VEBA - Voluntary Employees Beneficiary Association

WHAT IS A VEBA?

VEBA, which stands for Voluntary Employees Beneficiary Association is a tax-exempt organization that is described in Section 501 (c) (9) of the Internal Revenue Code of 1986. Also called welfare benefit plans, VEBAs have been around since 1928. A VEBA must have an independent third-party trustee, usually a bank. A VEBA receives a letter of determination from the Internal Revenue Service to operate as a tax-exempt trust. Contributions to a VEBA are tax deductible, and earnings are exempt from tax. Distributions can be taken from a VEBA prior to age 59 1/2 without penalties. You can also contribute and tax deduct much more than $40,000 per year. While many professionals are concerned about the claims of creditors, VEBA assets are free from the claims of creditors.

VEBAs can provide benefits such as:
life insurance,
accident insurance,
sickness insurance,
disability Insurance,
salary continuation benefits,
Retiree medical benefit,
medical benefits,
medical reimbursement payments,
Catastrophic medical benefit,
long-term care benefits,
educational benefits,
College education benefit,
children's educational benefits,
Pre-retirement death benefit,
Post-retirement death benefit reserve,
Severance pay benefit,
and other benefits to members of the VEBA, or their dependents or beneficiaries.

For Frequently Asked Questions about VEBA's Click Here

What you contribute in any given year is not subject to limitations like a 401K or IRA. In one case the IRS contested in 1992, a Midwest physician named Joel Schneider (Schneider vs. Commissioner) operated his medical practice with only one other employee. Over a three year period, Dr. Schneider contributed over $1.1 million to his VEBA to fund over $4.5 million in life insurance, disability insurance, and a tax-deductible education fund for his three teenage children. Over 98% of the deduction was attributable to benefits covering Dr. Schneider. The IRS audited him and they went to Tax Court, and Dr. Schneider prevailed!

Similarly, the IRS lost in a case called Moser v. Commissioner. There, the Tax Court upheld a deduction of $200,000 taken by the Mosers, although this represented full funding of their severance benefit in one year. The Court commented that prudent business practices often compel an employer to fund a VEBA with large contributions during years of good earnings, because money may not be available in bad years.

The simplest way to use the benefits of a VEBA is to join an existing, multi-employer VEBA which already has an IRS letter of determination. A multi-employer VEBA can be adopted by almost any business for the benefit of its employees, including owner-employees. An employer with one employee (even his or her spouse) can have a VEBA.

The investments of a VEBA are generally of low risk, and are generally held by major insurance companies that are highly rated. Contributions and benefits are based on sound and conservative actuarial assumptions. Part-time employees and employees with less than three years service can usually be excluded.

Estate Conservation

One of the most attractive benefits of a VEBA is that by working with an attorney, a VEBA can be designed so that the benefits paid from the VEBA will not be exposed to estate taxes. This is because the participants will have no "incidents of ownership" in the assets, including life insurance contracts held under the VEBA. This is because:

The VEBA is the owner and beneficiary of all insurance contracts.
The participants have no vesting in any insurance contract other than the right to purchase an individual conversion policy upon termination of employment.
The plan prevents any reversion of assets to the employer, meaning the sponsor has no ownership rights in the plan.
Each participant can make an irrevocable designation of beneficiary, usually a trust for the benefit of a spouse and/or children.

If a VEBA is terminated, all assets held under the VEBA are allocated to those people who were active participants in the plan on the date of termination. There's no vesting in the funds for employees who terminate prematurely.

Who should have a VEBA?

Because of the potential benefits of a Section 501 (c) (9) VEBA plan, the following businesses and business owners should consider establishing a VEBA:

Physicians, Dentists, Performers, Athletes, Professionals of all kinds.
Individuals who want to shelter excess proceeds from a sale of a business
Individuals who want to solve Estate Tax problems
Individuals who want to fund buy/sell insurance on deductible basis
Profitable businesses that want a way to reduce their tax liabilities.
Profitable businesses that want a way to reduce their retained earnings through VEBA contributions.
Companies that no longer make contributions to their qualified retirement plans because the plans are over-funded and/or plans that no longer favor the business owner.
Individuals with estate tax problems who wish to reduce or eliminate estate and inheritance taxes.
Businesses and individuals who want to protect their assets from creditors, especially individuals who are in high-risk businesses.

VEBAs are especially useful in times of great income fluctuation. For example, a law firm wins a big verdict, or a medical client group sells its practice to a large provider. Either situation nets the group cash and a huge taxable gain. If the members of that group continue in some type of practice or business, no matter how extensive, VEBAs can be designed with large contributions to offset the otherwise unavoidable tax burden. A single group could implement multiple VEBAs to accomplish the varying objectives of individual members.

Most importantly, VEBA assets are completely exempt from creditors' claims (subject, of course, to that old tool called fraudulent conveyance). One court held that the exemption extends to spousal claims, because the VEBA benefit is purely a contingent expectancy interest.

VEBA effects on Employee Termination

A multiple employer VEBA allows large, flexible deductible contributions with tax-deferred accumulations. It is available to almost any type of business entity, and favorable to the business owner. During its operating life, VEBA benefits are payable only when an event occurs that triggers the benefit. Unlike a retirement plan, there is no vesting. Therefore, employees who voluntarily terminate are not usually entitled to any part of the VEBA pot. The recent Seventh Circuit case of Wellons v. Commissioner illustrates the potential problems of providing a severance benefit upon voluntary termination. It could be recharacterized as nondeductible deferred compensation.

In contrast, if the employer chooses to fund a severance benefit upon involuntary termination (for example, if the company fires or lays-off a participant due to conduct or business reasons, like dissolution), exposure of the VEBA can be limited. Unlike most Employee Benefits, employees with less than three years of service, Over age 21, Greater than 1000 hours of service per year, Union employees, Non-resident aliens may be excluded from participation so most businesses are able to weed out problem employees and minimize potential mis-use of a severance benefit. VEBA assets are free from the claims of creditors, and life benefits can pass free of income and estate taxes. There are no penalties for early distribution.

After many years, an employer may find that a VEBA is no longer necessary. The employer would withdraw from the multi- employer plan. The plan then terminates for that employer, and current participants receive a distribution (usually, the cash values of policies) based upon cumulative salary during all years of participation. Let's say that our merchant participated for 10 years at an average salary of $195,000 for cumulative compensation of $1,950,000. Meanwhile, due to turnover, his $25,000 employee was only with him for 5 years. Since the employee was not eligible to participate until after 3 years of service, the employee had cumulative compensation of $50,000 (2 years @ $25,000). The assets in the VEBA would be distributed in the following proportion: merchant, 97.5%; employee, 2.5%. No other qualified plan permitted by present law can achieve this result.

The impact of this is demonstrated in this example. A law firm wanted to contribute approximately $440,000 annually to a VEBA. There were 5 partners and 30 staff (attorneys and clerical). Average annual earnings were approximately $520,000 per partner and $50,000 per staff person. Staff turned over at the rate of 8 persons per year. This plan assumed severance payments of $150,000 annually after year 3. Assuming that no one died, it was calculated that a termination distribution occurring ten years later would provide $5,170,000 to the partners (95.86%) and $700,000 for staff (4.14%). Of course, this would be taxable at ordinary income rates in effect at that time. In the meantime, the life insurance coverage was free as the government paid for it in the form of tax benefits.

To avoid taxation of the VEBA money and to preserve the estate planning value of the coverage in the plan, the VEBA could be amended to assume some or all of the firm's benefit commitments, like health care coverage. We predict that VEBAs will turn out to be life savers in the future if trends in heath care costs continue hopelessly upward. Relieved of the VEBA contribution, the firm would have sufficient earnings to fund a salary continuation plan for partners who terminate.

Aside from assuring current and long-term protection, cash value insurance serves the secondary purpose of providing a source for future benefits that are funded with today's deductible dollars. This tax-deductible benefit is then integrated into the client's estate plan for maximum effect. It is important to understand that the amount of the death benefit is probably more than most people would purchase for themselves using after tax dollars.

A properly designed multi-employer VEBA trust provides unlimited potential for achieving financial goals. Unlike a retirement plan, there is no $30,000 deduction limit. There are no penalties for distributions prior to age 59 1/2 or after age 70 1/2. There are no 15% excise taxes for excess accumulations or insufficient distributions. Unlike a pension plan, at death, a VEBA death benefit is completely exempt from income taxes. Additionally, the benefit can be structured to avoid all estate taxes. There are no gift taxes payable on contributions to a VEBA trust. and a VEBA can (and should) be established in addition to a pension plan. Because of these advantages, VEBAs can be beneficial for profitable businesses, professionals, entertainers, athletes and physicians.

Unlike a retirement plan, the cost of benefits for each participant is not relevant focus in determining whether a plan is nondiscriminatory. In fact, the designer of the plan "backs into" the benefit structure after inquiring what the firm wants to put away each year. The primary requirement is that benefits for all eligible employees be calculated with the same multiple of compensation. The benefit calculation can take into account only $150,000 of annual compensation. Thus, a merchant making $195,000 who desires a life benefit of 10 times compensation is limited to $1,500,000 of benefit. He must provide the same multiple for a $25,000 employee ($250,000 in coverage). The employee's benefit can be funded with inexpensive term insurance (about $300 for an unrated person under age 35). In contrast, the merchant's benefit is most often funded with cash-value insurance, the cost of which absorbs the lion's share of the desired level of annual contribution to the plan. The Eleventh Circuit case, American Association of Christian Schools, confirms that in the realm of VEBAs, the cost of benefits is immaterial when testing for prohibited discrimination. Proportionality of benefit amount is the test for discrimination.

Beware of VEBA Look-Alikes

There are trusts available that look like VEBAs, but are not. They have not received a determination letter from the IRS. The trust sponsor may not have taken the additional costly step to file the trust with the IRS, as permitted by Internal Revenue Code 501 (c) (9). By acquisition of a Favorable Letter of Determination from the IRS, the VEBA program has the approval of both Congress and the IRS.

When dealing with such matters, employers and plan sponsors should obtain an opinion letter from a tax attorney with regard to those issues that remain unclear. The large deduction available through the use of a properly constructed multiple employer VEBA must be weighed against the possible downside risks associated with the look-alikes. In the present environment, and because of the large deductions available, it is unwise for some businesses and professional practices to deal with anything other than properly structured multiple employer VEBAs. Unfortunately, there are many defective programs out there. Beware of the so-called "419 Plans" and "Taxable Welfare Benefit Trusts" that promise VEBA benefits without complying with the VEBA rules. Demand a legal opinion on how the multi- employer plan avoids experience rating and why it qualifies as a single plan. Experience rating relates to the ability of the plan to demand additional contributions from an employer if claims relating to that employer exceed assets contributed by that employer.

Ask for an IRS letter. Only VEBAs can get them. Non-VEBAs cannot. The determination letter provides comfort as to form of a trust and ammunition against the IRS in audits. For example, the VEBA regulations prohibit a VEBA from containing a deferred compensation benefit. This author believes that once a VEBA receives a favorable determination letter, and is operated accordingly, the benefits described therein (including severance) are immune from attack as deferred compensation. The IRS letter does not, however, provide any guidance on the amount of a deduction.

VEBAs are generally appropriate for employers who desire to provide additional benefits over and above retirement benefits to their employees (and obtain additional tax deductions for providing such benefits). More and more frequently professional corporations have adopted VEBAs as a supplement to their existing benefit programs. In addition, they are appropriate for those employers who desire to provide excellent benefits to their employees, but prefer slower vesting and benefit accrual rules than those provided under qualified retirement plans.

Because of administrative costs associated with this type of program, it is generally a good idea for employers with 10 or fewer employees who desire to make substantial contributions to the plan ($40,000 or more annually). CONSULT your Financial Planner, Attorney or tax adviser before making any tax-related investment decision.

For Frequently Asked Questions about VEBA's Click Here