A Court of Appeals for the Second Circuit has held that in order for contributions to a retiree medical benefit "reserve" to be tax-deductible under Voluntary Employees Beneficiary Association (VEBA) funding rules, their purpose must be solely to fund postretirement benefits.
Some years ago, General Signal Corporation established a VEBA, funded it annually and deducted the contributions under Internal Revenue Code §419. A portion of those annual contributions was claimed to fund a retiree benefit reserve under §419A(c)(2). Under the trust agreement, all assets were to be administered as one fund, and no one would have legal or equitable rights arising from the VEBA or have a direct interest in any of its assets. General Signal spent a significant portion of the contributions that were deductible based on retiree liabilities on active employee benefits in 1987 and 1988. By the end of 1989, the VEBA funds were almost gone.
General Signal claimed that VEBA funding rules allow employers to deduct from taxable income "a reserve funded over the working lives of the covered employees and actuarially determined on a level basis . . . as necessary for" certain postretirement benefits. The appellate court was to decide whether the term "reserve" (1) requires that tax-deductible contributions be intended only for postretirement benefits or (2) allows employers to deduct contributions intended for other entitlements (i.e., active employee benefits).
In General Signal Corporation v. Commissioner, the appellate court ruled that for contributions to a "reserve" under §419A(c)(2) to be tax-deductible, the sponsor must intend for the contribution to accumulate to fund postretirement benefits. General Signal had claimed that the reserve rule in §419A(c)(2) served only to guide its actuary in calculating the deductibility of contributions to the VEBA. The company also claimed that the reserve rule imposes no requirement with respect to the intention to accrue over time for postretirement benefits versus to spend on active employee benefits. The IRS argued that employer contributions to a postretirement benefit reserve are tax-deductible only if the employer's intention is for the funds to accumulate to provide future benefits to retired employees.
The court sided with the IRS. It found that both the plain language and the legislative history of the statute indicate that Congress envisioned reserves under §419A(c)(2) to accumulate funds and intended the statute to prevent companies from deducting benefits before incurring liabilities. For example, the conference report referred to contributions that "accumulate" so that retirement benefits may be "fully funded upon retirement."
According to the court, the deductibility of contributions under §419A(c)(2) turns on the intent of the taxpayer (General Signal) in establishing its reserve, especially the intent at the time the contribution is made. General Signal felt that this position would require them to make annual contributions indefinitely (thus requiring the fund to maintain a minimum balance). However, the court responded as follows:
While our reading of the statute does imply a commitment to establish funding through the working lives of covered employees, if subsequent events rendered maintenance of the reserve impossible, evidence of the reason for discontinuing or spending down the reserve could be presented in response to any accusation that a taxpayer never intended a reserve to be established in the first place.
The court also noted that its ruling does not require a separate account for postretirement benefits. Thus, the earnings on the reserve amounts could be used to pay other benefits under the VEBA.
Lastly, the General Signal VEBA benefits all beneficiaries equally. So, General Signal argued that the trustee would violate its fiduciary duty if it withheld benefits from active employees in favor of retirees. The court disagreed, ruling that the trust agreement could provide that contributions to a reserve for postretirement benefits be set aside for retiree beneficiaries. "Such earmarking would not place other beneficiaries at a disadvantage, because presumably the funds would not have been contributed in the first place if they were not deductible as a reserve for retiree benefits."
Plan sponsors who contribute to VEBAs for postretirement benefits should review the VEBA documents, contributions for postretirement benefits, their use of VEBA funds to pay benefits for active employees and actual accumulation of reserves for postretirement benefits. It is, of course, possible that General Signal will appeal to the Supreme Court, but until then, plan sponsors need to be mindful of the appellate court decision.