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.