A recent private letter ruling from the Internal Revenue Service (IRS) permits the use of a tax-effective method for funding retiree medical obligations. Due to the escalating costs of retiree medical obligations, many employers are searching for better ways to fund their obligations. Employers often fund retiree medical obligations through a trust known as a voluntary employees’ beneficiary association (VEBA). Employer contributions to a VEBA are deductible under the Internal Revenue Code (Code), subject to certain limitations. However, a VEBA can generate taxable income for the employer and the VEBA itself. The ruling provides a method for avoiding these unfavorable tax results.
Under the facts of the ruling, the VEBA will purchase a non-cancelable group retiree health insurance policy from an insurance company. The policy will be purchased by the VEBA. Under the policy, the insurance company will reimburse the VEBA for specified health benefits paid by the VEBA to retirees and their dependents who are covered by the employer’s retiree medical plan. The policy will not provide medical benefits directly to covered individuals. Instead, the individuals will be paid benefits by the VEBA, and the VEBA will then be reimbursed by the insurance company.
The premiums paid by the VEBA for the policy will be held and invested by the insurance company in a separate account, which will fluctuate in value depending upon investment performance. The insurance company will guarantee a policy fund equal to market value less certain fees and reserves. If any assets remain in the separate account after the VEBA has no more retiree medical obligations, the assets would be paid to the VEBA and could be used to provide other benefits (as permitted by the VEBA).
The IRS ruled that the benefit payments made to the VEBA by the insurance company will be excluded from the VEBA’s gross income (used to calculate the VEBA’s taxable income). In addition, the IRS ruled that any income in the insurer’s separate account will not result in taxable income to either the employer or the VEBA. The IRS did not rule on the tax treatment of the contract premiums.
The private letter ruling discussed herein was obtained by McDermott Will & Emery on behalf of one of our clients. While the ruling applies only to this particular client, it likely will be of interest to employers with existing VEBAs. The ruling is Private Letter Ruling 200404055 and can be found at www.irs.gov/pub/irs-wd/0404055.pdf.