419(e) Welfare Benefit Plans and Trusts 419e

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UPDATE: In October, 2007, the IRS issued new guidance for 419(e) Welfare Benefit Trusts that effectively eliminated certain benefits for plans funded with cash-value life insurance, see below and on the website of Riser Adkisson LLP.

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419(e) Welfare Benefit Plans

The term "419(e) plan" refers to a plan that qualifies under paragraph (e) of Internal Revenue Code Section 419, which provides for the treatment of funded welfare benefit plans.

A 419(e) plan is an employee benefit program that is sponsored by the employer and which provides welfare benefits to its participants. It is a "single employer" welfare benefit plan, meaning that all of the employee benefits are paid for by the same company. There is no pooling of benefits among the employees of various companies. Since Welfare Benefit Plans are for the benefit of employees and the business owners, the assets in the plan should not normally be available to creditors of the business.

The plan typically involves an independent trustee that holds the trust assets, and a third-party administrator that arranges actuarial certification of funding and benefits, and approves plan administration.

Cash contributions are made irrevocably to the trust without the possibility of reversion. They are determined actuarially based on an annual census using projected retirement ages of all employees and projected medical costs from retirement through actuarial death. The sponsoring employer may choose a target contribution or a target benefit. Contributions on behalf of key employees are kept separate from contributions for rank-and-file.

This type of plan allows a company a suite of benefits to its employees – including the owners of the business – ranging from death benefits during their working years to medical and long term care benefits in retirement. Essentially, the goal of a 419(e) plan is to allow the company to pre-fund certain retirement benefits in advance; thus, larger contributions may be made to the plan in the early years.

The employer is allowed to decide which benefits to provide to employees. New benefits may be coordinated with existing employee benefits, and new benefits that supplement the existing benefits may be offered.

One of the more popular benefits of 419(e) plans is post-retirement medical benefits. These benefits provide funding for health expenses incurred during retirement. Employees do not vest in the benefits, but instead become eligible when they reach a retirement age set by the employer.

The welfare benefits provided by a 419(e) plan are meant to enhance the financial security of employees and can include:

Supplemental Disability Benefits
Severance Benefits
Post-Retirement Medical Benefits
Long Term Care Benefits
Death Benefits

If you will need certain welfare benefits through retirement anyhow, a 419(e) plan allows you to essentially pay for those benefits in advance and obtain a substantial current-year tax deduction. Some 419(e) plans additionally pay death benefits on behalf of current employees and add substantial medical benefits for retirees. The medical benefits can include reimbursement for amounts paid for medical, dental, and psychological care, prescription and over-the-counter drugs, long term care services, nursing home care, home care, premiums for medical, dental, Medicare and long term care coverage and more.

Non-discriminatory rules apply except employees do not vest until actual retirement at a defined retirement age. Contributions to plans compliant with section 419 are deductible by the employer to the extent permitted by law. Distributions in the form of medical expense reimbursements are not taxable income.

The downsides of 419(e) plans include that, depending on the benefits provides, the contributions to the plan might not be fully deductible (such as where death benefits are provided) and discrimination among employees might not be allowed (such as where medical benefits are provided). Also, these plans are somewhat complex and require the services of an actuary who is experienced in these plans to correctly implement.

Nonetheless, 419(e) plans are good for businesses that desire to tailor an employee benefit plan to their specific needs or which need flexible funding options. The plans may also be structured to provide valuable incentives to employees to remain with the company.

The benefits of Welfare Benefit Plans include:

The employees benefit: The employee has the comfort of knowing that his family is protected in case of untimely death while covered and has the comfort of knowing that much of his medical needs in retirement — and the needs of his spouse and dependents — are met, including long-term care.
The owner-employees benefit: Like all employees the owner-employee has the comfort of knowing there is a death benefit and medical benefit awaiting the owner and the owner’s family as a before-tax expense of the company.
The company benefits: The company can offer valuable benefits to reward valued employees at affordable costs; benefits formerly offered only by large employers which are now available to small and mid-size companies; it can use these benefits as “golden handcuffs” to stem turnover of expensively trained and valuable employees; its contributions are deductible so long as the rules of §419 and §419A are met, in other words contributions are more affordable with before-tax dollars to the extent deductible.
A company that wants to offer supplemental benefits: Companies looking to reward their most important employees – the owners and executives – are often limited in the amount that can be contributed to plans for their benefit, particularly retirement plans. A Welfare Benefit Plan can offer additional benefits for these employees, such as family protection and retiree medical benefits, without limitations as long as actuarially reasonable.
Post-retirement medical accounts are not vested and only become available for use by an employee when retirement age is reached while still an employee. Amounts forfeited due to termination of employment are retained by the plan.

In summary, 419(e) welfare benefit plans offer significant advantages to farsighted business owners and their employees, with a substantial portion of the offered benefits being currently deductible to the business. When correctly structured, they allow the business to pre-fund valuable post-retirement and other welfare benefits for employees.

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NAVIGATION

Section 419. Treatment of funded welfare benefit plans (a/k/a “419(e) Plans”)

(a) General rule

Contributions paid or accrued by an employer to a welfare benefit fund -

(1) shall not be deductible under this chapter, but

(2) if they would otherwise be deductible, shall (subject to the limitation of subsection (b)) be deductible under this section for the taxable year in which paid.

(b) Limitation

The amount of the deduction allowable under subsection (a)(2) for any taxable year shall not exceed the welfare benefit fund's qualified cost for the taxable year.

For purposes of this section -

(1) In general

Except as otherwise provided in this subsection, the term ''qualified cost'' means, with respect to any taxable year, the sum of -

(A) the qualified direct cost for such taxable year, and

(B) subject to the limitation of section 419A(b), any addition to a qualified asset account for the taxable year.

(2) Reduction for funds after-tax income

In the case of any welfare benefit fund, the qualified cost for any taxable year shall be reduced by such fund's after-tax income for such taxable year.

(3) Qualified direct cost

(A) In general

The term ''qualified direct cost'' means, with respect to any taxable year, the aggregate amount (including administrative expenses) which would have been allowable as a deduction to the employer with respect to the benefits provided during the taxable year, if -

(i) such benefits were provided directly by the employer, and

(ii) the employer used the cash receipts and disbursements method of accounting.

(B) Time when benefits provided

For purposes of subparagraph (A), a benefit shall be treated as provided when such benefit would be includible in the gross income of the employee if provided directly by the employer (or would be so includible but for any provision of this chapter excluding such benefit from gross income).

(C) 60-month amortization of child care facilities

* * *

(4) After-tax income

(A) In general

The term ''after-tax income'' means, with respect to any taxable year, the gross income of the welfare benefit fund reduced by the sum of -

(i) the deductions allowed by this chapter which are directly connected with the production of such gross income, and

(ii) the tax imposed by this chapter on the fund for the taxable year.

(B) Treatment of certain amounts

In determining the gross income of any welfare benefit fund -

(i) contributions and other amounts received from employees shall be taken into account, but

(ii) contributions from the employer shall not be taken into account.

(5) Item only taken into account once

No item may be taken into account more than once in determining the qualified cost of any welfare benefit fund.

(d) Carryover of excess contributions

If -

(1) the amount of the contributions paid (or deemed paid under this subsection) by the employer during any taxable year to a welfare benefit fund, exceeds

(2) the limitation of subsection (b), such excess shall be treated as an amount paid by the employer to such fund during the succeeding taxable year.

(e) Welfare benefit fund

For purposes of this section -

(1) In general

The term ''welfare benefit fund'' means any fund -

(A) which is part of a plan of an employer, and

(B) through which the employer provides welfare benefits to employees or their beneficiaries.

(2) Welfare benefit

The term ''welfare benefit'' means any benefit other than a benefit with respect to which -

(A) section 83(h) applies,

(B) section 404 applies (determined without regard to section 404(b)(2)), or

(C) section 404A applies.

(3) Fund

The term ''fund'' means -

(A) any organization described in paragraph (7), (9), (17), or (20) of section 501(c),

(B) any trust, corporation, or other organization not exempt from the tax imposed by this chapter, and

(C) to the extent provided in regulations, any account held for an employer by any person.

(4) Treatment of amounts held pursuant to certain insurance contracts

(A) In general

Notwithstanding paragraph (3)(C), the term ''fund'' shall not include amounts held by an insurance company pursuant to an insurance contract if -

(i) such contract is a life insurance contract described in section 264(a)(1), or

(ii) such contract is a qualified nonguaranteed contract.

(B) Qualified nonguaranteed contract

(i) In general

For purposes of this paragraph, the term ''qualified nonguaranteed contract'' means any insurance contract (including a reasonable premium stabilization reserve held thereunder) if -

(I) there is no guarantee of a renewal of such contract, and

(II) other than insurance protection, the only payments to which the employer or employees are entitled are experience rated refunds or policy dividends which are not guaranteed and which are determined by factors other than the amount of welfare benefits paid to (or on behalf of) the employees of the employer or their beneficiaries.

(ii) Limitation

In the case of any qualified nonguaranteed contract, subparagraph (A) shall not apply unless the amount of any experience rated refund or policy dividend payable to an employer with respect to a policy year is treated by the employer as received or accrued in the taxable year in which the policy year ends.

(f) Method of contributions, etc., having the effect of a plan

If -

(1) there is no plan, but

(2) there is a method or arrangement of employer contributions or benefits which has the effect of a plan, this section shall apply as if there were a plan.

(g) Extension to plans for independent contractors If any fund would be a welfare benefit fund (as modified by subsection (f)) but for the fact that there is no employee-employer relationship -

(1) this section shall apply as if there were such a relationship, and

(2) any reference in this section to the employer shall be treated as a reference to the person for whom services are provided, and any reference in this section to an employee shall be treated as a reference to the person providing the services.

CAUTION!
The IRS has issued new guidance for 419(e) Welfare Benefit Trusts
funded with cash value life insurance

http://www.irs.gov/irs/article/0,,id=174844,00.html

IRS Warns Taxpayers About Certain Trust Arrangements Sold As Welfare Benefit Funds

IR-2007-170, Oct. 17, 2007

WASHINGTON – The Internal Revenue Service and the Treasury Department cautioned taxpayers about participating in certain trust arrangements being sold to professional corporations and other small businesses as welfare benefit funds and identified some of the arrangements as listed transactions.

There are many legitimate welfare benefit funds that provide benefits, such as health insurance and life insurance, to employees and retirees. However, the arrangements the IRS is cautioning employers about primarily benefit the owners or other key employees of businesses, sometimes in the form of distributions of cash, loans, or life insurance policies.

“The guidance targets specific abuses involving a limited group of arrangements that claim to be welfare benefit funds,” said Donald L. Korb, Chief Counsel for the IRS. “Today’s action sends a strong signal that these abusive schemes must stop.”

The guidance explains that, depending on the facts and circumstances, a particular arrangement could be providing dividends to the owners of a business that are includible in the owners’ income and not deductible by the business. The arrangement could also be a plan of nonqualified deferred compensation. Even some arrangements providing welfare benefits may have tax consequences different than what is claimed.

In Notice 2007-83, the IRS identified certain trust arrangements involving cash value life insurance policies, and substantially similar arrangements, as listed transactions. If a transaction is designated as a listed transaction, affected persons have disclosure obligations and may be subject to applicable penalties. Taxpayers who otherwise would be required to file a disclosure statement prior to Jan. 15, 2008, as a result of Notice 2007-83 have until Jan. 15, 2008, to make the disclosure.

In Notice 2007-84, the IRS cautioned taxpayers that the tax treatment of trusts that, in form, provide post-retirement medical and life insurance benefits to owners and other key employees may vary from the treatment claimed. The IRS may issue further guidance to address these arrangements, and taxpayers should not assume that the guidance will be applied prospectively only.

Today, the IRS also issued related Revenue Ruling 2007-65 to address situations where an arrangement is considered a welfare benefit fund but the employer’s deduction for its contributions to the fund is denied in whole or part for premiums paid by the trust on cash value life insurance policies.