Employee Benefits-U.S. Federal Circuit Court of Appeals Rules That A VEBA May Not Avoid Income Tax By Claiming That It Used Investment Income To Pay Members’ Benefits

In CNG Transmission Management VEBA v. United States, 06-CV-541 (U.S. Federal Circuit 2009), the U.S. Federal Circuit Court of Appeals held that a voluntary employees’ beneficiary association (the “VEBA”) may not avoid income tax by claiming that it used investment income to pay members’ benefits, in order to circumvent the limit on exempt function income (“EFI”) in section 512(a)(3)(E)(i) of the Internal Revenue Code (the “Code”). In this case, the VEBA had filed an amended Form 990-T, requesting a refund of income tax it had paid on unrelated business taxable income (“UBTI”) , on the ground that the amount it had reported as UBTI was instead non-taxable EFI. The IRS denied the VEBA’s refund request.

In analyzing the case, the Court said that a VEBA, which is otherwise exempt from federal income taxation under section 501(a) of the Code, is nevertheless taxed on its UBTI under section 511 of the Code. UBTI generally consists of all income other than EFI. Under the Code, there are two classes of EFI: (1) member contributions to the VEBA, and (2) income, including investment income, which is set aside (i.e., held by the VEBA) for the payment of life, sick, accident or other member benefits. However, an amount will not be treated as “set aside”, to the extent it results in the VEBA having, at year-end, assets set aside to pay benefits in excess of the statutory account limit under sections 419A and 512(a)(3)(E)(i) of the Code (the “Statutory Account Limit”) for that year. This limit is generally the amount necessary to pay for incurred but unpaid benefit claims as of the end of the year in question, as well as certain related administrative costs. The issue, in this case, is whether the VEBA’s investment income resulted in the VEBA having an amount of assets set aside to pay benefits which is in excess of the Statutory Account Limit-if there is no excess, there is no UBTI and the VEBA could get its refund. The VEBA’s position is that its investment income did not result in any excess because the VEBA spent that income during the year on member benefits. The IRS’s position is that, because the VEBA’s investment income caused the VEBA’s total assets set aside to pay benefits to exceed the Statutory Account Limit, that excess cannot be classified as EFI and is therefore taxable as UBTI.

The Court ruled that the IRS was correct. The key is that the VEBA’s investment income “resulted in” the VEBA’s total assets set aside to pay benefits exceeding the Statutory Account Limit. That does not change merely because the VEBA claims that it spent money from investment income, rather than money from some other source, on member benefits. The Code does not say that a VEBA’s investment income results in a year-end excess of the VEBA’s assets set aside to pay benefits over the Statutory Account Limit only to the extent that the actual dollars included in those assets are directly traceable to income made on investments.

Further, the IRS’s regulation, at section 1.512(a)-5T. must be followed. Under that regulation, a VEBA’s UBTI, for any year, will generally be equal to the lesser of (1) the VEBA’s income for that year or (2) the excess of the total amount set aside (i.e., the VEBA’s total assets held to pay benefits) at year-end over the Statutory Account Limit. Here, the VEBA did not establish the amount in prong (2), so its UBTI equals the amount in prong (1). The VEBA has income, in prong (1), even if it applied the income to the payment of members’ benefits.

As a result of the above, the VEBA is not entitled to a refund.

Comment: It seems strange to be able to conclude, as the Court did, that income can result in an asset accumulation even though the income has been spent: the income is either there or it isn’t . Even so, there is still Treasury regulation section 1.512(a)-5T to contend with. It is equally as strange that the VEBA did not try to establish the amount in prong (2) above, since it might have been able to obtain all or a part of the desired tax refund by doing so.