A death benefit that saves taxes

An employee plan called a VEBA trust can help business owners achieve their own retirement and estate planning goals.

By Allen F. Ross

One of the most underutilized business and personal planning tools is the Voluntary Employees’ Beneficiary Association trust, which provides a death benefit for employees who participate. When a VEBA is structured correctly, the family business owner often reaps great benefits. Like life insurance, the VEBA pays when a participant dies, and the money can be used to pay estate taxes. Normally, however, life insurance premiums are not tax deductible, and when the benefits are received, estate taxes and possibly excise tax must be paid. The contributions to a VEBA, which is a trust, are tax deductible, and the payout is free of estate taxes, excise taxes, and gift taxes if structured properly.

VEBAs can be set up by any type of family business entity. They are often used in addition to pension and profit-sharing plans, but because of the costs involved, they are most appropriate for owners who make in excess of $200,000 a year and pay $30,000 or more in taxes annually.

VEBAs have been used by large corporations and union organizations for decades. However, for smaller firms, the best way to use them is to join an existing VEBA that has already received a favorable letter of determination from the Internal Revenue Service. VEBAs must have an approved independent trustee—typically a bank.

Technically speaking, a VEBA is an employee health and welfare benefit plan, authorized under Section 501(c)(9) of the IRS code. It is a tax exempt trust that provides benefits to its members. The bank is the trustee, owns the insurance contract, and pays when an employee dies. The company makes the annual contributions for eligible employees who wish to participate (usually $200 to $800 per participant). The contributions are tax deductible to the company, and the ultimate estate tax benefits to the family far outdistance the costs.

As with a company pension or profit-sharing plan, participation in a VEBA must be open to any and all employees who are eligible and interested. If a person joins and dies while employed by the company, a death benefit is paid to his designated beneficiary. However, if an employee leaves the company, he is no longer enrolled, and the contributions on his behalf remain behind.

Since the IRS considers the company’s contribution for each enrollee to be an employee benefit, each enrollee must pay annual income tax on the value of the contribution. Typically, the yearly cost to the employee will be a few hundred dollars, and those employees who are interested in long-term estate planning will likely be the ones who will join.

This leaves the family business owner in a good position; he benefits from the plan, the costs are paid by the company, and the company ends up covering the cost of only the participants. In most cases, since benefits are based on the ages of the participants and a multiple of their compensation, 85 to 90 percent of the plan’s contributions to the trust will apply to the life of the owner. The plan can be set up to continue to cover a retired employee, such as the owner, who meets certain criteria.

When the owner dies, the benefit is paid from the trustee (the bank) to an irrevocable trust, which the survivor can use to cover estate taxes. Because the benefit is in trust, it is not included in the estate, saving the family more money. In contrast, life insurance can be put into an irrevocable trust, but the premiums are not tax deductible, and if they are large, gift taxes will have to be paid also. If funds are left over after the estate taxes are paid, they go to the survivor without any income or gift tax.

The workings of a VEBA may seem complicated, so let’s consider a brief example. Plastics Plus Inc. is a $10 million pet products manufacturer founded by a husband and wife, each about 65 years of age. Three sons are in the business, each in his 30s, and there are 10 employees. The parents determine that an annual company contribution of $250,000 to the VEBA will cover their estate planning needs. The three sons, and five nonfamily employees, are the eligible employees who decide to join; Plastics Plus will pay about $800 a year for each of them. Should either spouse die, their beneficiaries would receive about $2.5 million—income-tax, excise-tax, and gift-tax free, and the benefit can be structured to be estate-tax free. The VEBA would continue to cover the sons and the five nonfamily employees as long as they remained at Plastics Plus.

The downside is that the company must pay the annual costs. Also, as noted, each participant must pay income tax on the annual economic benefit received from the plan.

 

The fine print

There are a number of very specific requirements for a VEBA. There must be at least two participants in a plan (a spouse who works at the company qualifies). The benefits are based on annual compensation and age. All full-time employees who have completed up to three years of service and are at least 21 are eligible, although employees who are represented by a collective bargaining unit may be excluded. A VEBA must comply with some ERISA rules, including the 505(b) non-discrimination requirements.

The VEBA’s assets are not held in any one participant’s name. Instead each employer’s plan assets are held in an unallocated reserve for the exclusive benefit of the participants, their dependents, and their beneficiaries. The plan prohibits any reversion of assets to the employer sponsor; however, the plan can be amended or terminated by the employer at any time.

The IRS considers a death benefit to be a taxable economic benefit. No employee is required to participate in the program.

The survivor benefits can be constructed so that they will not be subject to income or estate taxes because participants have no “incidents of ownership” in the assets. The VEBA trustee is the owner and beneficiary of all contracts. The participant has no vested interest, other than the right to receive and convert the bare contract (no cash value) to individual ownership upon termination of employment. To avoid the estate tax, a participant should make an irrevocable designation of a beneficiary; a trust for the benefit of one’s family would create the greatest advantage in most cases.

Oftentimes, owners consider a VEBA when they reach the limit of tax deductible contributions they can make to pension or profit-sharing plans. Under a 401(k) plan, for example, the most an owner making $250,000 can contribute tax deferred per year is $9,000—not much, given the salary. VEBAs provide a way to accrue more long-term benefits using tax-deferred contributions, and create a tax-free means for paying estate taxes.

Because VEBAs are not yet widely used among small and mid-sized businesses, the family’s biggest initial challenge may be finding an organization that administers a VEBA, and finding a financial management company that can properly design and administer a program. More firms are beginning to offer these services. Owners who find possible providers should ask if they have a comprehensive due diligence package with a credible legal opinion and letter of determination; whether the VEBA in question follows the appropriate compliance requirements; and what other organizations it has worked with—accounting firms, law firms, financial institutions, educational forums—in setting up and administering VEBAs. Once an owner is satisfied in having found an appropriate sponsor, he can begin to implement the plan.

 

Allen F. Ross is chief business strategist for Asset Accumulation Inc. in Plainview, NY, a tax-oriented strategies consulting firm.