Funding Through a 501(c)(9) Trust

Section 501(c)(9) of the Internal Revenue Code provides for the establishment of voluntary employees' beneficiary associations, commonly called either 501(c)(9) trusts or VEBAs, which are funding vehicles for the employee benefits that are offered to members. The trusts have been allowed for many years, but until the passage of the Tax Reform Act of 1969, they were primarily used by negotiated trusteeships and association groups. The liberalized tax treatment of the funds accumulated by these trusts resulted in their increased use by employers as a method of self-funding employee benefit plans. However, the Tax Reform Act of 1984 imposed more restrictive provisions on 501(c)(9) trusts, and their use has diminished somewhat, particularly by smaller employers who previously had overfunded their trusts primarily as a method to shelter income from taxation.

Advantages

The use of a 501(c)(9) trust offers the employer some advantages over a benefit plan that is self-funded from current revenue. Contributions can be made to the trust and can be deducted for federal income tax purposes at that time, just as if the trust were an insurance company. Appreciation in the value of the trust assets or investment income earned on the trust assets is also free of taxation. The trust is best suited for an employer who wishes to establish either a fund for claims that have been incurred but not paid or a fund for possible claim fluctuations. If the employer does not use a 501(c)(9) trust in establishing these funds, contributions cannot be deducted until they are paid in the form of benefits to employees. In addition, earnings on these funds are subject to taxation.

Although the Internal Revenue Code requires that certain fiduciary standards be maintained regarding the investment of the trust assets, the employer does have some latitude and does have the potential for earning a return on the trust assets that is higher than what is earned on the reserves held by insurance companies. A 501(c)(9) trust also lends itself to use by a contributory self-funded plan, because ERISA requires that, under a self-funded benefit plan, a trust must be established to hold the contributions of employees until they are used to pay benefits.

There is also flexibility regarding contributions to the trust. Although the IRS will not permit a tax deduction for overfunding a trust, there is no requirement that the trust must maintain enough assets to pay claims that have been incurred but not yet paid. Consequently, an employer can underfund the trust in bad times and make up for this underfunding in good times with larger-than-normal contributions. However, any underfunding must be shown as a contingent liability on the employer's balance sheet.

Disadvantages

The use of a 501(c)(9) trust is not without its drawbacks. The cost of establishing and maintaining the trust may be prohibitive, especially for small employers. In addition, the employer must be concerned about the administrative aspects of the plan and the fact that claims might deplete the trust's assets. However, as long as the trust is properly funded, ASO contracts and stop-loss coverage can be purchased.

Requirements for Establishment

To qualify under Section 501(c)(9), a trust must meet certain requirements, some of which may hinder its establishment. These requirements include the following:

• Membership in the trust must be objectively restricted to those persons who share a common employment-related bond. IRS regulations interpret this broadly to include active employees and their dependents, surviving dependents, and employees who are retired, laid off, or disabled. Except for plans maintained pursuant to collective-bargaining agreements, benefits must be provided under a classification of employees that the IRS does not find to be discriminatory in favor of highly compensated individuals. It is permissible for life insurance, disability, severance pay, and supplemental unemployment compensation benefits to be based on a uniform percentage of compensation. In addition, the following persons may be excluded in determining whether the discrimination rule has been satisfied: (1) employees who have not completed three years of service, (2) employees under age 21, (3) seasonal or less-than-half-time employees, and (4) employees covered by a collective-bargaining agreement if the class of benefits was subject to good-faith bargaining.

• With two exceptions, membership in the trust must be voluntary on the part of employees. Members can be required to participate (1) as a result of collective bargaining or (2) when participation is not detrimental to them. In general, participation is not regarded as detrimental if the employee is not required to make any contributions.

• The trust must provide only eligible benefits. The list of eligible coverages is broad enough that a trust can provide benefits because of death, medical expenses, disability, and unemployment. Retirement benefits, deferred compensation, and group property and liability insurance cannot be provided.

• The sole purpose of the trust must be to provide benefits to its members or their beneficiaries. Trust assets can be used to pay the administrative expenses of the trust, but they cannot revert to the employer. If the trust is terminated, any assets that remain after all existing liabilities have been satisfied must either be used to provide other benefits or be distributed to members of the trust.

• The trust must be controlled by (1) its membership, (2) independent trustees (such as a bank), or (3) trustees or other fiduciaries, at least some of whom are designated by or on behalf of the members. Most 501(c)(9) trusts are controlled by independent trustees selected by the employer.

Limitation on Contributions

The contributions to a 501(c)(9) trust (except collectively bargained plans for which Treasury regulations prescribe separate rules) are limited to the sum of (1) the qualified direct cost of the benefits provided for the taxable year and (2) any permissible additions to a reserve (called a qualified asset account). The qualified direct cost of benefits is the amount that would have been deductible for the year if the employer had paid benefits from current revenue.

The permissible additions may be made only for disability, medical, supplemental unemployment, severance pay, and life insurance benefits. In general, the amount of the permissible additions includes (1) any sums that are reasonably and actuarially necessary to pay claims that have been incurred but remain unpaid at the close of the tax year and (2) any administration costs with respect to these claims. If medical or life insurance benefits are provided to retirees, deductions are also allowed for funding these benefits on a level basis over the working lives of the covered employees. However, for retirees' medical benefits, current medical costs must be used rather than costs based on projected inflation. In addition, a separate account must be established for postretirement benefits provided to key employees. Contributions to these accounts are treated as annual additions for purposes of applying the limitations that exist for contributions and benefits under qualified retirement plans.

The amount of certain benefits for which deductions are allowed is limited. Life insurance benefits for retired employees cannot exceed amounts that are tax free under Section 79. Annual disability benefits cannot exceed the lesser of (1) 75 percent of a disabled person's average compensation for the highest three years or (2) $135,000. (This amount is subject to periodic indexing.) Supplemental unemployment compensation benefits and severance benefits cannot exceed 75 percent of average benefits paid plus administrative costs during any two of the immediately preceding seven years. In determining this limit, annual benefits in excess of $45,000 cannot be taken into account.

In general, it is required that the amount of any permissible additions be actuarially certified, although deductible contributions can be made to reserves without such certification as long as certain safe-harbor limits on the size of the reserve are not exceeded. The safe-harbor limits for supplemental unemployment compensation benefits and severance benefits are the same as the amounts previously mentioned. For short-term disability benefits, the limit is equal to 17.5 percent of benefit costs (other than insurance premiums for the current year), plus administrative costs for the prior year. For medical benefits, the percentage is 35 percent. The Internal Revenue Code provides that the limits for life insurance benefits and long-term disability income benefits will be those prescribed by regulations. However, no regulations have been issued.

Employer deductions cannot exceed the limits as previously described. However, any excess contributions may be deducted in future years to the extent that contributions for those years are below the permissible limits.

There are several potential adverse tax consequences if a 501(c)(9) trust does not meet prescribed standards. If reserves are above permitted levels, additional contributions to the reserves are not deductible and earnings on the excess reserves are subject to tax as unrelated business income. [This effectively negates any possible advantage of using a 501(c)(9) trust to prefund postretirement medical benefits.] In addition, an excise tax is imposed on employers maintaining a trust that provides disqualified benefits. The tax is equal to 100 percent of the disqualified benefits, which include (1) medical and life insurance benefits provided to key employees outside the separate accounts that must be established, (2) discriminatory medical or life insurance benefits for retirees, and (3) any portion of the trust's assets that revert to the employer.

Total Self-Funding from Current Revenue and Self-Administration

The purest form of a self-funded benefit plan is one in which the employer pays benefits from current revenue (rather than from a trust), administers all aspects of the plan, and bears the risk that benefit payments will exceed those expected. In addition to eliminating state premium taxes, avoiding state-mandated benefits, and improving cash flow, the employer has the potential to reduce its operating expenses to the extent that the plan can be administered at a lower cost than the insurance company's retention (other than premium taxes). A decision to use this kind of self-funding plan is generally considered most desirable when all the following characteristics are present:

• Predictable claims. Budgeting is an integral part of the operation of any organization, and it is necessary to budget for benefit payments that will have to be paid in the future. This can best be done when a specific type of benefit plan has a claim pattern that is either stable or shows a steady trend. Such a pattern is most likely to occur in those types of benefit plans that have a relatively high frequency of low-severity claims. Although a self-funded plan may still be appropriate when the level of future benefit payments is difficult to predict, the plan will generally be designed to include stop-loss coverage.
  

• A noncontributory plan. Several difficulties arise if a self-funded benefit plan is contributory. Some employees may resent paying their money to the employer for benefits that are contingent on the firm's future financial ability to pay claims. If claims are denied, employees under a contributory plan are more likely to be bitter toward the employer than they would be if the benefit plan were noncontributory. Finally, ERISA requires that a trust be established to hold employees' contributions until the plan uses the funds; both the establishment and maintenance of the trust result in increased administrative costs to the employer.

• A nonunion situation. Self-funding of benefits for union employees may not be feasible if a firm is subject to collective bargaining. Self-funding (at least by the employer) clearly cannot be used if benefits are provided through a negotiated trusteeship. Even when collective bargaining results in benefits being provided through an individual employer plan, unions often insist that benefits be insured to guarantee that union members will actually receive them. An employer's decision about whether to use self-funding is most likely motivated by the potential to save money. When unions approve self-funding, they also frequently insist that some of the savings be passed on to union members through additional or increased benefits.

• The ability to effectively and efficiently handle claims. One reason that many employers do not use totally self-funded and self-administered benefit plans is the difficulty in handling claims as efficiently and effectively as an insurance company or other benefit-plan administrator would handle them. Unless an employer is extremely large, only one person or a few persons will be needed to handle claims. Who in the organization can properly train and supervise these people? Can they be replaced if they should leave? Will anyone have the expertise to properly handle the unusual or complex claims that might occur? Many employers want some insulation from their employees in the handling of claims. If employees are unhappy with claim payments under a self-administered plan, dissatisfaction (and possibly legal actions) will be directed toward the employer rather than toward the insurance company. The employer's inability to handle claims, or its lack of interest in wanting to handle them, does not completely rule out the use of self-funding. As will be discussed later, employers can have claims handled by another party through an administrative-services-only (ASO) contract.

• The ability to provide other administrative services. In addition to claims, the employer must determine whether the other administrative services normally included in an insured arrangement can be provided in a cost-effective manner. These services are associated with plan design, actuarial calculations, statistical reports, communication with employees, compliance with government regulations, and the preparation of government reports. Many of these costs are relatively fixed, regardless of the size of the employer, and unless the employer can spread these costs out over a large number of employees, self-administration will not be economically feasible. As with claims administration, an employer can purchase needed services from other sources.

• The ability to obtain discounts from medical care providers if medical expense benefits are self-funded. In order to obtain much of the cost savings associated with managed care plans, the employer must be able to secure discounts from the providers of medical care. Large employers whose employees live in a relatively concentrated geographic region may be able to enter into contracts with local providers. Other employers may use the services of third-party administrators who have either established or entered into contracts with preferred-provider networks.

The extent of total self-funding and self-administration differs significantly among the different types of group benefit plans. Plans that provide life insurance or accidental death and dismemberment benefits do not usually lend themselves to self-funding because of infrequent and large claims that are difficult to predict. Only very large employers can expect stable and predictable claims on an annual basis. In addition, federal income tax laws impede the use of self-funding for death benefits, because any payments to beneficiaries are considered taxable income for beneficiaries. Such a limitation does not exist if the plan is insured.

The most widespread use of self-funding and self-administration occurs in short-term disability income plans, particularly those in which the maximum duration of benefits is limited to six months or less. For employers of most any size, the number and average length of short-term absences from work are relatively predictable. In addition, the payment of claims is relatively simple, because benefits can be (and usually are) made through the usual payroll system of the employer.

Long-term disability income benefits are occasionally self-funded by large employers. Like death claims, long-term disability income claims are difficult to predict for small employers because of their infrequent occurrence and potentially large size. In addition, because small employers receive only a few claims of this type, self-administration of such claims is economically unjustifiable.

The larger the employer, the more likely that its medical expense plan is self-funded. The major problem with a self-funded medical expense plan is not the prediction of claims frequency but rather the prediction of the average severity of claims. Although infrequent, claims of $500,000 to $1,000,000 or more do occasionally occur. Most small and medium-sized employers are unwilling to take a chance that they might have to pay such a large claim. Only employers with several thousand employees are large enough to assume the risk that such claims will regularly occur and have the resources that will be necessary to pay any unexpectedly large claims. This does not mean that smaller employers cannot self-fund medical benefits. To avoid the uncertainty of catastrophic claims, these employers often self-fund basic medical expense benefits and insure major medical expense benefits or self-fund their entire coverage but purchase stop-loss protection.

It is not unusual to use self-funding and self-administration in other types of benefit plans, such as those providing coverage for dental care, vision care, prescription drugs, or legal expenses. Initially, it may be difficult to predict the extent to which these plans will be utilized. However, once the plans have "matured," the number and dollar amount of claims tends to be fairly stable. Furthermore, these plans are commonly subject to maximums so that the employer has little or no risk of catastrophic claims. Although larger employers may be able to economically administer the plans themselves, smaller employers commonly purchase administrative services.

CONTINUATION OF GROUP TERM INSURANCE

Most postretirement life insurance coverage consists of the continuation of group term insurance. This requires the employer to make important decisions regarding the amount of coverage to be continued and the method of paying for the continued coverage. Although the full amount of coverage prior to retirement may be continued, the high cost of group term life insurance coverage for older employees frequently results in a reduction in the amount of coverage. In some cases, employees are given a flat amount of coverage (such as $2,000 or $5,000); in other cases, employees are given a percentage (such as 50 percent) of the amount of coverage they had on the date of retirement.

Current Revenue Funding
The cost of providing postretirement life insurance is usually paid from current revenue, with each periodic premium the insurance company receives based on the lives of all employees covered, both active and retired. Because retired employees have no salaries or wages from which payroll deductions can be made, most postretirement life insurance coverage is noncontributory.

The tax implications of providing postretirement group term insurance on a current-revenue basis are the same for both the employer and the employee.

Retired-Lives Reserve To Continue Coverage
In the late 1970s and early 1980s, increasing interest was shown in prefunding the cost of postretirement group term insurance coverage through retired-lives-reserve arrangements. Much of this interest stemmed from Internal Revenue Service Section 79 regulations that made previously popular products less attractive. The concept was not new; retired-lives reserves, while not extensively used prior to that time, had been in existence for many years, primarily for very large employers. However, the trend in the 1970s was to establish them for smaller employers because the tax laws allowed the plans to be designed so that they often provided significant benefits to the firm's owners or key employees. Because the Tax Reform Act of 1984 imposed more stringent requirements on retired-lives reserves and because of the availability of newer products for postretirement coverage, there is little interest in establishing new plans. Nevertheless, plans still exist, primarily in heavily unionized industries and usually for employers with 2,000 to 5,000 employees. In addition, other plans still exist for employees and retirees previously covered under them, but other arrangements are used for newer employees.

A retired-lives reserve is best defined as a fund established during employees' working years to pay all or a part of the cost of their group term insurance after retirement. The fund may be established and maintained through a trust or with an insurance company. If properly designed, a retired lives reserve (1) will enable an employer to make currently tax-deductible contributions to the fund during employees' working years and (2) will not result in any taxable income to employees before retirement. However, current deductions may be taken only for prefunding coverage that will be received tax free by retired employees under Section 79. This amount is generally $50,000 but may be higher for certain employees, subject to a grandfather clause. In addition, contributions on behalf of key employees cannot be deducted if the plan is discriminatory under Section 79.

At retirement, the assets of the fund can be used to pay the cost of maintaining the postretirement coverage. If assets are withdrawn from a trust, there is the possibility of the fund's being inadequate in the long run because of higher premiums and/or shorter life expectancies than anticipated. However, insurance company products typically assume the adverse mortality risk and guarantee that the fund will be adequate to maintain the promised benefits as long as the prescribed contributions have been deposited with the insurer.

As long as an employee has no rights in a retired-lives reserve except to receive postretirement group term insurance coverage until his or her death, the employee will incur no income taxation as a result of either employer contributions to the reserve or investment earnings on the reserve. In addition, up to $50,000 can be received income-tax free by beneficiaries.

In those instances where death benefits are paid directly from trust assets, the tax consequences to the employee are the same as if death benefits were provided through group term insurance contracts, except that death proceeds will represent taxable income to the beneficiary