VEBA’s Excess Set-Aside is UBI

The Court of Federal Claims ruled that a tax-exempt voluntary employees’ beneficiary association (VEBA) recognized income subject to the unrelated business income tax (UBIT) because it exceeded the amount the VEBA could set aside to pay benefits.

The UBIT was enacted to prevent tax-exempt organizations from competing with taxable entities with an unfair advantage. Tax-exempt entities that receive business income unrelated to their exempt function must pay tax on this unrelated income. In 1984, Congress expanded the scope of UBIT to apply to certain passive income of VEBAs.

For tax year 2000, CNG, a tax-exempt VEBA, reported unrelated business taxable income (UBTI) of $2,693,592, from investments and paid UBIT of $1,065,684. In 2004, CNG filed an amended return for 2000 showing zero UBTI and requesting a refund of the $1,065,684 tax paid. The government denied the refund. The case was heard by the Court of Federal Claims under crossmotions for summary judgment.

Code § 512(a)(3)(B) provides that a VEBA may exclude from taxable income member contributions plus amounts set aside for payment of benefits and expenses. The amount that can be set aside without taxation, or the “qualified asset account,” is limited by section 419A(c)(1) to the amount of unpaid benefits at year-end plus expenses related to those benefits. CNG argued that its income did not exceed the set-aside amount as defined by IRC § 512(a)(3)(E). The government argued that the income exceeded the set-aside amount as defined in Treas. Reg. § 1.512(a)-5T, which it said is enforceable because the Code section is ambiguous.

The first issue before the court was whether section 512(a)(3)(E)(i) is ambiguous. Since the Code does not clearly describe the computation of the set-aside amount and the impact of using investment income to pay benefits, the court concluded that the section was ambiguous.

The court then turned to the amount of deference that must be given to the regulations. The court determined that the regulation was interpretative and entitled to deference under the standard announced in National Muffler Dealers Assn. (440 U.S. 472 (1979)). The regulation defines the set-aside amount as the total amount set aside for benefit payments from both member contributions and investment income. According to the court, this is a reasonable interpretation of the Code and congressional intent and therefore entitled to deference and enforcement.

The court also distinguished the instant case from the Sixth Circuit case of Sherwin-Williams (95 AFTR2d 2005-1864), which reached an opposite conclusion on similar facts. In Sherwin- Williams, the parties stipulated that the investment income was used to pay the benefits. In the current case, no such stipulation existed, the Court of Federal Claims noted. In addition, the fact that the investment income was paid out for benefits would not change the amount of the nontaxable set-aside, the court said. The Court of Federal Claims also said the Sixth Circuit incorrectly based the set-aside amount on the investment income left over after paying benefits.

The result of the current case is a conflict between the courts as to how the set-aside amount should be calculated. Future litigation will be necessary to determine the exact formula to calculate a VEBA’s UBTI. The final result likely will hinge on whether courts consider the regulations to be a reasonable interpretation of ambiguous Code provisions.

By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.