Voluntary Employees' Beneficiary Associations

A forgotten tool in the corporate tax plannerís belt.

August 30, 2007
by John E. Karayan, JD/PhD

Twenty-five years ago, a number of professional services firms set up separate tax-exempt employee benefit trusts — called Voluntary Employees' Beneficiary Associations (“VEBAs”) — and funded them in advance to pay for employee medical benefits. The classic VEBA strategy was for the employer-sponsor (just before its year-end) to pay into the VEBA the present value of the employer’s expected employee benefits cost for the next year.


Some firms — in particular, cash basis ones — thus generated a year-end deduction under Zaninovich, 616 F.2d 429, 432 (9th Cir. 1980). One such firm, then the world’s second largest independent business software and services, was Informatics General Corporation (ICG). Informatics was traded on the New York Stock Exchange and acquired in a leveraged buyout by rival Sterling Software.) A recent letter ruling (LTR 200727017) suggests that this approach still works.

VEBAs fell out of favor in the late 1980s, and have not been heard of much since then. LTR 200727017, which allowed modifications of a VEBA’s key terms, is a reminder that this keen business tax planning strategy might still be an effective tool when optimizing business tax burdens.

Put simply, a VEBA is a Sec. 501(c)(9) tax-exempt “welfare benefit fund” which employers can use to fund otherwise deductible employee benefits (e.g., life, sick, accident, or other medical insurance premiums) for employees, retirees, their dependents, or designated beneficiaries. Like any tax exempt employee benefit plan, no part of the VEBA’s net earnings may inure to the benefit of any private individual. Note that a VEBA is by definition, a qualified retirement trust under ERISA, and thus funds transferred to it cannot be returned to the employer-sponsor, nor are these funds subject to most of the firm’s (or the employees’) creditors.


The primary tax benefits derived from VEBAs are twofold. First is the ability to deduct prepayments of the following year’s employee benefits effectively, as well as deducting back-funding of accrued obligations for certain post-retirement for employee benefits. The second benefit is the ability of VEBAs to earn tax-free returns on investments.

Another tax benefit is that by investing a VEBA’s funds in the same manner that the firm invests its own idle funds, taxable returns can be converted into tax-free returns without the reduced yields of doing this the traditional way: Investing in municipal bonds. One interesting side effect results because the increased after-tax investment returns reduce employee benefits costs. This enhances operating income, in exchange for reducing “other income” from the firm’s investments. This can have a salutary effect on certain ratios, as well as make line managers happy by reducing corporate charge-backs for employee benefits.
Another tax benefit is that by shifting excess liquid assets to a VEBA, corporations can reduce the risk of certain penalty taxes, as well as reduce the cost of these taxes if they are imposed. There are nontax benefits, too.

By shifting liquid assets to a fairly judgment-free entity, firms can make themselves less attractive targets for litigation, union demands or for hostile leveraged buyouts. (As suggested by the Informatics example noted above, VEBAs did not always stop hostile leveraged buyouts.) VEBAs also can reassure executives and key employees that there is less risk that future benefits, such as post-retirement medical expenses, will be reduced or eliminated. This can be of great interest in some industries, such as car manufacturers.

Downfall of VEBAs
Why did VEBAs fall out of favor? Experts say some tax planners took the concept a little too far. The IRS rightly prevailed — and did a superb job of publicizing the fact — in several instances where cash-basis employers attempted to deduct prepayments of several years of expected benefits. Ardor for VEBAs cooled further when Congress stepped in.

After 1985, IRC Secs. 419 and 419A imposed strict limits on pre-funding. Employer payments to VEBAs are deductible when paid, but only if they are otherwise deductible and subject to the extent allowable under Secs. 419 and 419A. Under Sec. 419, current deductions generally are limited to an amount necessary to provide benefits for no more than the next taxable year — called the “qualified direct cost” — plus an addition to a “qualified asset account,” up to an account limit as set forth in Sec 419A, minus the fund's after-tax income.

A fund's qualified asset account consists of any assets set aside to provide for the payment of (1) disability benefits, (2) medical benefits, (3) supplemental unemployment compensation benefits or severance pay benefits or (4) life insurance benefits. Under Sec. 419A(c)(1), the account limit for any qualified asset account for any taxable year is the amount reasonably and actuarially necessary to fund claims incurred but unpaid (as of the close of the taxable year) and administrative costs with respect to those claims.

Section 419A(c)(2) provides that the account limit for any taxable year may also include a reserve funded over the working lives of the covered employees and actuarially determined on a level basis as necessary for (a) post-retirement medical benefits to be provided to covered employees or (b) post-retirement life insurance benefits to be provided to covered employees.

There is a silver lining to the cloud of Secs. 419 and 419A. They make it clear that employers can still use VEBAs to deduct prepayments of the net present value of the employer’s expected (otherwise deductible) employee benefits cost for the next year. In addition, pre-funding can also be deducted for reserves to cover post-retirement medical and life insurance benefits. Nevertheless, closely-held firms need to tread carefully with VEBAs.

Another excess which the IRS hammered away at during the 1980s, was the attempt by some closely-held firms — in particular one-doctor medical corporations — to use VEBAs as a family “slush” fund free from the nettlesome attention of creditors. This approach was rejected by the Tax Court in Sunrise Construction Co., Inc., 52 TCM 1358 LK:NON: TCM-LINK DEC43625(M), aff’d, 9th Cir. (unpublished opinion, 11/21/88). The case held that a VEBA could not merely be a separate fund controlled by a sole shareholder-employee for his own benefit. Similarly, Rev. Rul. 85-199 LK:NON: RULINK REVRUL85-199, 1985-2 CB 163, held that a VEBA could not effectively benefit only owner-employees. This case dealt with a professional corporation using a VEBA for the appropriate purpose of providing life, sick, accident and other benefits to its employees. Although all employees of the professional corporation were eligible to be members of the voluntary employees' beneficiary association, the corporation had only one employee, who was also a shareholder and an officer of the corporation.


Although VEBAs fell out of favor over the past quarter-century, they still can serve as an effective tool for optimizing business tax burdens. Provided the requirements of IRC Secs. 419 and 419A are attended to, VEBAs can be used to deduct prepayments of a year’s worth of many employee benefits as well as back funding of for reserves to cover post-retirement medical and life insurance benefits. VEBAs certainly are a tool to hang on the corporate tax planner’s belt.

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John E. Karayan, JD/PhD is Professor & Chair of Accounting at Woodbury University, and a testifying Expert Witness in complex business litigation on accounting and tax issues.