Is a single-employer welfare benefit plan appropriate for a small business?

In an era in which tax-deferral transactions are subject to intensified scrutiny, businesses are challenged to bring ever-greater discipline to the design and implementation of legitimate employee benefit arrangements that offer tax advantages. This is particularly true for businesses with very few employees.

However, a small business often has an even more acute need than its larger competitors for the nontax advantages a well-designed benefit plan offers. A small business's need to attract and retain quality workers can often be met if it can offer prospective employees a superior benefits package. Yet, this important recruiting and retention tool can be a challenge for smaller businesses that may not have the in-house benefits and tax expertise needed to assess these plans. Consequently, many of these employers would welcome a benefits plan governed by dear rules.

Congress and the IRS have provided specific rules for certain arrangements, which, if followed, allow employers comfortably to take advantage of the favorable tax treatments such arrangements offer, and make use of the recruitment and retention advantages they provide.

A good example of this type of plan is a single-employer welfare benefit plan (WBP) funded by a trust. Sec. 419 governs deductions for contributions to such trusts. While some WBPs use tax-exempt trusts, some opt for a taxable trust. Generally, rules on the types of benefits permitted, the funding limits and the deductibility of contributions are the same whether or not the trust is taxable.

The law on welfare benefit arrangements may be overwhelming for advisers to closely held businesses. However, there are some guidelines that can help an employer decide whether and how to implement a WBP.

In General

A WBP provides welfare benefits (e.g., health benefits) for active and retired employees; life insurance; disability income insurance or payments; severance pay; supplemental unemployment benefits; long-term care benefits; and post-retirement medical or life insurance benefits. Under Sec. 419(e)(2), a WBP cannot provide disguised deferred compensation and is not a qualified retirement plan. Hence, a trust funding a WBP cannot be a source of retirement income or deferred compensation benefits.

Payments from a WBP will be made only if the specific benefit being funded becomes payable to plan participants. Thus, if a WBP is funding postretirement medical benefits, amounts will be paid only if the medical expenses are incurred in retirement. Assets related to funded post-retirement benefits that are not paid because an employee terminates before being entitled to benefits stay in the trust and are used to pay benefits to other employees.

WBPs can be part of an arrangement under which an employee has a choice between current compensation and current benefits; however, the choice cannot be between current compensation and deferred (retiree) benefits. Such an arrangement does not meet the Sec. 125(d)(2) cafeteria plan rules that prohibit salary reduction amounts from being used to purchase deferred benefits. Thus, to the extent that retiree benefits are funded, contributions must be employer contributions, not salary-reduction contributions.

ERISA Rules

A full understanding of the rules applicable to WBP funds requires focusing on Employee Retirement Income Security Act of 1974 (ERISA), as well as tax, requirements. The trust document funding a WBP will specify when and how benefits can be paid. A trustee must be responsible for investing assets until such amounts are paid to plan participants and beneficiaries. Trust assets can be used to pay benefits only as directed by the trust document.

The WBP trust's assets are owned by the trust, not by the employer; any use of the assets by the employer for its own benefit or for the benefit of a related entity would be a party-in-interest transaction that violates ERISA Section 406(a)(1)(D). Further, ERISA Section 406(a)(1)(B) bars a loan of assets from the WBP fund to the employer or to any person or entity related to it. Similarly, under ERISA Section 406(a)(1)(A), the employer cannot sell or lease assets to the WBP fund; the fund cannot sell assets to or purchase assets from the employer or any related entity. It is important to maintain the separate nature of the WBP fund and carefully monitor any transactions between the fund and the employer, to ensure that the ERISA rules are not violated.

Employer's Deductible Costs

The choice of benefits in a WBP is critical to understanding the deduction rules that apply to the arrangement. Under Secs. 419 and 419A, an employer's deductible costs are limited to the "qualified direct cost" of the benefit(s) provided, a limited extra amount to fund incurred but unpaid claims, and a reserve for retiree benefits, reduced by any after-tax income the trust earned. The only retiree benefits for which a reserve can be funded are health and life insurance benefits, according to Sec. 419A(c) (2).

Under Sec. 419(c)(3), a benefit's qualified direct cost in any year is that year's cost of providing the benefit, plus related administrative costs, based on the cash method of accounting. These amounts must be paid into the trust funding the plan before the end of the employer's tax year, according to Temp. Regs. Sec. 1.419-1T, Q&A-10. Thus, the qualified-direct-cost portion of the deduction cannot be accrued, even by an accrual-basis taxpayer.

Although there is no ability to accrue expenses, Sec. 419A(c) allows a deduction for claims that have been incurred, but not paid, at year-end and for a reserve for retiree benefits. Thus, the trust can be used to accumulate assets that will be paid in future years. Determining the amount that can be deducted for incurred-but-unpaid amounts can involve an actuarial calculation. The deduction is an estimate of the claims incurred in the current year but not yet reported to the employer at year-end, plus those filed with the employer but not yet paid to the employee at year-end. It is often determined by reviewing prior-years' claims experience. Sec. 419A(c)(5) provides for a safe-harbor deduction based on a "reasonable for the plan" standard.

Actuarial computation: The determination of the deductible amount for funding retiree medical benefits involves an actuarial calculation that considers the cost of the benefits likely to be paid in retirement, the value of the assets currently held in the trust, the participants' life expectancies and current employees' remaining working lives. According to Sec. 419A(c)(2)(A), the calculation cannot take into account medical cost inflation in estimating future benefit costs. In addition, amounts in excess of the costs likely to be charged by a commercial insurance company insuring these benefits cannot be deducted. However, there are virtually no insured medical products covering future retiree benefits. Thus, while some employers may be tempted to fund amounts sufficient to pay for catastrophic illnesses in retirement, an actuarial determination of funding for those amounts would consider the likelihood that those costs would actually be incurred. This actuarial principle limits the deductible amount to less than what some believe would be needed for retirement.

As with any trust whose funding is actuarially determined, the trust's earnings and the benefits actually paid to participants and beneficiaries may vary from the assumptions used to calculate deductible contributions. Actual earnings that are greater than those used in the actuarial assumptions, and actual benefits paid that are less than those assumed in the calculations, are part of the trust's experience gains and reduce future years' deductible contribution amounts. Similarly, the trust may have experience losses, which would increase deductible amounts in future years.

Caveats: An employer adopting a WBP and funding a trust to provide current and retiree medical benefits should be wary of plans that claim to offer deductions appearing to be considerably in excess of the actual costs an employer would incur if the benefits were insured through a commercial insurance company. Rules to consider include:

* Benefits must be at a level that qualifies as an ordinary and necessary business expense under the general rules for deductible business expenses under Secs. 419(a) and 162 and, thus, for an individual, must constitute no more than an amount that, when combined with other salary and benefits, is reasonable compensation.

* The qualified direct cost of insured death benefits can be based on Table 2001, (1) or another acceptable method of determining the actual cost of the death benefit. (2) Generally, the life insurance benefit's qualified direct cost will approximate the term cost of the death benefits provided.

* A reserve for post-retirement medical and life insurance benefits is funded over the remaining working lives of the employees covered by these benefits. (3) This is an actuarial determination that must be done on a basis no more rapid than a level basis, according to Sec. 419A(c)(2). Death benefits provided through a pre-funded reserve cannot exceed $50,000, under Sec 419A(e)(2).

Key employees: Another important consideration in evaluating whether and how to provide post-retirement medical benefits is the Sec. 419A(d)(2) rule. This rule requires coordination of post-retirement medical benefits provided to key employees with their defined-contribution plan benefits. Under Secs. 419A(d)(3) and 416(i), a "key employee" is any 5% owner, any 1% owner earning more than $150,000 and any officer earning more than $140,000 (for 2006). Benefits for these individuals must be separately accounted for, according to Sec. 419(d)(1). Sec. 419(d)(2) states that deductible contributions to the trust to fund a post-retiree medical reserve are treated as an annual addition to the employer's defined-contribution plan and, thus, cannot exceed the amount that can be contributed to a defined-contribution plan (e.g., a Sec. 401(k) plan), reduced by any amount funded in such retirement plan by such employer for the key employee. For 2006, that amount is $44,000. (4) Thus, for example, if Sec. 401(k) deferrals and contributions to a profit-sharing plan for an employee already equal the maximum for the year, no deductible contribution for that employee for post-retiree medical reserve can be made to a WBP trust. However, there is no required offset for benefits accrued under a defined-benefit plan.

If a given year's contribution exceeds the deductible amount for that year, the excess can be carried over to and deducted in the following year, to the extent that the limits for that year are not exceeded, according to Sec. 419(d).

The employer's deduction limit is reduced under Sec. 419(c)(2) by the WBP trust's after-tax income. If the investment asset does not produce currently taxable income (e.g., cash-value life insurance or non-dividend-paying stocks), no adjustment would be required.

Discrimination

Sec. 419 does not contain discrimination rules. However, the WBP benefits paid by the trust are subject to the discrimination rules that would apply if the benefit were paid directly by the employer to the employee. In addition, exempt trusts would be subject to additional regulatory and statutory rules. (5)

According to Sec. 419A(e)(1), post-retirement medical and death benefits funded by a WBP trust are subject to the Sec. 505(b) discrimination rules. Under these rules, each class of benefits must be provided under a nondiscriminatory classification of employees and, in the case of each class of benefits, the benefits must not discriminate in favor of highly compensated employees. Self-insured health benefits funded in a WBP fund are subject to the Sec. 105(h) nondiscrimination rules; if they meet those rules, they are deemed to satisfy Sec. 505(b). Under these rules, health benefits must benefit at least 70% of all employees, or 80% of those eligible, with at least 70% of employees being eligible. Alternatively, the plan can benefit a nondiscriminatory classification of employees. "Eligibility" allows exclusion of certain classes of employees: workers with three or fewer years of service, those under age 25, those who work part-time or seasonally, those in a collectively bargained plan, and nonresident aliens with no U.S.-source income.

In applying these rules, all employees of a controlled group are treated as employees of a single employer. Thus, under Sec. 414(t), post-retirement life insurance and medical benefits must be provided in a nondiscriminatory manner to all in the controlled group.

If discriminatory benefits are provided, the employer is subject to a 100% excise tax under Sec. 4976 (b)(1)(B). The same tax applies if any assets contributed to a WBP fund revert to the employer, under Regs. Sec. 1.105-2.

Tax Treatment of Plan Beneficiaries

Benefits paid from a WBP trust are subject to the same income exclusion rules that apply to benefits paid directly by an employer. Thus, payment of health benefits to retirees would be tax free, assuming all applicable nondiscrimination rules are met. The ability to pay tax-free benefits makes this arrangement more tax beneficial than a qualified retirement plan. Assets set aside to pay retiree medical benefits can only be used to fund those benefits, although the WBP can be amended to provide for payment of "other" permitted welfare benefits. Amounts would be taxable if, under the arrangement, the employee can be paid those amounts regardless Of whether they incur medical expenses. (6)

If the trust provides a current benefit beyond funding future benefits, those amounts are currently taxed. For example, similar to death benefits in a qualified retirement plan, the value of life insurance protection provided by a WBP trust is currently taxable to the insured individual. For this purpose, the economic value of the life insurance protection is typically calculated using the Table 2001 rates or a valid alternative term rate permissible in split-dollar arrangements. Death benefits payable to the plan participant's designated beneficiary are tax free, under Sec. 101(a)(1).

Trust's Taxation

A WBP trust can be either exempt or taxable. An exempt trust is subject to certain restrictions that do not apply to a taxable trust. (7) Generally, there are requirements involving common employment, under Regs. Sec. 1.501(c) (9)-2(a)(1). There are also administrative issues to consider; for example, exempt trusts need to apply for exempt status within the first 15 months of their existence, under Sec. 505(c). In addition, annual Forms 990, Return of Organization Exempt From Income Tax, need to be filed, under Sec. 6033.

Exempt trusts are subject to unrelated business income tax (UBIT) on trust earnings, under Sec. 512. According to Sec. 512(a)(3), this includes all earnings, less amounts set aside to pay benefits. Under Sec. 512(a)(3)(E), the maximum amount that can be set aside to pay year-end benefits cannot exceed the allowable reserve that can be accumulated to fund such benefits. For trusts funding retiree benefits, the calculation does not allow any adjustment for reserves. Thus, under Temp. Regs. Sec. 1.512(a)-5T, Q&A-3(b), the calculation of taxable income for a trust that includes retiree benefits is the lesser of (1) taxable income or (2) total assets set aside to pay benefits, less any allowable reserve for benefits other than retiree benefits. If the trust funds only retiree benefits for which no reserve can be taken into account for calculating unrelated business taxable income, it is taxed on the lesser of taxable income or the total assets set aside at year-end.

Taxable trusts are not subject to all of the restrictive rules applicable to an exempt trust. (8) However, they do not avoid the UBIT rules. To prevent taxpayers from avoiding current taxation with the use of a taxable trust, Congress provided in Sec. 419A(g) that employers sponsoring such trusts would be subject to "deemed" unrelated business income (UBI). Deemed UBI is calculated in the same way as UBI would be calculated if the trust were exempt. In addition to deemed UBI, a taxable trust would be subject to tax to the extent that taxable income is not distributed or distributable to beneficiaries. (9) In calculating a taxable trust's distributable net income deduction, amounts paid from separate accounts reduce earnings allocated to the separate accounts. To avoid UBIT, many WBP funds invest in assets that do not produce current taxable income (e.g., life insurance or exempt bonds).

Summary

A WBP funded by a trust can provide compelling nontax advantages for recruiting and retaining employees, and significant tax advantages for both employers and employees. Key to taking advantage of the beneficial rules is understanding them. With a basic knowledge of how WBPs work, employers can confidently implement and administer such plans, to the benefit of their workers and themselves.

BY DEBORAH WALKER, CPA, PARTNER, DELOITTE TAX LLP, WASHINGTON, DC, AND MEMBER, AICPA TAX SECTION, AND DANEA M. KEHOE, ESQ., DBK CONSULTING, WASHINGTON, DC

(1) See Notice 2002-8, 2002-1 CB 398.

(2) See Neonatology Associates, P.A., 115 TC 43 (2000), aff'd, 299 F3d 221 (3d Cir. 2002).

(3) See Wells Fargo & Co., 120 TC 69 (2003).

(4) See Notice 2005-75, IRB 2005-45, 929.

(5) See Regs. Sec. 1.501(c)(9)-2 and Sec. 505.

(6) See Regs. Sec. 1.105-2.

(7) See generally, Regs. Sec, 1.501(c)(9)-1 through -8.

(8) See generally, subchapter J of the Code.

(9) See Secs. 641 and 643.