by Lance Wallach

Certain retirement arrangements, such as pension plans, profit-sharing plans and stock bonus plans, qualify for favorable tax treatment. An employer may deduct contributions to a plan, and an employee’s tax liability is deferred until plan distributions are received.

Nonqualified plans are used by employers to provide supplemental deferred compensation to executives and key employees. An employer maintaining a nonqualified plan does not receive a deduction until benefits are actually paid to the employee. Small employers with no more than 100 employees are eligible to receive a tax credit for some of the costs of establishing new retirement plans, effective for costs paid or incurred in tax years after 2001. The credit equals 50 percent of the start-up costs.

Pension plans can be defined-benefit plans, defined-contribution plans, or “hybrid plans.” The first allows an employee to anticipate a fixed or determinable payment upon retirement. Employer contributions necessary to provide such benefits are then determined on an actuarial basis.

A defined-contribution plan does not guarantee an employee a fixed level of benefits. Instead, the employer contributes a fixed amount to the individual accounts of the participants. and the accounts rise or fall based on the trust fund’s investment performance. Defined-contribution arrangements are profit-sharing plans, including 401(k) plans, money purchase pension plans, and stock bonus plans, including employee stock ownership plans.

A hybrid plan is a plan that has the features of both a defined-contribution and a defined-benefit plan. Types of hybrid plans include floor offset plans, cash balance plans and target benefit plans.

A cash balance plan is considered to be a defined-benefit hybrid, under which a separate account is maintained for each participant. The employer credits a certain percentage of compensation to each account and credits each account with interest earned. The amounts to be contributed are actuarially determined to insure sufficient funds to provide for the benefits promised. If, at retirement, the balance in a participant’s individual account is less than the amount promised by the employer, the participant will receive the promised amount.

Because benefits are not based solely on actual contributions and forfeitures allocated to an employee’s account and the actual investment experience and expenses of the plan allocated to the account, the arrangement is treated as a defined-benefit plan.

Under a target benefit plan, an employer contributes an amount necessary to pay a target benefit for employees at retirement age. Each employee’s benefit is based on the amount in her individual account.

A profit-sharing plan is established and maintained by an employer to provide for the inclusion in its profits of its employees or their beneficiaries. The plan must provide a definite predetermined formula for allocating the contributions made to the plan among the participants and for distributing the funds accumulated under the plan after a fixed number of years, the attainment of a stated age, or upon the prior occurrence of some event such as layoff, illness, disability, retirement, death or severance. In addition, a profit-sharing plan must provide for “recurring and substantial contributions.”

VEBAs
A voluntary employees’ beneficiary association, or 501(c)(9) trust, is a tax-exempt trust designed to provide for the payment of life, sick, accident or other welfare benefits to employees or their dependents or beneficiaries. No part of the net earnings of the association may inure (other than through such payments) to the benefit of any private shareholder, individual or business entity.

VEBAs allow an employer that joins to receive a current tax deduction while putting away funds that are not currently needed. A VEBA allows the employer a great deal of latitude in choosing plan benefits. Contributions are tax-deductible and funds grow tax-deferred. VEBAs have no penalties for early distributions, and life benefits can pass to the employee’s family free of income, estate and gift taxes. A VEBA can be designed so that the benefits paid are not subject to estate taxes because participants have no “incidents of ownership” in the assets.

VEBA assets are protected from creditors, the amounts in which contributions are made can be flexible, and benefits are highly favorable to the business owners, with no vesting for employees. Additionally, a VEBA can supplement or enhance buy/sell and stock-redemption agreements, or solve retained earnings problems.

Almost any business can establish a VEBA for its employees, including owner-employees. An employer with one employee (including a spouse) can establish a VEBA. A VEBA is a tax-exempt organization, as described under IRC Section 501(c)(9), and would receive a tax-exemption letter from the IRS. An employer can maintain both a retirement plan and a VEBA.

VEBA trust earnings are tax-exempt while the trust is accumulating funds.

In most cases, a VEBA is set up as a trust with a bank as the trustee. Some trusts look like VEBAs but are not because the sponsor has not taken the additional, costly step of filing the trust with the Internal Revenue Service under IRC Section 501(c)(9).

The IRS has recently taken decisive action against abusive plans claiming to be in conformance with IRC section 419(A)(f)(6). Under Treasury Decision 9000, the disclosure requirement was extended to include participants. All employers and participants in such an arrangement would be required to attach a notification to their tax returns disclosing their participation in a “listed transaction.” In addition to the potentially devastating financial ramifications, failure to disclose such participation to the IRS carries criminal penalties.

VEBAs are subject to some Employee Retirement Income Security Act of 1974 rules, but are not subject to the rules governing qualified plans. Therefore, VEBA termination can be made prior to age 59 without subjecting the distributee to the 10 percent early distribution penalty.

In addition, VEBA distributions are not required to begin by the time that the participant reaches age 70. VEBAs allow employees much larger tax deductions than those available under qualified plans.

Another advantage of the VEBA to the employer-owner is that, upon termination, all plan assets are distributed to the active participants as of the date of the termination. As a result, there is no vesting to employees who have left the service of the employer.

A VEBA allows more tax-deductible contributions than a 401(k) plan because it is not subject to strict pension plan guidelines. Contribution limits are based on “reasonableness.” In 1992, the Tax Court allowed a $1.1 million VEBA tax deduction that covered two people.

A VEBA is well-suited to a business that:


  • Is highly profitable;
  • Can no longer fund its retirement plan because it is overfunded or because there is no benefit to the owner-employees; and,
  • Has owners who would like to protect assets from their creditors, and has owner-employees who would like to reduce their estate tax exposure.

Lance Wallach is a New York-based speaker and writer who extensively covers VEBAs, 412(i) plans, estate planning, pension plans and tax reduction. Reach him at (516) 938-5007 or visit www.vebaplan.com.

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