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

Tax considerations for pensions, VEBAs and other institutional investors

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.


Disclaimer

Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. For more information about our organization, please visit www.ey.com. This presentation is © 2012 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party. Views expressed in this presentation are not necessarily those of Ernst & Young LLP.


Presenters

► Brad Bond Treasurer University Hospitals Cleveland, OH ► Ben Pitchkites

Ernst & Young LLP Indianapolis, IN + 1 317 681 7440 [email protected]

► Bob Vuillemot Ernst & Young LLP Pittsburgh, PA + 1 412 644 5313 [email protected]

► Jennifer Richter Ernst & Young LLP St. Louis, MO + 1 314 290 1024 [email protected]


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)


K-1s (and other info)

Federal filing requirements

Filing requirements resulting from foreign transactions

Foreign bank account reports

State filing requirements

Domestic compliance


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

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


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 taxable

investors

US tax-exempt

investors

Master Fund Cayman LP

Foreign investors

Cayman Corp. (foreign feeder)

US Delaware 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.

VEBA trust tax considerations


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 amount of any employer deduction under § 419 shall not exceed the fund’s “qualified cost” for the taxable year.

► Formula for qualified cost:

Qualified direct cost =

cash-basis cost of current benefits paid by the fund

Plus: addition to qualified asset account =

Addition to reserves funded for: 1) disability 2) medical 3) supplemental

unemployment 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.


Section 501 (c)(9) VEBA exemption 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)


Section 501 (c)(9) VEBA exemption 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.


Section 501 (c)(9) VEBA exemption 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


Section 501 (c)(9) VEBA exemption 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


Section 501 (c)(9) VEBA exemption 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)


Section 501 (c)(9) VEBA exemption 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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