Dissolving VEBA may preserve exemption and avoid unrelated business income tax

Plain-English summary

The IRS considered a self-insured VEBA that planned to terminate after several significant claims and use its excess assets to continue providing medical and dental benefits. The trust proposed to allocate its fund balance among participating tax-exempt employers and send payments directly to group insurers or third-party administrators, rather than distributing cash to the employers. The IRS ruled that adopting and implementing the plan would not adversely affect the trust’s tax-exempt status under IRC § 501(c)(9) and would not cause unrelated business income tax under § 511. The ruling relied on the proposed use of the assets for permitted benefits, the absence of any reversion to employers, and the employers’ tax-exempt status.

Ruling snapshot

• Question: May a terminating VEBA use excess assets to prepay medical and dental benefits and avoid unrelated business income tax?
• Outcome: Approved, both requested rulings were granted
• Key authorities: IRC §§ 501(c)(9), 511, 512(a)(3), and 6110; Treas. Reg. §§ 1.501(c)(9)-1, 1.501(c)(9)-3, 1.501(c)(9)-4, and 1.512(a)-5T

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Contact Person:

Number: 201410037
Release Date: 3/7/2014

Identification Number:

Telephone Number:

Date: December 11, 2013
Employer Identification Number:

UIL: 501.09-00; 511.00-00

Legend:

X =
Y =
Z =
State A =
Year =
Date =
Trust =

Dear:

We have considered your letter dated October 23, 2012, in which you request rulings on the
application of §§ 501(c)(9) and 511 of the Internal Revenue Code (the “Code”) to your plan to
distribute your assets upon your dissolution.

Facts

You represent that you are a self-insured trust recognized as exempt under § 501(a) of the
Code as an organization described in § 501(c)(9) as a Voluntary Employees’ Beneficiary
Association (“VEBA”).

You provide medical and dental plan benefits to employees of your participating tax-exempt
members/employers (individually referred to herein as the “Employer” and collectively as the
“Employers”). All claims for benefits are paid from your funds, subject to certain reinsurance
agreements for large claims. The Employers consist of X, Y, and Z, all of which are tax-exempt
entities. All of the Employers are located in State A.

Due to several significant claims and a relatively low number of employees served, your ability
to provide cost-effective benefits is deteriorating. In order to maintain necessary reserves, you
have had to increase premiums higher than those typically assessed by other providers offering
similar plans (but who service many more customers). Furthermore, the cost to you of
complying with future regulatory mandates would be high compared to providers offering similar
plans. Consequently, your board of trustees has voted to terminate the Trust at the end of the

2

Year plan year. You anticipate having excess assets upon termination.

Your Trust Agreement states the following:

Upon termination of this Trust Agreement, the Trust Board shall promptly wind up
the affairs of the Trust... . With respect to any other form of termination, any
and all money and assets remaining in the Trust, after the payment of expenses,
shall be used for the continuance of benefits provided by then existing [medical
and dental plans], until such money and assets have been exhausted, unless
some other disposition is required under the applicable laws. In no event shall
any of the remaining money or assets be paid to or be recoverable by any
Participating Municipality.

Your proposal to handle excess assets upon the termination of your medical and dental plans at
the end of Year is to enter into an agreement with the Employers (the “Plan”) that would contain
the following provisions:

• The fund balance of the Trust would be used only to continue to provide participant-
employees of Employers in the Trust as of [Date], [Year], with medical and dental
benefits after termination, until the fund balance is exhausted. No Employer would have
a legal right to a reversion of assets, either under the Internal Revenue Code or under
the agreement with the Trust.

• Employers must use their allocated share of the Trust fund balance for the following
purposes:
o Obtain group medical or dental insurance plan coverage, as applicable, for
employees of the Employer; or
o Provide self-insured medical or dental benefits through a third-party administrator
for employees of the Employer.

• The Employer must submit information to the Trust about each group insurance plan or
self-insured plan providing sick or accident benefits. Upon verifying that the group
insurance plan or self-insured plan would provide sick or accident benefits for the
participant-employees of the Employer, the Trust would draw a check in the name of the
group plan insurer or third-party administrator participant plan, and mail the check
directly to the insurer or third-party administrator.

• Employers will be required to agree that benefit plan arrangements paid for with the
Trust’s fund balance may not provide disproportionate benefits for officers or highly-paid
employees of each Employer.

• Each Employer must acknowledge that the IRS may audit the Employer to ensure that
the Employer applied its share of the fund balance to pay benefits consistent with the
terms of the agreement.

3

• The party providing group medical or dental insurance plan coverage, or acting as the
third-party administrator of a self-insured plan, would be required to agree that any
monies paid to such group insurer or third-party administrator by the Trust could not
revert to the Employer.

• Any failure to comply with the terms of the agreement would cause the Employer to
forfeit any right to application of its share of the fund balance.

After payment of all administrative expenses and claims of the Trust, the Trust’s fund balance
would be allocated among Employers on the following basis:

• By line of coverage (i.e. medical and dental) using total contributions by all Employers
over the last five years of the Trust as the denominator, and total contributions by
Employers for each line of coverage over the last five years of the Trust as the
numerator.

• Determine each Employer’s share of the fund balance per line of coverage using total
contributions by all Employers during the last five years as the denominator, and the
Employer’s total contributions during that period as the numerator.

• If an Employer does not provide medical or dental benefits after termination of the Trust,
or fails to meet the conditions of participation under the termination agreement, that
Employer’s share would be allocated among other Employers on a pro-rata basis, based
on their total contributions to the Trust for such benefits over the past five years.

Rulings Requested

You have requested the following rulings:

1. Adopting and implementing the Plan will not adversely affect your tax-exempt status as
   an organization described in § 501(c)(9) of the Code.

2. Adopting and implementing the Plan will not cause you to incur unrelated business
   income tax under § 511 of the Code.

Law

Section 501(c)(9) of the Code provides for the exemption from federal income tax of voluntary
employees’ beneficiary associations providing 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 earnings 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 § 501(c)(9), it must be an employees’ association; membership in the association
must be voluntary; the organization must provide for the payment of life, sick, accident, or other
benefits to its members; and there can be no inurement (other than by payment of permitted

4

benefits) to the benefit of any private shareholder or individual.

Section 1.501(c)(9)-3(c) defines “sick and accident benefits” for purposes of § 501(c)(9) as
amounts furnished to or on behalf of a member or a member’s dependents in the event of
illness or injury to a member or a member’s dependent. Such benefits may be provided through
reimbursement to a member or a member’s dependent for amounts expended because of
illness or personal injury, or through the payment of premiums to a medical benefit or health
insurance program.

Section 1.501(c)(9)-4(a) provides, generally, that no part of the net earnings of an employees’
association may inure to the benefit of any private shareholder or individual other than through
the payment of benefits permitted by § 1.501(c)(9)-3.

Section 1.501(c)(9)-4(d) provides that it will not constitute prohibited inurement if, on termination
of a plan established by an employer and funded through an association described in §
501(c)(9), any assets remaining in the association, after satisfaction of all liabilities to existing
beneficiaries of the plan, are applied to provide, either directly or through the purchase of
insurance, life, sick, accident or other benefits within the meaning of § 1.501(c)(9)-3 pursuant to
criteria that do not provide for disproportionate benefits to officers, shareholders, or highly
compensated employees of the employer.

Section 511 imposes a tax on the unrelated business taxable income of organizations described
in § 501(c)(9).

Section 512(a)(3)(A) provides that, in the case of an organization described in § 501(c)(9), the
term “unrelated business taxable income” means the gross income (excluding any exempt
function income) less the deductions allowed by this chapter which are directly connected with
the production of the gross income (excluding exempt function income), both computed with
modifications.

Section 512(a)(3)(B)(ii) provides that in the case of an organization described in paragraph (9),
(17) or (20) of § 501(c), “exempt function income” includes all income (other than an amount
equal to the gross income derived from any unrelated trade or business regularly carried on by
such organization computed as if the organization were subject to § 512(a)(1)), which is set-
aside to provide for the payment of life, sick, accident, or other benefits, including reasonable
costs of administration directly connected with its exempt purpose.

Section 512(a)(3)(E) provides that, generally, for organizations described in paragraph (9), (17)
or (20) of § 501(c), a set-aside may be taken into account under subparagraph (B) only to the
extent that such set-aside does not result in an amount of assets set aside in excess of the
account limit determined under § 419A (without regard to subsection (f)(6) thereof) for the
taxable year (not taking into account any reserve described in § 419A(c)(2)(A) for post-
retirement medical benefits).

Section 512(a)(3)(E)(iii) provides that subparagraph 512(a)(3)(E) does not apply to an
organization if substantially all of the contributions to such organization are made by employers
who were exempt from tax under Chapter 1 of the Code throughout the 5-taxable year period

5

ending with the taxable year in which the contributions are made.

Analysis

First, you have requested a ruling on whether the adoption and implementation of the Plan will
adversely affect your tax-exempt status as an organization described under § 501(c)(9).
Pursuant to § 1.501(c)(9)-4(a), a voluntary employees’ beneficiary association will jeopardize its
exempt status under § 501(c)(9) if any part of its net earnings inures to the benefit of any private
shareholder or individual other than through the payment of benefits permitted by § 1.501(c)(9)-

3. Pursuant to § 1.501(c)(9)-4(d), it will not constitute prohibited inurement if, on termination of
   a plan established by an employer and funded through an association described in § 501(c)(9),
   any assets remaining in the association, after satisfaction of all liabilities to existing beneficiaries
   of the plan, are applied to provide, either directly or through the purchase of insurance, life, sick,
   accident or other benefits within the meaning of § 1.501(c)(9)-3 pursuant to criteria that do not
   provide for disproportionate benefits to officers, shareholders, or highly compensated
   employees of the employer.

You represent that, after you terminate the Trust and pay administrative expenses and liabilities,
the remaining fund balance of the Trust will be used to make pre-payments on group plans or to
the self-insured plan’s third-party administrator that would benefit the Employers’ participant-
employees of the VEBA. The Employers would not receive distributions of cash or other assets
under the Plan. Instead, you would send checks directly to the Employer’s group plan or third-
party administrator providing benefits as described in § 1.501(c)(9)-3(c). These checks would be
drawn only after you verify information regarding the group plan or self-insured plan and its cost.

In order for an Employer to receive an allocable share of the fund balance, it must agree to, and
comply with, the terms of the Plan. The Plan provides that the fund balance of the Trust will be
used only to continue to provide participant-employees of Employers in the Trust as of Date,
Year, with § 501(c)(9) benefits after termination until the fund balance is exhausted, and that no
Employer will have a legal right to a reversion of assets. Employers will be required to agree
that benefit plan arrangements paid for with the Trust’s fund balance may not provide
disproportionate benefits for officers or highly paid employees of the Employer. Further, the
party providing group medical or dental insurance plan coverage, or acting as the third-party
administrator of a self insured plan, would be required to agree that any monies paid to such
group insurer or third-party administrator by the Trust could never revert to the Employer. Thus,
because you will use the fund balance to pre-pay the group plan insurers or third-party
administrators secured by the Employers to provide medical and dental benefits permitted under
§ 501(c)(9) of the Code with no disproportionate benefit inuring to any person, and because
none of the Trust’s assets will revert back to any Employer, we conclude that this transaction
will not jeopardize your tax-exempt status under § 501(c)(9).

Second, you have requested a ruling on whether the transfers will result in liability for unrelated
business income tax under § 511. The transfers described above will not, in and of themselves,
result in unrelated business income tax under § 511.

The unrelated business taxable income of a VEBA is determined pursuant to § 512, including §
512(a)(3)(E) and Treasury regulation §1.512(a)-5T. However, pursuant to § 512(a)(3)(E)(iii), §

6

512(a)(3)(E) does not apply to a VEBA such as the Trust if substantially all of the contributions
to the VEBA are made by employers who were exempt from tax under Chapter 1 of the Code
throughout the 5-taxable year period ending with the taxable year in which the contributions are
made. You represent that the contributing employers, X, Y, and Z are tax exempt entities, and
that substantially all of the contributions to Trust are made by employers who were exempt from
tax under Chapter 1 of the Code throughout the 5-taxable year period ending with the taxable
year in which the contributions are made. Accordingly, unrelated business taxable income of
Trust is computed without regard to § 512(a)(3)(E).

Rulings

Based on the information submitted, we rule as follows:

1. Adopting and implementing the Plan will not adversely affect your tax-exempt status as
   an organization described in § 501(c)(9) of the Code.

2. Adopting and implementing the Plan will not, in and of itself, cause you to incur unrelated
   business income tax under § 511 of the Code.

This ruling will be made available for public inspection under § 6110 of the Code after certain
deletions of identifying information are made. For details, see enclosed Notice 437, Notice of
Intention to Disclose. A copy of this ruling with deletions that we intend to make available for
public inspection is attached to Notice 437. If you disagree with our proposed deletions, you
should follow the instructions in Notice 437.

This ruling is directed only to the organization that requested it. Section 6110(k)(3) of the Code
provides that it may not be used or cited by others as precedent.

This ruling is based on the facts as they were presented and on the understanding that there will
be no material changes in these facts. This ruling does not address the applicability of any
section of the Code or regulations to the facts submitted other than with respect to the sections
described. Because it could help resolve questions concerning your federal income tax status,
this ruling should be kept in your permanent records.

7

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

In accordance with the Power of Attorney currently on file with the Internal Revenue Service, we
are sending a copy of this letter to your authorized representative.

Sincerely,

Steven Grodnitzky
Manager, Exempt Organizations
Technical Group 4

Enclosure
Notice 437