Earlier this month, the Internal Revenue Service (IRS) withdrew proposed regulations (Old Regulations) for calculating the unrelated business taxable income (UBTI) of voluntary employees’ beneficiary associations (VEBAs) within the meaning of Internal Revenue Code (Code) Section 501(c)(9) and supplemental unemployment benefit trusts (SUBs) within the meaning of Code Section 501(c)(17). The IRS replaced the Old Regulations, which had been issued in 1986, with new proposed regulations (New Regulations). The New Regulations are generally similar to the Old Regulations, but are intended to clarify a particular aspect of the UBTI calculations that had been the subject of contradictory interpretations by reviewing courts.
The Code defines the UBTI of VEBAs and SUBs (Covered Entities) as gross income less expenses that are directly connected with the production of that gross income, but excluding “exempt function income.” Exempt function income is defined to include, among other things, investment income that is set aside by the Covered Entity for the payment of benefits and associated reasonable administrative costs.
To prevent a Covered Entity from using the set-aside provision to avoid tax on an amount that is greater than that reasonably needed to provide benefits, the Code limits the amount of set-aside investment income that may be considered exempt function income. Thus under the Code, a Covered Entity’s investment income is considered UBTI (and not exempt function income) to the extent the total asset value of the Covered Entity at year-end (excluding certain assets that have useful lives extending substantially beyond the end of the tax year) exceeds the limit specified in Code Section 419A (419A Limit), which represents the amount that is reasonably and actuarially necessary to fund incurred but unpaid benefit claims and associated administrative costs.
In determining the amount of exempt function income at tax year-end, the IRS position has always been that all set-aside investment income of the Covered Entity is taken into account, including amounts used earlier in the year to pay benefits. A 2008 decision of the U.S. Court of Appeals for the Federal Circuit upheld the IRS’s position. However, in a 2003 decision, the U.S. Court of Appeals for the Sixth Circuit had concluded that the set-aside investment income taken into account should only include amounts accumulated and remaining in the set-aside fund at the end of the tax year. The New Regulations clarify this aspect of the Old Regulations so as to preclude the Sixth Circuit’s interpretation going forward.
The New Regulations also explicitly incorporate the statutory provisions that:
- a Covered Entity’s UBTI includes UBTI derived from any unrelated trade or business regularly conducted by the Covered Entity;
- a Covered Entity is not subject to the 419A Limit for a tax year if substantially all the contributions to the Covered Entity during the tax year are made by employers who had been tax exempt for the preceding five-year period; and
- a Covered Entity that is part of a 10- (or more) employer plan is subject to the 419A Limit.
The New Regulations retain the prior transition provisions from the Old Regulations applicable to existing reserves for post-retirement medical or life insurance benefits. The New Regulations refrain from addressing issues relating to collectively-bargained welfare benefit funds, which the IRS has stated will be the subject of future guidance.
Comments on the New Regulations are due by May 7. The Old Regulations will continue to apply until final regulations are published in the Federal Register. The final regulations would apply for tax years ending on or after the date on which they are published.