IRS denies VEBA exemption application for private inurement and impermissible benefits

that provides life insurance for Plan participants.

was the initial Trustee of the Plan. It wasn't until agp that @ale and resigned as Trustees and appointed (QM. In your letter dated I you stated that negotiations were under way to replace BD with

and @ilim» We subsequently requested a copy of the agreement with the Bank. In your letter dated you state that no agreement had been reached with Sa and nd that a verbal agreement had been reached with

o act as Plan Trustee. In response to our request for a written copy of the agreement with you provided a copy of an e-mail from a representative of the Department stating they were moving forward to act as Trustee of the Plan provided:

1. The Trust plan was updated to current law and [RS and Treasury requirements.

2. That an IRS determin ation be obtained.

3. That Sp, SEE (Plan Administrator) and QE, Power of

Attorney for the Plan, work out a funding agreement set forth within the Trust for accepted investments.

Based on the unmet requirements listed above, continues to act as Trustee of the Plan. In regards to the "independence" of , you state you were advised that as jong as it is "properly disclosed” that he is "independent." You also state he is independent because he is not a relative of the )QERENB or their employee.

Article |, Sec. 1.1 of the Trust states that the Trustee shall hold the Trust Fund in trust and shall manage and administer the same in accordance with the terms and for the purpose of the Trust.

Article |, section 1.4 states that the Plan Administrator shall have full responsibility for and contro! of the administration of the Plan and, except as specifically provided otherwise herein, and the powers necessary to carry out the provisions of the Trust.

Article Ili, Section 3.1 states that "The Trustee shall invest and reinvest the principal and income of the Trust Fund and keep the Trust Fund invested, without distinction between principal and income, in such securities or in such property, real or personal, tangible or intangible, as the Trustee shall deem advisable...”

Article Il, Section 3.2 states that "The Plan Administrator shall, pursuant to the Plan, establish and carry out a funding policy consistent with the purposes of the Plan and the requirements of applicable law, as may be appropriate from time to time.”

Article IV, Section 4.1, states in part, that the Trustee is authorized and empowered, in part, (a) to sell, exchange, convey, transfer, or dispose of, and grant options with respect to any property held by the Trust; (b) to acquire, hold, dispose of any real estate, at such time, in a manner and upon such terms as the Trustee may deem advisable; to remain, manage, operate, repair, improve, partition, mortgage or lease for any term or years any such real estate, or to exchange all or part of thereof for other real estate, upon such terms as the Trustee deems proper, (c) to compromise, compound and settle any debt or obligation due to or from it as the Trustee, (d) to vote any stocks or other securities at any time held in the Trust Fund and exercise any options appurtenant to any stocks, bonds or other securities, (e) to accept and hold any securities or other property received by the Plan, (f) to borrow or raise money for the purpose of the Trust Fund, (g) to enforce any right, obligation or claim in its discretion to protect the interests of the Trust, (h) to make and deliver deeds or any other instruments necessary, (i) to cause any investments held by it to be registered in, or transferred into, its name as Trustee, (j) to hold any part or alt of the Trust Fund uninvested; and (k) to do all acts which the Trustee may deem necessary or proper to exercise the powers of the Trustee.

Article IV, Section 4.4 states that the Trustee may be paid such reasonable compensation as agreed upon in writing by the Corporation and the Trustee.

Article Vi, Section 6.2 states the Corporation may remove the Trustee at any time upon 30 days notice in writing to the Trustee.

Article VI, Section 6.3 allows the Corporation to appoint a successor Trustee, upon the resignation or removal of the Trustee.

Article Vil, Section 7.2 states that the Trust Agreement may be termin ated at any time by the Corporation and upon termin ation, dissolution, or liquidation of the Corporation, the Trust Fund shall be paid out by the Trustee as and when directed by the Plan Administrator or the Corporation in accordance with the provisions of Article II of the Plan. You provided an Amendment to this section of the Trust that was adopted or" The Amendment states the Agreement may be termin ated at any time upon the agreement of the Corporation and the Trustee or in the event of the dissolution or liquidation of the Corporation. The Trust Fund will be paid out to the participants by the Trustee upon the directive of the Plan Administrator. In the event of the termin ation or dissolution of the Trust, all funds will be distributed to Plan participants; no assets will be returned to or inure to the benefit of the

Corporation.

Article |, Section 1.6 of the Plan Agreement defines “Board” as the Board of Directors of the Company or the officer or officers of the Company to whom such Board of Directors may delegate any of its rights, duties or powers.

Article I!], Section 3.2(b) of the Plan Agreement states that all monies contributed by the Company, as well as all earnings, shall be returned to the Company in the event the IRS determines the Plan and Trust does not qualify for exemption under section 501(c)(9) of the

Code.

Article 1V, Section 4.1 of the Plan states the Trustee shall have the authority and discretion to manage and control the Trust Fund Assets.

Article V, Section 5.1 of the Plan describes the Governing Employee Board. It states that the Board shall consist of at least two Participants, only one of whom may own stock in the Company (Corporation). Section 5.2 of the Plan states that the Board has the power and authority to designate, remove, or replace the Plan Administrator and approve of, overrule or revise any rules, regulations or interpretations adopted by the Plan Administrator.

Article X, Section 10.1 of the Plan states that the Board and the Governing Employee Board, acting jointly, have the right to amend the Plan and Trust at any time. Section 10.2 states the Company reserves the right to permanently discontinue contributions to the Trust at any time by written notification to the Plan Administrator, the Governing Employee Board and the Trustee. The Plan defines the "Board" as the Board of Directors of the Company.

The Adoption Agreement provides that the Plan will cover all employees of QM who are (1) at least 21 years of age, (2) completed 1,000 or more hours of service within a fiscal year, (3) part-

5

time employees working less than 20 hours a week, (4) seasonal employees (less than 6 months of service or temporary), (5) unionized employees, and (6) employees who are insurable at standard rates. The Participation Commencement Date is the first day of the Plan year following the completion of 2 years of service but no more than 3 years. After [redacted], [redacted] and [redacted] were hired in [redacted] the Plan was amended on [redacted] to waive the two year waiting period.

You included a copy of the First Amendment to the Adoption Agreement, dated [redacted]. Section 1 of the Amendment states the Governing Employee Board shall include [redacted] and [redacted]. You provided a second amendment, dated [redacted], which lists [redacted], [redacted] and [redacted] as members of the Board.

The financial information you provided shows you received the following payments from [redacted]. 200[illegible] [redacted] 200[illegible] [redacted] 200[illegible] [redacted]

*Includes $[redacted] for [redacted] who was not approved for disability or life insurance and thus ineligible to participate in the Plan)

You provided the following information for tax year 200[illegible]:

NAME SALARY BENEFITS PREMIUMS

[redacted] $[redacted] $[redacted] $[redacted]
[redacted] $[redacted] $[redacted] $[redacted]
[redacted] $[redacted] $[redacted] $[redacted]
[redacted] $[redacted] [redacted] * see above reference

The amount of benefits attributable to the [redacted] for [redacted] totals $[redacted] or [redacted]% of all benefits. The amount of premiums paid on behalf of the [redacted] for 200[illegible] is $[redacted] or [illegible] of the total premiums for all employees.

You provided the following information for tax year 2006:

NAME SALARY BENEFITS PREMIUMS

[redacted] $[redacted] $[redacted] $[redacted]
[redacted] $[redacted] $[redacted] $[redacted]
[redacted] $[redacted] $[redacted] $[redacted]

ee: 3 $ $ Qa
ae $ a $ wa $ ou

The amount of benefits attributable to the IEEE totals SQqgERB or @B% of all benefits. The amount of premiums paid on behalf of the (@gg#—lBs for 2006 is SQM or, % of the

total premiums for all employees.

LAW

Section 501(c)(9) of the Code provides for the exemption of voluntary employees’ beneficiary associations that provide for the payment of life, sick, accident, or other benefits to the members of such association or their dependents or designated beneficiaries, if no part of the net eamings of such association inures (other than through such payments) to the benefit of any

private shareholder or individual.

Section 1.501(c)(9)-1 of the Income Tax Regulations provides that for an organization to be described in section 501(c)(9) an organization must meet ail the following requirements:

(a) the organization must be an association of employees;

(b) membership in the association must be voluntary;

(c) the organization's purpose is to provide for the payment of life, sick, accident, or other benefits to its members or their dependents or designated beneficiaries, and substantially all of its operations are in furtherance of providing such benefits, and

(d) no part of the net earnings of the organization inures, other than by payment of the benefits referred to in (c), to the benefit of any private shareholder or individual.

Section 1.501(c)(9)-2(a)(i) of the regulations states that the determin ation whether the selection or administration of objective conditions has the effect of providing disproportionate benefits to officers, shareholders, or highly compensated employees generally is to be determined on the basis of ali the facts and circumstances.

Section 1.501(c)(9)-2(a)(2)(ii)(F) of the regulations states that, a uniform percentage of compensation is a permissible restriction on the amount of life benefits received by the

individual whose life is covered.

Section 1.501(c)(9)-2(c)(1) of the regulations provides, in effect, that a voluntary employee beneficiary association must be an entity, such as a corporation or trust established under applicable local law, having an existence independent of the member-employees or their

employer.

Section 1.501(c)(9)-2(c)(3) of the regulations states that in order to be described in section 501(c)(9) an organization must be controlled--

(i) By its membership
(ii) By independent trustee(s) (such as a bank), or

(iii) By trustees or other fiduciaries at least some of whom are designated by, or on behalf of, the membership.

Section 1.501(c)(9)-3(f) of the regulations describes nonqualifying benefits from a VEBA to include: the provision of loans to members, except in times of distress; the provision of savings facilities for members; any benefit that is similar to a pension or annuity payable at the time of mandatory or voluntary retirement

Section 1.501(c)(9)-4(a) of the regulations provides that no part of the net earnings of a VEBA inure to the benefit of any shareholder or individual other than through the payment of permitted types of life, sick, accident, or other benefit. Prohibited inurement will be determined with regard to all of the facts and circumstances.

Section 1.501(c)(9)-4(b) of the regulations states, "For purposes of subsection (a), the payment to any member of disproportionate benefits, where such payment is not pursuant to objective and nondiscrimin atory standards, will not be considered a benefit within the meaning of Section 1.501(c)(9)-3." As an example, the payment to highly compensated personnel of benefits that are disproportionate in relation to benefits received by other members of a plan will constitute

prohibited inurement.

Section 1.501(a)-1(c) of the Regulations provides that the words "private shareholder’ or "individual" in section 501 refers to persons having a private interest in the activities of an organization.

Revenue Ruling 81-94, 1981-1 C.B. 330 holds that the inurement prohibition precludes the tax exemption of an organization operated to promote the private interests of an individual or individuals standing in relation to the organization as an investor for private gain.

Section 414(q) of the Code provides that “highly compensated employee” means any employee who (A) was 2 5-percent owner at any time during the year or the preceding years, or (B) for the preceding year, had compensation from the employer in excess of $80,000, and was in the top- paid group of employees for any preceding year, as the employer elects.

In Lima Surgical Associates, Inc. Voluntary Employees’ Beneficiary Plan Trust, Huntington National Bank, Trustee v. United States, 20 Cl. Ct. 674 (1990), affd 944 F.2d 885(Fed. Cir. 1991) the Claims Court held that a VEBA plan, formed and controlled by three surgeons that provided non-qualifying retirement benefits and that limited the authority of the Trustee, did not qualify for exemption under section 501(c)(9) of the Code. The Court held the plan did not meet three of the four mandatory requirements for a qualified VEBA as stated in Regulations 1.509(c)(9)-1 because it is not a "voluntary association of employees because it is not controlled by an independent trustee within the meaning of Regulations 1.501(c)(9)-2(c)(3), it does not provide for the payment of life, sick, accident or other permissible benefits and the Trust

provides disproportionate benefits to its officers, shareholders, and highly compensated in a manner prohibited under Regulations 1.501(c)(9)-4(b) and because the Trust violates the proscription against private inurement by providing disproportionate benefits to its officers, shareholders, and highly compensated employees in a manner prohibited under Regulations

1.501(c)(9)-4(b)."

In Wade L. Moser v, Commissioner, 56 TCM 1604, T.C. Memo, 1989-142 (1989) affd as to other issues, 914F.2d 1040, 90-2USTC [50,498 (8th Cir. 1990) the IRS disallowed a $200,000

deduction by the taxpayer to a VEBA Plan. The Tax Court allowed the deduction in full as a section 162 business expense. The tax-exempt status for the VEBA plan was not an issue decided by the Court. The VEBA was subsequently revoked by the IRS.

in Joel A, Schneider, M.D., 63 TCM 1787, T.C. Memo 1992-24 (1992) a doctor was allowed to deduct VEBA contributions in excess of $1.1 million over three years where 95% of the benefit was for the doctor and his children. The trust applied for tax-exempt status under section 501(c)(9) but was denied, and this was not an issue in the case.

APPLICATION OF LAW

Inurement

Section 501(c)(9), in conjunction with section 501(a), exempts from Federal income tax a voluntary employees’ beneficiary association (VEBA) providing for the payment of life, sick, accident, or other benefit to its members or their dependents, or designated beneficiaries, if no part of the net earnings of the association inures (other than through such payments) to the benefit of any private shareholder or individual.

You were organized pursuant to a Trust Agreement executed on sama.

signed the Agreement in his capacity as the 100 percent shareholder of the Corporation and as one of the two Trustees. Until his resignation on he was one of two members of the Governing Employee Board of the Plan. On i and

resigned as Trustees and ie CPA, was appointed the sole Trustee of the Plan. Article VI of the Trust Agreement states @ may remove the Trustee at any time.

GMP is the sole owner of SB, the company that funds the Plan. He and received 94 percent and 88 percent of the benefits of the Plan for 2005 and 2006 respectively.

They are each insured for $@§8®. Their applications for life insurance list each other as the beneficiary whereas the Plan is listed as the beneficiary for the remaining employees.

The Plan is subject to a degree of direct control by; | MM the owner-member, since he is the sole owner of the contributing employer, has ultimate contro! over the Plan by determining the level of contributions and benefits, and reserves the right to appoint, remove and control the activities of trustees. As contributing employer, he also controls the right to termin ate the Plan

at any time.

During your operation and upon your termin ation, you provide a domin ant share of aggregate benefits to WR the highly compensated owner-employee, and his wife. In addition, by reason of having direct control over == maintains effective control over your operation, administration, and termin ation. These circumstances indicate that you operate primarily for the benefit of. and: QB, rather than primarily for the benefit of an employee group. You accumulate funds predomin antly for the current benefit of, | and QM. Because you are subject to termin ation at the discretion of J§HEERIB, he is able to direct the distribution of his allocable share of trust assets. In this manner, you function substantially as an investment fund for the direct and private benefit of | and (uae.

The accumulation of investment funds for the private benefit of . and! GRRE does not fall within the ambit of permissible benefits as described in section 1.501(c)(9)-3(d) of the regulations. Under these circumstances, notwithstanding that current benefits are subject to a restriction that is generally permissible under section 1.501(c)(9)-2(a)(2)(ii)(F) of the regulations, you are organized and operated to promote the private interests of and. os

The holding of Rev. Rul. 81-94 is applicable to your Plan in that the Plan promotes the private

interests of the GUAM by providing a large percentage of benefits to them and by not using the services of an independent Trustee to oversee the Plan and its investment. This inurement precludes the Plan from qualifying for exemption under section 501(c)(9).

Your Plan is similar to the Plan discussed in Lima Surgical Associates, Inc. VEBA in that your Trust covers a small number of employees and provides a domin ant share of the aggregate

benefits to the quam.
Other Impermissible Benefits

Universal life insurance policies are not eligible for inclusion in a 501(c)(9). Since the policies have provisions for period payments to the insured as a settlement option, it is not an eligible benefit based on section 1.509(c)(9)-3(f) of the regulations. Also, the life insurance policies allow loans, which are impermissible benefits under section 501(c)(9).

Independent Trustee

Section 1.501(c)(9)-2(c)(3) of the regulations states that in order to be described in section 501(c)(9) an organization must be controlled by its membership, or independent trustee(s) (such as a bank), or by trustees or other fiduciaries at least some of whom are designated by, or on

behalf of, the membership.

Although the QB resigned as Trustees on ) three years after the adoption of the Plan, they appointed , CPA, their personal and business accountant to act as a temporary "independent” Trustee. Although gg has resigned as Trustee he is still able to exert significant control over the operation of the Plan because he controls the company that provides the funding for the Plan and he has authority to remove the Trustee at any time. He indirectly exhibits control over the Trustee in that he uses the Trustee as the accountant for §jg the company he owns as well as for his own personal accounting

10

and income tax services. (MMB cannot be described as an "independent" trustee as he wears many hats for the ap.

You attempted to secure the services of a bank to act as permanent Trustee. You gave assurances that negotiations were underway to have STE act as Trustee for the Plan. Upon our request for a copy of the written agreement you stated that you could n h an agreement with the Bank but that a verbal agreement had been reached with ee ee Upon our request for a copy of a written agreement you provided a copy of an e-mail from a representative of SEEBr that they are willing to act as a Trustee as long as the Plan has secured tax-exempt status from the IRS. The Plan has been in existence

since and it still has not secured the services of an independent Trustee. This allows the to maintain too much control over the assets of the Plan. APPLICANT'S POSITION

You state the Courts have not generally upheld the Internal Revenue Service's position with regard to VEBAs, as to private inurement, impermissible control by owner, and failure to observe non-discrimin atory rules and prepaid expenses. You cite Wade L. Moser vs. Commissioner which ruled that a $200,000 deduction claimed by the taxpayer to a VEBA pian to pre-fund a severance benefit, was deductible as a section 162 business expense. The Court rejected the IRS assertion that the plan was nothing more than a private investment fund created and operated for the benefit of the principal shareholders. You note that over 90 percent of the insurance premiums and the cost of funding the severance benefit were for benefits attributable to the principal shareholders. From the Court ruling you quote ... Thus, we hold that the fact that the plan benefits are skewed in favor of the is not a determin ative factor in deciding the issue of deductibility of Inland's VEBA contribution."

As to the issue of control you quote, in part, “Although as the committee, had significant input into the management of the VEBA's assets, the independent trustee was the actual titleholder of those assets, and it retained possession and exerted day-to-day control over

the assets.”

You cite Joel A. Schneider, M.D. as another Tax Court Memo which followed Moser in holding that an employer does not necessarily retain too much control when it retains the right to alter or termin ate a plan as long as the funds in the plan never revert to or inure to the benefit of the employer. In this case the plan benefits attributed to one participant were in excess of 95% of

the aggregate benefits.

You conclude that the Tax Court rejected in both cases the difference in cost of benefits as a basis for denial of tax benefit and that the Trustee is now independent and is expected to shortly be replaced by an independent contractor.

You distinguish the findings in Lima from your case on several grounds including a finding that it was created to replace a termin ated retirement plan and that the corporation retained too much contro! over the VEBA. You state in Lima the court approved the uniform percentage of the

11

compensation method which is the same basis used to determine benefits in the Meter Management VEBA.

SERVICE RESPONSE TO APPLICANT'S POSITION

In Moser the Court began their opinion by stating the question of whether the VEBA plan qualified for exemption under section 501(c)(9) was not an issue in their ruling. However, the Plan was subsequently revoked by the IRS. The Court was asked to rule on whether the funding corporation to the Plan was entitled to a $200,000 business deduction under section 162 as an ordin ary and necessary business expense. The IRS disallowed the deduction, in part, because 90 percent of the deduction was attributable to one individual. Of note is the fact that the Trustee of the VEBA Plan was an independent trust company. The Court determined the contribution was a section 162 business deduction and that there wasn't a statutory or regulatory provision prohibiting a deduction to an employee benefit plan because a large portion of the benefits were attributable to one employee. The Court made its ruling, in part, because an independent Trustee exerted day-to-day control over the assets.

In Schneider the issue was also the deductibility of contributions to a VEBA plan by a corporation as a section 162 business expense. The Service had already denied the application for tax-exempt status for the VEBA Plan that received the contributions that were being challenged. In Schneider, an independent bank served as trustee which gave the Court the assurance that the employer did not retain too much control over the Plan. Also, Schneider was decided prior to the section 419 and 419A of the Code which, in effect, allowed deductions only for the costs of current benefit plus and actuarially determined allowance for certain reserves and benefits accounts. The Schneider case has no relevance to qualification for exemption under section 501(c)(9) and little relevance to current issues of deductibility.

In Lima, the only court case cited where the primary issue was whether a Trust qualified for tax- exempt status under section 501(c)(9), the Court held the plan did not qualify for exemption as it did not meet three of the four mandatory requirements listed in Regulations 4.501(c)(9)-1. The Court held the Trust was not a voluntary association of employees because it was not controlled by an independent trustee; it did not provide for the payment of life, sick, accident, or other
-benefits; and the Trust violated the proscriptions against private inurement because it provides disproportionate benefits to its officers, shareholders, and highly compensated employees in a way prohibited under Regulations 1.501(c)(9)-4(b). Your Plan can be compared to Lima in that you do not have an independent trustee and you are providing disproportionate benefits to the NB. These two factors together form the basis for our opinion that you do not qualify for exemption under section 501(c)(9).

Throughout the process of reviewing your request for tax-exempt status under section 501(c)(9) you have promised that you will obtain the services of an independent trustee on a number of occasions. In response to our questioning (EIEREMEK as a Trustee to the Plan he resigned in
@@M He was temporarily replaced by gaa CPA, who you claim is an “independent” trustee even though he is the accountant for ggg and the personal accountant in income tax preparer for the @giags You are now in negotiations with WEE Who require you to have tax-exempt status before they will agree to act as the

12

Trustee. It is now three years after the plan was adopted and you still do not have an independent trustee.

CONCLUSION

The Trust is organized and operated in a way that violates the inurement proscriptions of Section 1.501(c)(9)-4 of the Income Tax Regulations. The Trust was established for the

personal and private benefit of @gBhand QNIIMpand initially for GI, the father of @j™m The lack of an independent trustee in combin ation with the allocation ofa

domin ant share of aggregate benefits to the arya indicates that the Trust is organized and operated for their benefit and not for any employee group. Therefore the net earnings of the

Trust improperly inure to the benefit of the

The universal life policies in the plan are not eligible for inclusion in a 501(c)(9) because they allow for periodic payments and loans.

The Trust is not controlled by an independent trustee as required in Section 1.501 (c)(9)-2(c)(3) of the Income Tax Regulations.

Therefore, the Trust does not qualify for tax-exempt status under section 501(c)(9) of the Code.

You have the right to file a protest if you believe this determin ation is incorrect. To protest, you must submit a statement of your views and fully explain your reasoning. You must submit the statement, signed by one of your officers, within 30 days from the date of this letter. We will consider your statement and decide if the information affects our determin ation. {f your statement does not provide a basis to reconsider our determin ation, we will forward your case to our Appeals Office. You can find more information about the role of the Appeals Office in Publication 892, Exempt Organization Appeal Procedures for Unagreed Issues.

An attomey, certified public accountant, or an individual enrolled to practice before the Internal Revenue Service may represent you during the appeal process. If you want representation during the appeal process, you must file a proper power of attorney, Form 2848, Power of Attorney and Declaration of Representative, If you have not already done so. You can find more information about representation in Publication 947, Practice Before the IRS and Power of Attorney. All forms and publications mentioned in this letter can be found at www. irs.gov, Forms

and Publications.

If you do not intend to protest this determin ation, you do not need to take any further action. If we do not hear from you within 30 days, we will issue a fin al adverse determin ation letter. That letter will provide information about filing tax returns and other matters.

Please send your protest statement, Form 2848, and any supporting documents to the applicable address:

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Mail to: Deliver to:
Internal Revenue Service Internal Revenue Service
EO Determin ations Quality Assurance EO Determin ations Quality Assurance Room 7-008 550 Main Street P.O. Box 2508 Room 7-008 Cincinnati, OH 45201 Cincinnati, OH 45202

You may fax your statement using the fax number shown in the heading of this letter. If you fax your statement, please call the person identified in the heading of this letter to confirm that he or she received your fax.

If you have any questions, please contact the person whose name and telephone number are shown in the heading of this letter.

Sincerely,
See pe Reve
Robert Choi

Director, Exempt Organizations
Rulings & Agreements