Treasury and the IRS issued final regulations (TD 9886) clarifying that voluntary employees' beneficiary associations (VEBAs) and supplemental unemployment benefit trusts (SUBs) cannot exclude income spent before the end of the year on benefit payments.

The final regulations address the unrelated business taxable income (UBTI) calculations for certain tax-exempt entities — VEBAs under IRC Section 501(c)(9) and SUBs under IRC Section 501(c)(17). The new rules are especially important for VEBAs that have been following a different interpretation based on the 2003 Sixth Circuit decision (Sherwin-Williams Co. Employee Health Plan Trust v. Commissioner, 330 F.3d 449 (6th Cir. 2003), I s, 115 T.C. 440 (2000)).

Background

IRC Section 512(a) provides rules for calculating UBTI for certain tax-exempt organizations, including VEBAs and SUBs. IRC Section 512(a)(1) generally defines UBTI as gross income from any unrelated trade or business activity that an organization regularly conducts, less certain deductions. For VEBAs and SUBs, IRC Section 512(a)(3)(A) defines UBTI as gross income, less directly connected expenses, but excludes exempt-function income.

IRC Section 512(a)(3)(B) defines exempt-function income as gross income from two sources:

1. Amounts members pay as consideration for providing them, their dependents or guests with goods, facilities or services in furtherance of the organization's exempt purposes
2. All income, other than the gross income derived from an unrelated trade or business regularly carried on by the organization, that is computed as if the organization were subject to IRC Section 512(a)(1) and is set aside for:

a. Charitable purposes specified in IRC Section 170(c)(4)

b. Provision of "life, sick, accident, or other benefits" by a VEBA or SUB or

c. Reasonable administrative costs directly connected with either "a" or "b"

Under IRC Section 512(a)(3)(E), the excluded set-aside is limited to the amount of total assets in the entity at the end of the tax year that does not exceed the IRC Section 419A account limit for the tax year. However, the account limit does not take into account any reserve under IRC Section 419A(c)(2)(A) for post-retirement medical benefits.

Sixth Circuit opinion

In Sherwin-Williams, the Sixth Circuit held that investment income a VEBA had earmarked and allegedly spent before year-end on reasonable administrative costs was not subject to the IRC Section 512(a)(3)(E) limit on exempt-function income.

2014 proposed regulations

In response to the Sixth Circuit's decision, the IRS issued proposed regulations (REG-143874-10) under IRC Section 512(a) in 2014, providing guidance on how some tax-exempt organizations that provide employee benefits must calculate UBTI (see Tax Alert 2014-0278).

The proposed regulations expressly stated that any investment income a covered entity earns during the tax year constitutes UBTI to the extent the entity's year-end assets exceed the account limit, regardless of how the investment income is used.

The proposed regulations also reaffirmed the rule under IRC Section 512(a)(3)(B) that the UBTI of a covered entity includes UBTI that it derived from an unrelated trade or business that is regularly conducted, in addition to the investment income included in UBTI under IRC Section 512(a)(3)(E).

Final regulations have few changes from the proposed regulations

The final regulations adopt the 2014 proposed regulations with a few minor changes:

1. The applicability date is the tax year beginning on or after the date of publication of the final regulation (December 10, 2019).
2. The definition of covered entity is modified to include certain corporations described in IRC Section 501(c)(2), as provided in IRC Section 512(a)(3)(C).
3. A clause referring to the provision in IRC Section 512(a)(3)(D) addressing nonrecognition of gain for sales of certain property is added.
4. Examples are updated.

The final regulations make clear that the Sixth Circuit's decision in Sherwin-Williams "is contrary to the statute, the legislative history of [IRC Section] 512(a)(3)(E), [Treas. Reg. Section] 1.512(a)-5T, and the 1986 and 2014 proposed regulations." The IRS states in the Preamble that it disagrees with the Sixth Circuit's conclusion that investment income may be set aside and used separately before the end of a tax year to pay the reasonable costs of administering health care benefits and thereby avoid the limit imposed by IRC Section 512(a)(3)(E)(i) on exempt-function income.

The Preamble explains, however, that entities such as VEBAs in the Sixth Circuit's jurisdiction that have been acting in good faith based on the Sixth Circuit's interpretation can continue to apply that interpretation through the end of the VEBA's tax year in which the final regulations are issued.

Implications

The final regulations will affect VEBAs that have been relying on the Sixth Circuit's decision in Sherwin-Williams. While that may be a relatively small number of VEBAs, the implications for those VEBAs may be profound. The Sixth Circuit's reasoning in Sherwin-Williams allowed a VEBA to eliminate its UBTI entirely, and some VEBAs may have been relying on that decision for well over a decade. Those VEBAs are now faced with a potentially large unrelated business income tax (UBIT) liability on investment income beginning as soon as January 2020. Consideration should be given to the types of tax-planning strategies that VEBAs outside the Sixth Circuit's jurisdiction have been using all along, such as purchasing life insurance (often called "trust-owned life insurance" or TOLI), municipal bonds, and other tax-exempt or tax-efficient assets. After-tax rates of return, liquidity, risk, and other factors should also be considered.

Employers funding welfare benefits through VEBAs that will soon be subject to UBIT should consider whether to stop contributing to them. In some cases, it may make sense to spend down the VEBA's assets and terminate it.

For many VEBAs, however, the final regulations will have no effect whatsoever. This includes not only VEBAs outside the jurisdiction of the Sixth Circuit (which are generally subject to UBIT) but also collectively bargained VEBAs (which generally are not subject to UBIT, even without relying on Sherwin-Williams).

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