The tax impact on pension plans, VEBAs and more

22nd Annual Health Sciences
Tax Conference
Tax considerations for pensions, VEBAs and
other institutional investors

December 3, 2012

Disclaimer

► Any US tax advice contained herein was not intended or written
to be used, and cannot be used, for the purpose of avoiding
penalties that may be imposed under the Internal Revenue
Code or applicable state or local tax law provisions.

Page 2 Tax considerations for pensions, VEBAs and other institutional investors

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Presenters

► Brad Bond ► Bob Vuillemot
Treasurer Ernst & Young LLP
University Hospitals Pittsburgh, PA
Cleveland, OH + 1 412 644 5313
robert.vuillemot@ey.com
► Ben Pitchkites
Ernst & Young LLP ► Jennifer Richter
Indianapolis, IN Ernst & Young LLP
+ 1 317 681 7440 St. Louis, MO
benjamin.pitchkites@ey.com + 1 314 290 1024
jennifer.richter@ey.com


Objectives

► Review federal and state tax issues impacting § 501(a)
pension trusts and § 501(c)(9) voluntary employees
beneficiary association (VEBA) trusts
► Identify international tax implications and compliance
requirements
► Identify planning ideas to reduce US and foreign taxes of
pension and VEBA trusts


Pension trust tax considerations

Background — Section 501(a) pension trusts

► US corporate-defined benefit pension plan assets total
approximately US$1 trillion
► Average allocation to alternative asset class is 14% and is
increasing
► Public pension plan average allocation is 20%
► Composition of alternative asset investments:
► Private equity 45%
► Hedge funds 18%
► Real estate 31%
► Real assets 6%

Source: Cliffwater LLC 2011 Survey, “Allocations to Alternative Investments.” Composition percentages reflect public pension fund allocations.


Tax considerations for pension trusts

► Investment structuring
► Obtaining treaty benefits
► Reclaiming foreign withholding at source
► Domestic tax compliance
► Federal tax compliance
► State tax compliance
► Information returns — e.g., reportable transactions, foreign
activities
► Foreign tax compliance
► Accounting Standards Codification (ASC) 740
► Qualification issues
► Forms 5500

Domestic taxation of pension trusts

► Pension trusts are exempt from federal income tax under
§ 401(a) and § 501(a).
► Pension trusts are not required to file Form 990, but are
required to file Form 990-T if they earn unrelated business
income (UBI) of more than US$1,000.
► Note that pension trusts are entities separate from their
sponsors.
► Standard trust tax rates under § 1(e) apply.
► Currently, 35 states and DC also tax unrelated business
taxable income (UBTI) of pension trusts.


Unrelated business income tax (UBIT)

► Income from an “unrelated” trade or business
► Income from property that is leveraged, i.e., that the
taxpayer borrowed money to buy, or continued debt in
order to carry (debt-financed property)
► Limited exception for certain real property indebtedness
► "Income" subject to UBIT includes both income derived from, and
gain on the sale of, debt-financed assets that produce income
subject to UBIT
► Standard federal tax rates (35%, plus possible state tax)


UBI information provided by partnerships

► Section 6031(d) of the Internal Revenue Code (IRC)
states:

“the information required … to be furnished to its partners
shall include such information as is necessary to enable
each partner to compute its distributive share of
partnership income or loss … in accordance with section
512(a)(1).”


Compliance overview — Form 990-T

► Qualified plans (e.g.,
pension trusts) are not
required to file Form 990.
► Qualified plans file Form
990-T if they earn more
than US$1,000 of UBTI.
► Note earlier due date for trust
returns (April 15 for calendar
year trusts)


Domestic compliance

Federal filing
requirements

State filing K-1s Foreign bank
requirements (and other info) account reports

Filing requirements resulting
from foreign transactions


K-1 analysis — objectives

► Federal UBI
► State UBI
► Classification of UBI — passive/non-passive
► Foreign filing requirements
► Reportable transactions


Unrelated business income concepts

► There are three typical ways that a fund organized as a
partnership may generate UBI:
► Operation of a trade or business
► Example: an oil and gas partnership
► Borrowing to make investments
► Example: a commodities fund that borrows to make large investments
in futures contracts
► Flow-through from other investments
► Example: a fund of funds that invests in other partnerships
► Depreciation recapture under Sections 1245 or 1250


Unrelated debt — financed income

► 514(c)(9) exception
► Debt-financed income from real property is excluded from UBI for
“qualified organizations.”
► Qualified organizations
► Section 170(b)(1)(A)(ii) educational organizations and their Section
509(a)(3) supporting organizations
► Section 401 qualified trusts
► Section 501(c)(25) multiple parent real property holding organizations


Identification of federal UBI

► Total UBI should be disclosed and marked with the
appropriate code:
► 05 Form K-1 — code “P”
► 06–11 Forms K-1 — code “V”


Identification of federal UBI (cont.)


IRC Section 469 — passive activity loss
limitation

► § 469 limits the deductions and credits taxpayers may
claim related to passive activities.
► General rule: net losses from a taxpayer’s passive
activities (passive activity losses or “PALs”) may not be
used to offset net income from the taxpayer’s non-passive
activities.
► PALs may be carried forward and used to offset passive income in
future years, and may be deducted fully when taxpayers dispose of
their interest in the passive activity.


Classification of UBI — passive/non-passive

► Need to break UBI into three categories:
► Passive
► Portfolio
► Non-passive


Classification of UBI — passive/non-passive
(cont.)

► Portfolio income/loss
► Not subject to passive activity loss rules
► Includes debt-financed income (not derived in the ordinary course
of a trade or business) from interest, ordinary dividends, annuities
or royalties, gain or loss on the sale of property that produces such
income or is held for investment, and related deductions
► Consists of specific Schedule K-1 line items


Schedule K-1 instructions

► The Schedule K-1 instructions
identify the line items that are
considered portfolio income.

► The corresponding Box 13
deductions (e.g., investment
interest expense) are
considered to be “portfolio”
in nature.


Portfolio income on the Schedule K-1


Portfolio deductions on the Schedule K-1


IRS Form 8582

► Passive activity loss limitations
► Determine allowable passive activity loss for the year and
suspended portion to carry forward
► Do not report losses from publicly traded partnerships
(PTPs)


Publicly traded partnerships — § 469(k)

► What is a PTP?
► Any partnership if:
► Interests in the partnership are traded on an established
securities market
or
► Interests in such partnership are readily tradeable on a
secondary market (or substantial equivalent)


Schedule K-1


Publicly traded partnerships — general rules

► You can not offset loss of a PTP against anything other
than income of the same PTP.
► If there is an overall loss and less than the entire interest
in the PTP was disposed of, losses are allowed only to the
extent of the income, and the excess is carried forward
and can be applied against future income from the PTP.
► If there is a loss and the entire interest in the PTP was
disposed of, the losses are not limited by the passive loss
rules.


Potential filings due to alternative
investments

► Form 5471
► Form 8865
► Form 926
► Form 8858
► Form 8621
► Reports of foreign bank and financial accounts (Form TD
F 90-22.1)


Potential filings related to foreign
transactions

► Transfers to foreign partnerships and corporations
► Transfers to foreign partnerships are required to be reported on
Form 8865 — “Return of U.S. Persons With Respect to Certain
Foreign Partnerships.”
► Transfers to foreign corporations are required to be reported on
Form
926 — “Return by a U.S. Transferor of Property to a Foreign
Corporation.”


Reportable transactions

► Five categories of reportable transactions
1. Listed transactions
2. Confidential transactions
3. Contractual protection transactions
4. Loss transactions
5. Transactions of interest


Loss transactions

► Section 165 losses
► Reporting thresholds
► Corporations — US$10 million in any single tax year; US$20
million in any combination of tax years
► Trusts — US$2 million in any single tax year; US$4 million in any
combination of tax years
► Exception — Section 988 foreign currency losses — US$50,000
threshold for any single tax year


States that tax UBI from pension trusts

State UBI State UBI State UBI
Alabama Taxable Kentucky Not taxable North Dakota Taxable
Alaska Taxable Louisiana Taxable Ohio Not taxable
Arizona Taxable Maine Taxable Oklahoma Taxable
Arkansas Not taxable Maryland Taxable Oregon Taxable
California Taxable Massachusetts Not taxable Pennsylvania Not taxable
Colorado Taxable Michigan Taxable Rhode Island Taxable
Connecticut Taxable Minnesota Not taxable South Carolina Taxable
DC Taxable Mississippi Taxable South Dakota Not taxable
Delaware Not taxable Missouri Taxable Tennessee Taxable
Florida Taxable Montana Taxable Texas Not taxable
Georgia Taxable Nebraska Taxable Utah Taxable
Hawaii Taxable Nevada Not taxable Vermont Taxable
Idaho Taxable New Hampshire Not taxable Virginia Taxable
Illinois Taxable New Jersey Not taxable Washington Not taxable
Indiana Taxable New Mexico Not taxable West Virginia Not taxable
Iowa Taxable New York Taxable Wisconsin Taxable
Kansas Taxable North Carolina Taxable Wyoming Not taxable


Structuring considerations

► Alternative investments may generate UBTI
► UBTI can be “blocked” by interposing an entity treated as a
corporation for US tax purposes.
► A blocker doesn’t eliminate the economic cost of UBTI; it just
means that the pension trust won’t have to do the compliance
itself.
► In some cases, a blocker can make matters worse.
► Dividends on US stocks earned directly by a tax-exempt entity, or
through a partnership, are exempt from UBIT (unless debt-financed
property).
► Dividends on US stocks earned by foreign corporations are subject to
US withholding tax (quite possibly, 30%) and there is no way for the
US owner to get it back.


Hedge funds

US US tax- Foreign
taxable exempt investors
investors investors

US
Delaware LP Cayman Corp.
(foreign feeder)

Master Fund
Cayman LP


Foreign tax issues

► Foreign countries can impose tax on dividends, interest,
profits from a local business and, in some cases, gains on
sale of local investments.
► A US pension trust might be exempt from some of these
taxes.
► And even if it is exempt, it might need to get a local ruling.
► Some US tax treaties give special benefits for US pension
trusts, if they are properly and timely claimed.
► Investing through a blocker might affect availability of US
tax treaty benefits.


Background

► Funding of welfare benefits by employers through a trust
► Welfare benefits include: medical, dental, supplemental
unemployment benefits, sick and accident benefits, disability
benefits, life insurance and severance pay
► Irrevocable welfare benefit trust places assets beyond the
reach of employer’s creditors
► Distinction between welfare benefit “plan” and “trust”
► Welfare benefit plan
► A “plan” is a program of benefits promised to employees —
embodied in written plan document
► Form 5500 filed for “plan” (if 100 or more participants)


Background (cont.)

► Trust
► A “trust” is the employer’s vehicle for funding its obligation under a
plan
or plans.
► It is established by a written trust instrument naming the employer
as settlor of the trust, appointing a trustee, and describing powers
and duties of the trustee.
► The employer may fund some, or all, benefits under its plan
through one or more trusts. Therefore, activity of the trust reflected
on the Form 990 may not reflect financial statements of the plan
(as shown on Form 5500).


Typical funding via VEBA Trust

Employer

$

VEBA Trust

$

1. Employee
2. Care provider
3. Insurance company


Employer deduction using VEBA Trust

► Prior to enactment of §§ 419 and 419A, acceleration of
the deduction was generally allowed when the
contribution was paid or accrued to the trust, irrespective
of when the actual benefits were paid to employees.
► The ability to control timing of the deduction is a prime advantage
associated with a trust.
► If a trust qualified for exemption of VEBA, then investment
earnings were tax-free prior to 1986.
► Since 1986, deductibility of employer contributions to a trust fund
is governed by §§ 419 and 419A.


Employer deduction limitation

► § 419(b) provides that the Qualified direct cost = cash-basis cost of
current benefits paid
amount of any employer by the fund

deduction under § 419
Plus: addition to Addition to reserves
shall not exceed the fund’s qualified asset funded for:
account =
“qualified cost” for the 1) disability
2) medical
taxable year. 3) supplemental
unemployment
► Formula for qualified cost: benefits or
severance pay
4) life insurance
benefits [up to
account limit]
Minus: after-tax income = fund income less UBI
or other tax
Equals qualified cost = maximum deduction


Voluntary employees beneficiary
associations — exemption requirements

► A VEBA is exempt from taxation under § 501(c)(9) if:
► The organization is an employees association
► Membership is voluntary
► The organization provides for the payment of life, sick, accident or
other benefits to its members or their dependents
► No part of the net earnings inures to the benefit of any private
shareholder or individual. Treas. Reg. § 1.501(c)(9)-1


Section 501 (c)(9) VEBA exemption
requirements

► Same employer (or affiliated employer)
► Same collective bargaining agreement or labor union
► Same line of business in “same geographic locale”
► Participants must be “employees”
► At least 90% of participants must be employees (or their
spouses or dependents).
► Generally, employee status is based on employment tax status
or collective bargaining.
► Partners and sole proprietors are not employees for purposes of
the 90% test.


requirements — voluntary and association

► Voluntary
► Generally, an employee must affirmatively elect
► Considered voluntary even if membership is required as a result of
collective bargaining or where there is no detriment to employees
(e.g., reduction in pay for contributions)
► Association
► Legal entity — almost always a trust (can be a corporation or an
unincorporated association)


requirements — control

► A VEBA must be controlled by:
► Its membership, i.e., members elect or appoint administrators or
trustees of VEBA
► Independent trustee(s) (i.e., bank)
► If the VEBA is exclusively a welfare benefit plan under the Employee
Retirement Income Security Act of 1974 (ERISA), this requirement is
automatically considered satisfied (very rarely is a VEBA not an
ERISA plan).
► Trustees or fiduciaries, at least some of whom are designated by
the membership
► Most employee welfare benefit plans meet the control
requirement by coming under § 3(1) of ERISA.


requirements — permissible benefits

► Life benefits — consist of current protection only and
generally do not permit “permanent” life insurance (PLR
9903032)
► Sickness and accident
► Similar (other) benefits
► These are benefits designed to safeguard or improve the health of
an employee (or dependents), or protect against contingency that
interrupts or impairs earnings power


requirements — other benefits

► Examples of “other benefits” (PLR 9801011) are:
► Holiday and vacation pay
► Recreational activities (athletic leagues)
► Child-care
► Temporary living expenses
► Supplemental unemployment compensation benefits —
involuntary separation due to reduction in force, plant or operation
shut-down, or similar event — § 501(c)(17)
► Severance
► Education/training


requirements — non-qualifying benefits

► Examples of non-qualifying benefits are:
► Commuting expenses
► Homeowner’s insurance
► Savings facilities
► Malpractice insurance
► Non-distress loans
► Pension/annuity
► Deferred compensation payable over time (vs unanticipated event)


requirements — prohibited inurement
► Facts and circumstances
► Unreasonable compensation to trustees or employees
► Non-arm’s-length transactions with entities related to trustees or fiduciaries
► Prohibited inurement to employer
► “Excess assets” upon fund termination cannot revert to employer
► Loan to employer treated as prohibited inurement where loan was excessively large
and improperly secured (GCM 39884)
► Transfer of assets from one VEBA to another does not affect the tax-exempt status
of either VEBA and is not an employer reversion (PLR 9709006)
► Use of excess plan assets following plan termination to provide other qualified
benefits does not constitute prohibited inurement so long as the benefits do not
disproportionately benefit highly compensated employees (PLR 9740024)
► Form 1024 is used for application for exemption and generally must be filed
within 15 months after establishment of the VEBA


Overview of UBIT rules for VEBAs

► Unrelated business taxable income is taxed at corporate
or trust rates (usually trust).
► UBTI is the lesser of:
► Excess set-aside
or
► Gross income (excluding exempt-function income) less applicable
deductions
► Basically = “taxable” net investment income (interest, dividends,
rents, royalties)
► Exempt-function income includes all fees paid by members of a VEBA


Overview of UBIT rules for VEBAs — excess
set-aside

► Definition: Net assets in VEBA at year-end in excess of
the qualified asset account (QAA) limit under § 419A.
► An account receivable on the books of the VEBA does not
constitute “assets set aside” for purposes of increasing
the VEBA account limit.
► QAA limit does not include reserves for post-retirement
medical benefits (See Parker-Hannifin Corp. v.
Commissioner of Internal Revenue, 139F.3d 1090).


Qualified asset account limit

► For qualified benefits, the amount reasonably and
actuarially necessary to fund:
► Claims incurred but unpaid
► Reported to claims-paying agent
► Incurred but not reported (IBNR)
► No reserve allowed for amounts set aside to pay insurance premiums
► No addition to QAA for claims incurred but unpaid if benefits provided
through insurance
► Administrative costs associated with claims
► Additional “reserve” for post-retirement medical and life insurance
benefits (however, medical reserve excluded for purposes of
excess set aside (see Code §512(a)(3)(E)(i) in UBIT calculation))
► Special additional account limit for severance and supplemental
unemployment benefits


Calculation of qualified asset account

► Two acceptable methods for calculation:
► Actuarial certification (Code § 419(A)(c)(1))
► Safe harbors (Code § 419(A)(c)(5))
► Short-term disability — 17.5% of qualified direct costs (excluding
insurance premiums) for immediately preceding tax year of fund
► Medical — 35% of qualified direct costs (excluding insurance
premiums) for immediately preceding tax year of fund
► Long-term disability and life insurance — to be prescribed by
regulations
► Safe harbor only valid if amount determined is “reasonable and
actuarially necessary” to fund the benefits
► Safe harbor subject to IRS challenge


Calculation of qualified asset account (cont.)

► Example (all dollars in US):
► Acme VEBA incurred qualified direct costs for medical benefits in 2011
of US$100,000.
► The safe harbor addition to the QAA is $35,000 (35% of $100,000).
► However, at December 31, 2012, the actuaries have calculated the
IBNR and unpaid claims reserves to be $25,000.
► Allowable additions to QAA will therefore be $25,000.
► If the taxpayer estimated QAA to be $40,000, without actuarial
certification, then only $35,000, the safe harbor, would be allowed.


Unrelated business income formula

UBI = the lesser of:
(x-y) – (z-w) “excess assets”
Or
(p-q) – r “income”
Where x = the assets of the fund
y = assets not taken into account (facilities; assets
with useful life > one year)
z = account limit
w = post-retirement medical reserves described in
419A(c)(2) (grandfathered amounts excluded)
p = income of fund
q = employer and employee contributions
r = income from grandfathered post-retirement
reserves


Overview of UBIT rules for VEBAs

► Exceptions to set aside limits under § 512(a)(3)(E):
generally, no UBIT for excess set-asides for the following:
► Employee pay — all VEBAs
► Plan must have at least 50 employees
► Nonrefundable contributions
► Collectively bargained plans — must cover 90%
► VEBAs sponsored by tax-exempt employers are
exempt from
§ 512(a)(3)(E)(iii). VEBA must have received funds
from an employer which was tax-exempt for a five-year
period.


Recent UBIT case law developments

► The interpretation of VEBA UBIT rules is split among
federal courts where actual expenditures during the year
exceed the amount set aside in excess of the account
limit.
► Example (all dollars in US):
► VEBA has year-end assets of $1,000
► Year-end account limit = $750; excess set aside of $250
► VEBA earned $200 in investment income and spent $300 in actual
direct costs
► Taxpayers argued that $200 received in investment income was part
of $300 spent in direct costs, therefore, no UBI since all investment
income “spent” on direct costs


Recent UBIT case law developments (cont.)

► Sherwin-Williams Co. v. Commissioner of Revenue: 330
F.3d 449 (2003)
► The Tax Court rejected the above interpretation but the Sixth
Circuit Court of Appeals (“Sixth Circuit”) held that VEBA trust
investment income may be set aside and used separately before
tax year-end to pay reasonable costs of administering health care
benefits, thereby avoiding
§ 512(a)(3)(E) exempt-function income limits.
► AOD 2005-002: The IRS won’t acquiesce to the Sixth Circuit
holding; will only follow in Sixth Circuit. The IRS position is that
amounts spent during the year cannot be specifically sourced, for
UBTI purposes, to the VEBA’s investment earnings for the year.


Recent UBIT case law developments (cont.)

► CNG Transmission Management VEBA v. United States,
84 Fed.
Cl. 327; EBC 2790 (2008)
► The US Claims Court agreed with the IRS’ interpretation, and
rejected the Sixth Circuit, concluding that the taxpayer’s view was
contrary to temp. regs., which it found reasonable and entitled to
deference.
► Northrop Corp. Employee Insurance Benefit Plans Master Trust v.
United States, No. 08-23 T (Ct. Fed. Cl., June 28, 2011) —
followed CNG and held that a VEBA could not avoid limitation on
exempt function income under Code Sec. 512(a)(3)(E)(i) merely by
allocating investment income toward payment of welfare benefits
during the course of the year.


Miscellaneous issues

► VEBAs use trust tax rate schedule and follow other trust
rules to calculate income on the 990-T
► Form 1041 Schedule D used to calculate rates for capital
gains and qualified dividends
► Trust limitation on net capital losses of $3,000 applies
► Passive activity loss rules apply
► Excise tax under 4976(b)(3) could apply to the return of
funds to the employer; tax = 100% of amounts returned
► Aggregation rule — § 419(h)(1)(B): permits aggregation of
two or more funds at election of employer; possible to
minimize UBI by combining multiple VEBAs of same
employer

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