IRS challenges deductibility of contributions to certain multiple employer welfare benefit funds.

Background

Taxpayers and their representatives have inquired as to whether certain trust arrangements qualify as multiple employer welfare benefit funds exempt from the limits of Secs. 419 and 419A. In response, the IRS issued Notice 95-34 to alert taxpayers and their representatives to some of the significant tax problems that may be raised by these arrangements.

Generally, contributions to a welfare benefit fund are deductible when paid, but only if they qualify as ordinary and necessary business expenses of the taxpayer and only to the extent allowable under Secs. 419 and 419A. These sections impose strict limits on the amount of tax-deductible pre-funding permitted for contributions to a welfare benefit fund.

Sec. 419A(f) (6) provides an exemption from Secs. 419 and 419A for certain welfare benefit funds. Generally, for this exemption to apply, an employer normally cannot contribute more than 10% of the total contributions and the plan must not be experience-rated with respect to individual employers.

In recent years, a number of promoters offered trust arrangements that they claim satisfy the requirements for the 10-or-more-employer plan exemption and that are used to provide benefits such as life insurance, disability and severance pay benefits. These promoters claim that all employer contributions are deductible when paid, relying on the 10-or-more-employer exemption from the Sec. 419 limits and on the fact that they have enrolled at least 10 employers in their multiple employer trusts.

These arrangements typically are invested in variable life or universal life insurance contracts on the lives of the covered employees, but require large employer contributions relative to the cost of the amount of term insurance that would be required to provide the death benefits under the arrangement. The trust owns the insurance contracts. The trust administrator may obtain the cash to pay benefits (other than death benefits) by such means as cashing in or withdrawing the cash value of the insurance policies. Although in some plans benefits may appear to be contingent on the occurrence of unanticipated future events, in reality most participants and their beneficiaries will receive their benefits.

The trusts often maintain separate accounting of the assets attributable to the contributions made by each subscribing employer. Benefits are sometimes related to the amounts allocated to the employees of the participant's employer. For example, severance and disability benefits may be subject to reduction if the assets derived from an employer's contributions are insufficient to fund all benefits promised to that employer's employees. In other cases, an employer's contributions are related to the claims experience of its employees. Thus, pursuant to formal or informal arrangements or practices, a particular employer's contributions or its employees' benefits may be determined in a way that insulates the employer to a significant extent from the experience of other subscribing employers.

IRS Position

In general, these arrangements and other similar arrangements do not satisfy the requirements of the Sec. 419A (f) (6) exemption and do not provide the tax deductions claimed by their promoters for any one of several reasons, including the following:

* The arrangements may actually be providing deferred compensation. This is an especially important consideration in arrangements similar to that in Wellons, 31 F3d 569 (7th Cir. 1994), aff'g TC Memo 1992-704, in which the courts held that an arrangement purporting to be a severance pay plan was actually deferred compensation. If the plan is a nonqualified deferred compensation plan, deductions for contributions will be governed by Sec. 404(a) (5) and contributions to the trust may, in some cases, be includible in employees' income under Sec. 402(b). Sec. 404(a) (5) provides that contributions to a nonqualified plan of deferred compensation are deductible when amounts attributable to the contributions are includible in the employees' income, and that deductions are allowed only if separate accounts are maintained for each employee.

* The arrangements may be, in fact, separate plans maintained for each employer. As separate plans, they do not qualify for the Sec. 419(A) (f) (6) 10-or-more-employer plan exemption.

* The arrangements may be experience-rated with respect to individual employers, in form or operation, because (among other things) the trust maintains, formally or informally, separate accounting for each employer and the employers have reason to expect that, at least for the most part, their contributions will benefit only their own employees. Arrangements experience-rated with respect to individual employers do not qualify for the Sec. 419A (f) (6) exemption.

* Even if the arrangements qualify for the Sec. 419A (f) (6) exemption, employer contributions to the arrangements may represent prepaid expenses nondeductible under other Code sections.

Taxpayers and their representatives should be aware that the Service has disallowed deductions for contributions to these arrangements and is asserting the positions discussed above in litigation.

Finally, in response to questions raised by taxpayers and their representatives, the IRS notes that it has never issued a letter ruling approving the deductibility of contributions to a welfare benefit fund under Sec. 419A (f) (6). Although a trust providing benefits under an arrangement of the type discussed in Notice 95-34 may have received a determination letter stating that the trust was exempt under Sec. 501 (c) (9), that type of letter did not address the tax deductibility of contributions to such a trust.