viewed in isolation the benefits provided by such a trust may appear to be permissible VEBA benefits (a medical benefit plus a death benefit), this combination suggests the trust is operating as a permanent wealth-building vehicle.

Such a payment upon death is not a permissible VEBA benefit."

I will deal with your other 2 questions seperately.

Don Levit

[Don Levit]

George:

You asked this non commercial insurer question before.

I directed you to General Counsel Memorandum 39817, and provided specific excerpts.

This Memorandum dealt specifically with the differences between a commercial insurer and a VEBA.

I have several other documents as well.

One is a paper published by the IRS which can be found ar http://www.irs.gov/pub/irs-tege/eotopicl92.pdf.

This describes in detail why Blue Cross lost its tax exemptions through 501©(3) and 501©(4).

On page 1 it states, "Congress determined that the Blues had evolved where many of the characteristics that distinguished them from the commercial insurance carriers were no longer apparent.

Therefore, there was no longer any justification for the continuing exemption if their primary purpose was providing medical insurance indistinguishable from that provided by commercial carriers."

This paper and other documents such as the GCM I provided strongly suggests that VEBAs can offer innovative plans, distinct from what is commercially available.

To my knowledge, none of the VEBAs is presently doing so.

That assessment, of course, is quite a stretch, and I would hope that it would not be true.

Don Levit

[GBurns]

As someone said recently, Huh ?

Both of the EO papers that you reference are irrelevant to both my questions and the issues at hand. The GCM in particular.

Additionally, has it not dawned on you that there must be a reason why there are no VEBAs with these innovate plans and operations that you keep alluding to ? Constantly alluding to something that does not exist seems futile.

[Don Levit]

George:

It would be helpful if you would be more specific as to why the EO papers and GCM are irrelevant.

I can't respond to your comments, unless you provide more details.

Don Levit

[GBurns]

Don

I am paid at a very high rate for explanations and advice etc. But even then, I cannot read documents for people.

You will have to understand the basic subject matter, then read the documents to determine applicability and relevance to each particular issue. I think that someone else recently made a similar suggestion to you also.

[Don Levit]

George:

Without either of us reading any documents, maybe you could comment on the specific excerpts I have provided, and tell us how they are outdated.

What specific provisions or regulations supersede the excerpts?

If you are unable to provide the documentation, then a rational conclusion is you feel the excerpts are outdated, but you don't know exactly why.

The same conclusion is extended to vebaguru.

Don Levit

[Ron Snyder]

None of the materials you refer to in connection with your obsession with "commercial vs. non-commercial insurers" relates to VEBAs. IRS was concerned about 501©(3) & (4) orgs which were competing directly with commercial insurance cos. Coverage under a VEBA is limited to employees of a single employer, a controlled group or geographically limited group of employers who share an employment-related common bond. That is why the issue doesn't arise: they are no competing with commercial insurers because they don't and can't offer policies to the general public.

[Don Levit]

vebaguru:

You are correct that the discussion about 501©(3), 501©(4), and 501(m) do not deal with VEBAs directly.

But they do deal with the differences between commercial and non commercial insurers.

Because VEBAs do not sell to the public, they are non commercial insurers.

One characteristic of a non commercial insurer is not selling to the public.

Another characteristic is selling products which the commercial insurers do not make available to the public.

Thus, VEBAs have the opportunity of offering innovative plan designs.

Don Levit

[GBurns]

Don

That discussion does not deal with VEBAs even indirectly.

You keep going in circles and never answering the questions:

When and where did the IRS ever say that VEBAs are non-commercial insurers?

Aside from that Which VEBAs do you know of that sell anything and To whom?

And once again you are back talking about VEBAs and "innovative plan designs". So once again, Which VEBAs offer or have these innovative plan designs?

[Don Levit]

I have already addressed the questions you posed.

VEBAs are mentioned indirectly, for they are non commercial insurers.

I already gave you the GCM material attesting to that fact.

How can one think out of the box, if he is always going in circles?

Don Levit

[J Simmons]

Hi, Don,

I'm a bit confused. Is there something other than paying health premiums out of the VEBAs assets or paying plan-promised health benefits out of the VEBA assets that you are referring to as "innovative plan designs"?

Is it purchasing life insurance on the lives of VEBA members, with the owner and the beneficiary of the policy being the VEBA, as a method of increasing the VEBAs assets with which to pay other, promised health benefits to other VEBA members?

[Don Levit]

John:

I am saying that one of the distinguishing characteristics between a commercial insurer and a non commercial insurer, according to the IRS, is that a non commercial insurer offers products which are not provided by commercial insurers.

Don Levit

[J Simmons]

Hi, Don,

I think you also explained in this thread that because a VEBA is a like a non-commercial insurer, the VEBA can offer products that commercial insurers do not and "Thus, VEBAs have the opportunity of offering innovative plan designs."

I'm just wondering what specifically you might have in mind.

[Don Levit]

John:

Thanks for asking.

The type of plan I envision is one in which benefits build over time.

The idea is to accumulate between $25,000 and $50,000 of benefits in 2-5 years.

Benefits would vary in direct proportion to contributions made, less claims incurred.

The reason I am thinking of $25,000-$50,000 of benefits is that the price break seems to be the largest in that area.

For with $25,000-$50,000 of coverage, and the VEBA plan as primary, the traditional group plan's deductible would be raised to start where the VEBA benefits end.

Using one's individual savings account and the VEBA as insurer for all the particpants, there are many innovative ways to maximize benefits.

Don Levit

[Ron Snyder]

This is not new or particularly innovative. Defined contribution health plans have been around for years now in their various forms. Although most don't use a funded model, those done for governmental employers and union groups frequently use VEBAs for such arrangements. I have established several of these plans for government and union groups. cf, Illinois, Burbank, etc.

[Don Levit]

vebaguru:

Thanks for providing these links.

Can you tell us more specifically how these plans are unique from what we see in the marketplace?

Also, are you aware of any organizations that are working in the small employer market, specifically, those small employers in the same line of business across 3 contiguous states?

Don Levit

[Ron Snyder]

There are groups that offer plans similar to what you describe, including our own. However, because of the additional limitations on VEBAs and the fact that we don't get a tax exemption on the medical accumulations, it made more sense to us to use taxable trusts and tax-favored investments. That way the 3-state limitation doesn't come into play.

I know of no one who presently offers such plans through a VEBA structure.

[Don Levit]

vebaguru:

Thanks for your reply.

This discussion is really not about my particular plan design, and how creative or innovative it may be.

Rather, it is about non commercial insurers having the ability to offer innovative plans.

I believe the VEBA is one example of a non conmercial insurer.

I also think the small employer market (those small employers in the same line of business across 3-contiguous states) has a real need for this type of non commercial insurer.

If the VEBA was to be properly licensed, and monitored, we could provide some real competition for the commercial insurers.

Don Levit

[Ron Snyder]

Okay, I'll bite. Why would a 3-state VEBA that is "properly licensed, and monitored" be better than a national welfare benefit plan that is not limited to 3 contiguous states?

Properly licensed and monitored means licensed as an insurance carrier in each state in which it operates. So the VEBA could purchase an insurance company charter that is already licensed in 3 or 50 or some other number of states. How do you get enough funds into a VEBA to fund this venture?

Casualty companies are already potentially tax-exempt under 501©(15 ) and life and health companies already receive favorable tax treatment under IRC section 801 et seq. What possible reason could anyone with the millions required to fund such a venture choose to comply with the additional VEBA requirements?

I'm really sick of your cluttering up these boards with irrelevant arguments about a non-issue.

[Don Levit]

vebaguru:

I am interested in small employers in the same line of business combining to self-fund health benefits.

I don't think it is necessary for 50 states to be involved to get the law of large numbers working for small employers.

Three contiguous states would seem to suffice.

In addition, the three state area (at the most) gives a bit more intimacy to the arrangement, such that participants may not feel they are one small piece of a big conglomerate.

I envision the trustees and the participants to have more rapport than an insurance company home office and its policyholders.

The licensing of the VEBA would require state departments of insurance to use their discretion in applying the laws on the books.

By that I mean this would be a non commercial insurer, which is not selling to the public, and would have lower liabilities than a commercial insurer.

In addition, the plan I envision would max out at $50,000 per family.

Don Levit

[GBurns]

Don

At $50,000 per family (and presumably less per individuals) it does not seem to make any sense. Aside from statutory caputal requirements, set up costs, and ongoing administrative costs etc, it does not seem to be worth the effort for a small group. Mini-med or limited benefits plans should be a much more feasible way to go.

I doubt that you will find any regulatory body who would exercise the "discretion" that you allude to, and not properly apply the statutory capital, reserves and other laws and requirements that apply. The capital requirements alone should be enough to kill your idea. If not the MEWA prohibitions should.

There are probably a number of Association plans that have already been estalished and which have already overcome other obstacles. It does not seem worthwhile to "re-invent the wheel" in this manner, just to have a VEBA/MEWA.

An insurer (aside from capital and reserve requirements etc) does not have lower liabilities based on whether it is a commercial or a non-commercial insurer. Liabilities are a function of amount at risk. Also, as a general rule the larger the risk pool, the lower the risk, so a larger insurer gets to spread the risk or have better experience simply because of volume. Volume also carries the possibility of better operating margins and free cash flow etc.

[Don Levit]

George:

I don't want to reinvent the wheel either.

But, apparently, there are not enough wheels out there to serve the small employers.

If a state applied the mandatory surplus and reserve requirements, without considering the actual amount at risk, they could very well exceed the set asides for VEBAs allowed by federal law.

This may not only give departments of insurance pause from doing so, but also provide them a legitimate opportunity to use the laws as guidelines, rather than as commandments.

Don Levit