IRC

419(e) Q&A

IRC §419(e) Single employer welfare benefit plans

1: What is a single employer welfare benefit plan?

Single Employer Welfare Benefit Plan (referred to as "Plan") is a plan that has been established by an employer for the benefit of its employees. The plan generally provides for the payment of life, sickness, accident or other benefits to its members or their dependents or their designated beneficiaries. A Plan is formed as a trust, generally having as its trustee a bank or trust company, and administered by a common plan administer.

2: How does a single employer plan differ from a multi-employer trust?

A Multiple Employer Welfare Benefit Plan is a welfare benefit plan which is part of a 10-or-more employer plan and which qualifies for a special treatment under I.R.C. §419A(f)(6). In order for a Plan to qualify, it must be a plan to which at least 10 employers contribute, and to which no single employer generally contributes more than 10% of the total contributions made by all employers, and in addition is not "experienced-rated". The Plan described in this Tax Guide is not a Multiple Employer Plan, and therefore is not qualified under these special rules.

3: What authority in the I.R.C. permits favorable tax treatment of a single employer plan?

4: Is a single employer plan subject to the new IRS final regulations covering welfare benefit plans under IRC §419A(f)(6)?

No. The IRS Final Regulations released on July 16, 2003 apply only to multiple employer welfare benefit plans that seek exemption from the restrictions of IRC §419 and IRC §419A, but since these Plans are not subject to those rules, exemption is not needed. Therefore, compliance with the Final Regulations is not necessary.

5: Is a single employer plan subject to the IRS rules for qualified retirement plans?

No. A Plan is not qualified retirement plan subject to the rules of I.R.C. 401, which is the governing law for that type of plan, because it does not fit that definition of a retirement plan. A Plan will not file a request for determination with the IRS under that section, because it is not a retirement plan but rather is a plan that provides current benefits. It is therefore not subject to the voluminous body of law governing retirement plans, and is not subject to restrictive rules under which those plans must operate.

For example, the Plan distributions are not subject to the rules for premature withdrawal penalties (prior to age 59? ) nor are they subject to the minimum distribution rules for late withdrawals (beginning at age 70?). More importantly, a Plan is not subject to the maximum limitation of $40,000 under IRC§415. A properly structured Plan does not have to be concerned with compliance with the pension rules, and with constant updating of plans as the tax law continually changes in that area. A plan is also not subject to the $225,000 (indexed) salary cap for benefit computations, nor the affiliated service company or controlled group rules.

6: Is a plan subject to the rules of ERISA?

Yes. A Plan that receives employer contributions and covers common-law employees is subject to Title 1 of ERISA (the Employee Retirement Income Security Act of 1974) in particular those rules that apply to employee welfare benefit plans. Under these rules, the employer must prepare a Summary Plan Description, to be filled with the Department of Labor and distributed to the plan participants. Additionally, the trustee must generally file IRS Forms 5500 annually, to report on the financial aspects of the Plan. The trustee of the Plan is subject to all of the fiduciary, disclosure and reporting rules of ERISA.

7: What type of business should be considered when adopting a plan?

1. A profitable business (C Corporation, S Corporation, partnership, or LLC), that is seeking a way to reduce its tax liabilities and to provide benefits to its employees, including owner-employees.
2. Companies that can no longer make contributions to their qualified retirement plans because the plans are over funded.
3. Companies that have pension plans which no longer favor the business owners, due to the $225,000 (indexed) cap on compensation.
4. Businesses and individuals who would like to protect their assets from creditors, especially individuals who are in high-risk businesses (e.g. surgeons, real estate developers, manufacturers).

8: Can a sole proprietorship adopt a plan?

No. A single member LLC may only adopt a WBP if it elects to be taxed as a corporation and is not the equivalent to a sole proprietorship.

9: Must there be more than one employee participating in the plan?

Yes, if a majority shareholder is a participant there must be at least one other non-shareholder participant as long as the participants names are part of a select group of management of highly compensated employees, D.O.L. regulations 2520 104.20.

10: How is  a plan organized?                                                                     top

A Plan may be organized as one of two types of legal entities, either a trust or a non-profit corporation. Although either entity will qualify to operate a Plan, in practice the trust form is almost always used, and in most instances a bank or trust company serves as the trustee. In practically all cases, the employer establishes its participation in the Plan by adopting an existing Trust that has been organized by a sponsoring organization, where the individual Trusts are under common administration and held by a common Trustee.

11: Who can qualify to join a plan?

Participants must consist of individuals who have become entitled to participate by reason of their being employees. To be an employee, generally you must receive W-2 compensation. The employer members who have adopted the Trust do not require any particular attributes, other than being corporations (C or S type), LLCs, or partnerships.

12:Are there any  geographic restrictions of a plan?

No. The IRS Regulations relating to VEBAs are not applicable to a Plan, and therefore there are no geographic restrictions.

13: Do all of the participantes of the plan have to be employees?

The IRS Regulations relating to VEBAs are not applicable to a Plan, and therefore those provisions that allow some VEBA participants to be sole proprietors are not applicable to a Plan. Participants must generally be employees. See questions 14, 15, and 16 for exceptions.

14: Can non-employee be participants of the plan?

Generally, only employees can be participants.

15: Can retirees and other former employees be plan participants?

Yes. If the Plan is designated to permit it, former employees with ten years of plan participation that have met the eligibility requirements can be participants.

16: Can spouses be plan participants?

Spouses of active employees cannot be Plan participants although they can receive Plan death benefits in the instance of survivorship or second to die life insurance.

17: Is there any requirements that plan membership must be voluntary?

Eligibility employees may elect to participate. Participation is voluntary. Only management and highly compensated employees are eligible.

18: Who may control the plan?

A Plan must be controlled by any of the following:

1. an independent trustee, such as a bank: or
2. trustees selected by the employer

As a general rule, in order to operate conservatively, an independent bank trustee should be appointed in all cases.

The tax requirement of control by an independent trustee is deemed satisfied if in the Plan is an employee welfare benefit plan subject to ERISA. The employer cannot exercise substantial control, as a fiduciary, under the Plan.

19: What benefits may a plan provide?

A Plan may provide the following benefits:

1. Life benefits- payable on the death of a participant or dependent. The death benefit should be provided through life insurance. Pensions, annuities and similar benefits cannot be included.
2. Sickness and accident benefits- these include medical benefits and disability income benefits, whether insured or uninsured. There can also be benefits in non-cash forms, such as clinical care by clinical nurses and medical care transportation.
3. Other benefits- these benefits are intended to safeguard or improve the health of a participant or his or her dependents, or to protect against a contingency that interrupts or impairs a participant's earning power. These may consist of vacation and recreational benefits, childcare facilities, severance benefits, disability benefits, educational benefits, disaster loan and grants, and loan services benefits.

If any post-retirement death or medical benefits are provided, the Plan must be non-discriminatory. (See Appendix)

The IRS has established additional rules in the VEBA Regulations as well as in case law, dealing with the concept of "prohibited increment". It is possible that this VEBA case law could apply equally to a Plan.

The Plan's governing document must provide that no assets remaining will be returned to the employer that contributed to it; otherwise, the Plan will fail to qualify.

20: What is the tax status of a plan?                                                          top

The Plan is not exempt from income tax, since it does not request nor does it receive an IRS exemption letter under I.R.C. §501(c)(9). Further, it is still subject to the deductible contribution limits under the I.R.C. §419A, because it does not qualify as a multiple employer plan under I.R.C. §419A, because it does not qualify as a multiple employer plan under I.R.C. §419A(f)(6).

21: May a plan discriminate in favor of highly compensated employees?

Yes. The Plan may be designed to avoid the restrictive non-discriminatory rules under I.R.C. §505(b). The Plan may be designated as a "Top Hat" Plan as defined as in the DOL Reg. 2520-105, as exempt (assuming post-retirement medical is not a Plan benefit).

22: What is the maximum compensation that may be used as a base for plan benefits? 

There is no compensation limit, such as the $225,000 (indexed) restriction in a VEBA, since the Plan may be designed to avoid the rules of §505 (b). This means that all compensation can be used as a base for benefits in a Plan, without the need to limit compensation to $225,000 or any other figure.

23: Can a plan secure an IRS approval letter of tax-exempt status?

No. A Plan is not a tax-exempt organization, and is therefore not entitled to receive a determination letter of tax-exempt status from the IRS. This means that all income earned by the assets in the Plan is subject to current income tax. As a result, most benefits are funded by tax advantaged investments like permanent life insurance.

24: What is the latest date for an annual plan contribution to be made so that it is tax deductible? 

A Plan contribution that is made by the last day of the calendar year, or the last day of the employer's fiscal year if other than the calendar year, is deductible in that year. This result assumes that the employer reports its income on the cash basis. In the event that the employer reports on the accrual basis, the contribution is deductible provided all necessary documentation is completed be the last day of the year, and the Plan contribution is made no later than 75 days after the end of the fiscal year. In order to secure the deduction in either case, the adoption agreement and all other ancillary documents must be completed, executed and forwarded to the Plan trustee by the last day of the employer's year.

25: Do the participants in a plan realize current taxable income? 

When death benefits are provided through a welfare benefit fund the Treasury Regulations (1.61-22(c)(i)(iii)(c)) applicable to split dollar life insurance arrangements apply when the fund owns permanent policies of life insurance for the benefit of employees and death benefits are payable from the fund to the employees' designated beneficiaries. In this case the participants must take into gross income each year the current cost of the death benefit coverage provided to them for current tax year, the policy cash values for the year they are made available and the economic benefit value of any other benefit made available to the participant during the tax year. Cash values are generally not available so the split dollar rules require the participant to pay tax value of the death benefit using Table 2001 rates.

26: How are the participants taxed upon the receipt of their plan benefits? 

The death benefit paid by the Plan to the participant's beneficiary is income tax free under Code section 101(a) because a life insurance policy funds the benefit and each participant takes into income the economic value of the Plan's death benefit each year (i.e. Table 2001 value).

27: What is the funding method for the death benefit?                              top

The death benefit is generally funded by the proceeds of a permanent or ordinary life insurance. The type of insurance contract that is used is flexible, and it may consist of a fixed, variable, universal or any other type of insurance.

The insurance contracts may be set up so that the death benefit portion of the annual premiums will constitute "qualified direct costs", as defined in the 419?(1). An annuity should not be utilized.

28: What happens upon the death of a participant?

In the event of death of the participant, the death benefit is paid to the trustee, who will distribute those proceeds to the participant's beneficiary, under the terms of the beneficiary designation which the participant executes and which is on file with the trustee, administrator and the insurance company.

29: Are there any income tax consequences to a participant's beneficiary when the proceeds of the policy are received? 

No. I.R.C. 101(a) provides an income tax exclusion for benefits payable under a life insurance contract because of the death of the insured. In the case of a Plan death benefit, the benefit is payable because of the death of the insured. Failure to report the Table 2001 value of the death benefit would cause the policy death benefit to be income taxable.

30: Are there any estate tax consequences to participant upon death and payment of the proceeds of  the policy? 

Yes. Insurance is taxable for estate tax purposes, provided that the insured possessed any incidents of ownership, or had the right to designate the beneficiary of the policy. Under the ordinary circumstances, all life insurance is includable in the estate unless some action is taken to insulate it from taxation.

31: Upon termination of the plan, how are the funds paid out to the participants?

The policy is distributed to the participant. The participant is taxed on the fair market value minus any period amounts included in income.

32: How safe are the plan assets against claims of creditors of the employer or the participants? 

The employer has no interest in the assets in the Plan trust. The employer has no ownership of the fund, and under the terms of the Plan the employer has no right to have any of the assets revert to the employer. Therefore, the assets of the Plan are not subject to the employer's creditors. Similarly, the participants have no current interest in the funds in the hands of the Plan trustee, which is an independent trustee not under control of the participants. Therefore, the Plan assets will not be subject to claims of creditors of any of the parties to the Plan.

33: Can a plan provide a severance benefit?                                             top

Yes, it is possible to provide a severance benefit in a Plan, not to exceed two times the participant's annual compensation but this benefit is not likely to produce much of an employer deduction.

34: Can a plan provide an educational benefit?

Yes, but it is questionable whether this type of benefit would be advantageous for the business owners. This type of benefit cannot be provided on any method that is proportionate to salary, since educational benefits do not constitute income replacement benefits under the IRS rules. Therefore, the educational benefit must be made available to all employees on a nondiscriminatory basis. This could cause a serious problem, if some of the employees who are not owners have children who are attending private schools, colleges or graduate schools, since the educational benefit could be severely diluted. Therefore, this type of benefit, while allowed by the IRS rules, is not generally recommended.

35: Can a employer maintain both a plan and a qualified retirement plan and make deductible contributions to both plans? 

Yes. There is no reason why both plans cannot operate in tandem in the same company, because each accomplishes its own separate purposes. One is for providing life insurance benefits, whereas the other is aimed at providing for retirement benefits. A Plan should not be considered as a replacement for qualified plan, but rather as a separate plan to accomplish another goal.

If an employer maintains an existing qualified retirement plan, that plan should be continued after adoption of a Plan, so that it is clear that the purpose of installing the Plan is not a supplant or replace the retirement plan. If the retirement plan has life insurance as one of its investments, consideration may be given to terminating the insurance portion of the retirement plan, once the life benefit in the Plan becomes effective.

36: What are the distinctions between a plan and a veba? 

A VEBA is a tax-exempt organization that receives a favorable determination letter from the IRS, in which the IRS determines that the organization is exempt from the current income tax under I.R.C. §501(c) (9). A Plan does not fall within this exemption of the Code, and therefore does not request a §501(c)(9) exemption letter.

The following are the differences between the two plans, other than the tax treatment of income within the trust.

1. A VEBA is subject to the $225,000 compensation limit, for the computation of multiple of compensation benefits; a Plan has no limitation on compensation that can be utilized in computing that multiple.
2. A VEBA must comply with the employment-related affiliation rules and the geographic limitation rules (3-state safe harbor); a Plan can be installed for any type of business location in any geographic area, with no particular relationships.
3. A VEBA is subject to the controlled group rules and affiliated services group rules, and must cover all employees of all such related groups; a Plan must cover only employees of its own business entity, and need not cover controlled groups of affiliated services groups.
4. A VEBA is subjected to the non-discriminatory rules of 505; a Plan is subject only to the test of reasonableness in developing a rational method of excluding certain categories of employees, so long as that method is based upon some logical business purpose.

Other than the above distinctions, both the VEBA and the Plan are of the same generic derivation, both being employee welfare benefit plans, both established for the purpose of providing lifetime benefits to employees and both having similar operating rules and regulations under 419 and 419 A of the Code.

37: In summary what are the tax and economic advantages of adopting a plan? 

(1) Tax Advantages:

1. The employer obtains a current income tax deduction for the contributions made to the Plan to provide for the costs of furnishing the benefits for its employees who are participants
2. The participants are required to pay the current economic benefit which is usually lower than the total life insurance premiums paid by the employer;
3. The benefits of the Plan may be structured by appropriate estate planning as to escape taxation at the death of the participant.

(2) Economic Benefits:

1. The assets of the Plan should be exempt from creditors of both the employer and the participants, since they do not possess title or ownership interests in the funds;
2. The employer can provide for the life insurance needs of the participants;
3. Contributions consist of the qualified direct costs of the life insurance;
4. The investments of the Plan can be limited to policies issued by major insurance companies that are highly rates;
5. There are no restrictive rules regarding early distributions or late distributions, since no distributions are intended;
6. There are no specified limits on the amount of contribution, other than those limitations provided by sound and conservative actuarial concepts;
7. The plan prohibits any reversion of assets to the employer, since all funds must be utilized for the benefit of employees.

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Contributions made by employers to fund the post-retirement life or medical benefits require the Plan to be non-discriminatory both in terms of coverage and benefits.

2: What does non-discrimination mean in terms of employee coverage? 

The Plan benefits such employees as qualify under a classification set up by the employer and found by the Secretary not to be discriminatory in favor of highly compensated employees. For coverage purposes there may be excluded from consideration for eligibility employees who have not completed three years of service, part-time employees who work less than 35 hours per week, seasonal employees who work seven months a year or less, employees who have not attained age 25, union employees subject to a good faith collective bargaining agreement. §105(h)(2)(A)

3: What impact does that addition of a post-retirement medical benefit have on an employer's defined contribution retirement plan?

Contributions made by employers to fund post-retirement medical benefits for key employee are aggregated for purposes of Code section 415 testing. The 415 aggregation rules do not seem to apply if the employer does not contribute to a defined contribution plan for key employees.

4: What is the amount of the employer's deductible contribution to the plan?

The employer's contribution paid or accrued to the Plan is deductible for the tax year up to the plan's "qualified cost" and reduced by any "after-tax income".

5: What are the components of "qualified cost"?

There are two parts to the "qualified cost". The "qualified direct cost" which is the actuarially certified cost of the plan benefits for a respective tax year. The second piece is the annual "addition" to the "qualified asset account". This amount is essentially the contribution to pre-fund future benefits and goes into the Plan reserves. The amount is also actuarially certified as being correct within the plan "account limit" for the taxable year. §419A(c)(1).

6: May the employer contributions vary with post-retirement medical benefit added to the plan?

Contributions to the Plan are based on reasonable actuarial principles and are certified by the Plan actuary. Contributions may vary from year to year and are designed to ensure each employee's policy of insurance contains a cash surrender value at entitlement age equal to the sum of money necessary to pay that employer's and employee's spouse and legal dependents (if applicable) covered post-retirement medical expenses for their remaining expected lifetimes.

7: Does the addition of post-retirement medical change the type of life insurance policy that may be chosen as the funding vehicle?

Per TAM 200511015 the IRS approved the purchase of a (variable) permanent life insurance policy to fund post-retirement medical benefits. The face amount of the policy may be substantially less and the cash surrender value substantially higher in the early years compared to a plan using life insurance to fund a death benefit only plan benefit with no other plan provided benefits.

8: How are post-retirement medical claims paid?                                      top

Post-retirement medical expense benefits for key employees must be held in separate accounts and accounted for in the policies of insurance held in the Plan. Benefits paid in response to post-retirement welfare benefit claims are paid from the policy cash values. These payments will cause the participant to forfeit future death benefits under the Plan because cash withdrawals reduce the death benefit.

9: When is an employee eligible for a post-retirement medical expense claim payment? 

The Plan provides that post-retirement medical expense benefit entitlement is limited to participants who actually reach a stipulated retirement age and fulfill a minimum number of years of plan participation.

10: Are employer contributions subject to a vesting schedule like a qualified retirement plan requires? 

There are no vesting rules for the funding of post-retirement benefits. Participants who terminate before the entitlement date forfeit 100% of any contributions put into the fund on their behalf. Any forfeitures reduce future actuarial expense calculations or increase benefits.

11: What is the tax treatment of medical reimbursement payment to the participant?

Payments made to a participant to reimburse medical expenses or provide medical care to the participant and the participant's spouse and legal dependents paid by the Plan are not included in the Participant's gross income, even if the plan is funded solely with employer contributions.

So long as the non-discrimination rules are satisfied, an employer may create a welfare benefit fund to reimburse medical expenses for active and retired employees and their legal dependents and the benefits received will not be included in their gross income.

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