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IRS Proposed Rules Address UBTI Calculations for VEBAs and SUBs
Practical Law Legal Update 6-556-7725 (Approx. 4 pages)
IRS Proposed Rules Address UBTI Calculations for VEBAs and SUBs
by Practical Law Employee Benefits & Executive Compensation
| Published on 10 Feb 2014 • USA (National/Federal) |
The Internal Revenue Service (IRS) has issued proposed regulations addressing how voluntary employees' beneficiary associations (VEBAs) and supplemental unemployment benefit trusts (SUBs) calculate unrelated business taxable income (UBTI).
The IRS has issued proposed regulations addressing how certain tax-exempt 501(c) organizations, including voluntary employees' beneficiary associations (VEBAs) and supplemental unemployment benefit (SUB) trusts, determine unrelated business taxable income (UBTI). The proposed regulations:
- Limit the amount of exempt function income that VEBAs and SUBs can set aside in calculating UBTI.
- Clarify and replace regulations on this issue that were proposed in 1986, which are withdrawn under the new proposed regulations.
- Add examples reflecting IRS positions taken in the new proposed regulations.
Exempt Function Income for VEBAs and SUBs
VEBAs are plans established under Section 501(c)(9) of the Internal Revenue Code (IRC) to provide certain benefits, including health and accident benefits life insurance and similar benefits, to their members, dependents or designated beneficiaries. A VEBA may include a trust, which is tax exempt if it satisfies the requirements of Section 501(c)(9).
SUB plans, which are established as separate trusts for providing unemployment compensation benefits, are funded by employer payments. SUBs trusts can qualify for tax exemption under Section 501(c) if they satisfy the requirements of IRC Section 501(c)(17).
However, VEBAs and SUBs are taxed on UBTI, which is generally defined as income from unrelated trade or business regularly carried on by the entity, but excluding "exempt function income." Exempt function income consists of:
- Member income, which includes member-paid dues, fees or similar amounts.
- Passive income, which includes investment income if it is set aside for charitable gift purposes, paying benefits or related administrative purposes.
To address concerns that VEBAs were using this set-aside provision to amass tax-free income in amounts that exceeded what they actually needed to provide benefits, Congress imposed a limit on how much income a VEBA could set aside under the exempt function income rules (26 U.S.C. § 512(a)(3)(E)). The set-aside limit is determined by reference to an account limit under a related IRC provision, but excluding reserves for post-retirement medical benefits to be provided to covered employees (26 U.S.C. § 419A).
Accounting for Amounts Set Aside and Spent During the Year
The proposed regulations reflect the IRS' position on an aspect of the UBTI calculation that was the subject of litigation in recent years. At issue in this litigation was whether income that a trust sets aside and actually spends on administrative costs and paying benefits during the year was subject to the exempt function income limit. Before the proposed regulations, the federal circuit courts of appeals reached different outcomes on this issue:
- In 2003, the Sixth Circuit held that the set-aside limit did not include investment income a VEBA claimed was allocated for and spent on reasonable administration cost before year-end (Sherwin-Williams Co. Employee Health Plan Trust v. Comm'r, 330 F.3d 449 (6th Cir. 2003)).
- More recently, the Federal Circuit Court of Appeals concluded that a VEBA could not avoid the set-aside limit by allocating investment income to the payments for welfare benefits during the tax year (CNG Transmission Mgmt. VEBA v. U.S., 588 F.3d 1376 (Fed. Cir. 2009)).
The IRS rejects the Sixth Circuit's decision in its proposed regulations. In the IRS' view, and as reflected in the proposed regulations, the UBTI calculation is based on the extent to which an entity's assets at year end exceed the set-aside limit, regardless of whether income was allocated to paying benefits during the year.
Practical Impact
The IRS' position in the proposed regulations (that is, that the set-aside limit includes amounts set aside but spent over the year), could make the difference in whether a trust falls within (or exceeds) the limit on set-aside income. According to the IRS, if the final regulations take the same approach as the proposed regulations, the IRS will no longer recognize the precedential effect of the Sixth Circuit's decision on the set-aside limit. The regulations would apply for tax years ending on or after the date that final regulations are published.