by Charles Epstein, CLU, ChFC
Most family businesses have not used a welfare benefit trust (WBT) to provide employee benefits because it involves extra cost and, several years ago, Congress changed the tax law to remove some of the trust’s tax shelter capability. There are, however, other features that now warrant using this type of trust.
What Is a Welfare Benefit Trust?
A WBT can be set up by a company to provide benefits to their employees. The employer contributes money to the trust, then the trust pays for employee benefits instead of the money coming directly from the company. These employer-provided benefits may include medical insurance, disability insurance, severance pay, life insurance, dental and vision, and more. Benefits can be provided by insurance or the employee may be self-insured with the trust insulating the employer from liability from a catastrophic occurrence, such as a large uninsured medical expense. Employees will not experience any difference between the employer or the trust providing the benefits.
If an employer decides to use a WBT, it has two types of trusts to choose from. The first is the Voluntary Employees’ Beneficiaries Association (VEBA), which is a tax-exempt entity. The second trust is not. Apart from the exempt status, the trusts have few differences. This may be important if contributions to the trust are not all invested in insurance policies.
What Can a WBT Do?
If you create a WBT, it can allow the family business to prefund the cost of certain employer benefits. A VEBA WBT can receive tax-free earnings on the amounts put into the trust, which can reduce benefit costs. If you have no union employees and no other companies participate with yours in the WBT, you can generally only fund the current year’s cost and a small amount extra in some cases. Even so, if you fully fund the trust early in the year after benefits are paid, you should have funds left over at the end of the year because of the tax-free investment earnings.
If the WBT covers union employees or is part of a multiple employer plan, (one where 10 or more employers participate) you can prefund as much as is allowed under the employer’s accounting method. In the case of a cash basis company, often as much as 12 months of costs may be prefunded. If accrual basis, the contribution may also be prefunded to some extent. The prefunded amounts may be deducted for tax purposes even before they are used to pay benefits, so long as the amounts are actually contributed by the employer. (You cannot merely accrue the amount.)
A taxable WBT operates much the same as a VEBA except it is not tax-exempt. Both types of trusts must file Form 5500 to report the welfare benefits paid by the plan. The VEBA type WBT must also file Form 990 to report the trust’s income, even though it is tax-exempt.
A WBT can also, in some cases, allow you to take a tax deduction when you could not previously do so without the trust. The best example of this is a death benefit only plan. Ordinarily, life insurance premiums are not tax deductible. If you purchase life insurance in the trust, employer contributions can be tax deductible. The trust can use them to pay life insurance premiums.
Who Should Use a WBT?
If your company meets any of the following profiles, you should explore using a WBT:
- Lots of excess cash flow.
- Need for tax shelter.
- Desire to reduce welfare benefit costs.
- Desire to self-insure some employee benefits.
- Special Rules for Union Benefits
Changes made in 1984 restricted the amount of excess cash that an employer could put in a WBT and take a current tax deduction. The changes also took away a planning opportunity for companies needing an immediate tax deduction or wanting to take advantage of the time value of money. These rules do not apply, however, to collectively bargained plans. If your company has an employee benefit commitment for union employees, it can be prefunded to the extent allowed by your company’s accounting method. You may need an actuary to determine the amount to be prefunded, especially if benefits are provided all or part without insurance. This amount can often be quite large, providing a significant tax benefit to the employer.
Special Rules for Multiple-Employer Plans
If a welfare benefit plan covers employees of at least 10 unrelated employers and not more than 10% of the benefit cost is attributable to any one of them, your company can also prefund future costs even if union employees are not involved. Some institutions have constructed multiple-employer plans to take advantage of this exception. In some cases, these plans are also used to provide severance benefits.
While it’s proper to provide severance benefits under a more-than-10 employer welfare benefit plan, each employer’s contribution to the plan must be available to pay benefits for all participants, regardless of their employer. This requirement makes providing anything other than a pure death benefit under policies of insurance unattractive to most family businesses. The death benefit only plan funded with life insurance in a multiple employer plan can provide all employees a death benefit and allow the employer to shelter large contributions without the problems caused by severance benefits.
VEBA vs. Taxable WBTs
Clearly, one of the benefits of VEBAs is the tax-free investment of the cash in the plan. When a company has available investable cash, a VEBA is an appropriate vehicle. The tradeoff is that the VEBA must file Form 1024 to tax qualify the plan with the Internal Revenue Service, which costs money, and other more stringent requirements may apply.
In certain situations, however, companies don’t need a tax-free vehicle, such as when they expect to invest the plan money solely in life insurance contracts, which are already tax-deferred investment vehicles, or when the trust will never have excess investable assets. If a VEBA is not necessary, it probably should not be the vehicle for the WBT. While this is a simplified explanation, it generally holds true, although some professionals may differ on the last point.
The Benefits of a Death Benefit Only Plan
A WBT can provide tax-deductible death benefits through life insurance. Typically, the employer will cover all eligible employees on a uniform multiple of salary. If “10 times salary” is selected, an employee making $30,000 per year would be covered for $300,000 of life insurance. This means that because of generally higher pay, the family business owner will have a higher amount of coverage than line employees. The insurance can also be funded differently for family and other key employees than for the rest of the work force, which makes sense because turnover is usually greater among rank and file employees. Therefore, the family employees can be covered with universal life, whole life or even variable life insurance while the other employees can be covered with term. This increases the contribution on behalf of the family and the value of the policy held in the trust on their behalf.
There are several providers around the country which have plans that your company can join. They are designed to meet the requirements for multiple employer plans and because life insurance is used, it need not be a VEBA although some professional advisors prefer VEBAs even for death-benefit-only plans.
Designing Your Plan
WBTs can provide a vast array of benefits for employees or just a single benefit. How you set yours up and what it provides depend on your and your company’s needs. Call us so we may help you design this very useful tool.