Research indicates that there are many and complex reasons why employees are attracted to and leave businesses, and that employers must “take care of business” to assure that little grievances by employees do not turn into big problems in retention. In short, the employer has to assure that employees feel wanted, appreciated and needed.
This paper discusses a powerful way of providing your employees (and yourself) financial benefits that will be significantly paid for as a deduction on your business tax return. Those benefits can be provided by adopting a “welfare benefit plan.”[1]
What is a Welfare Benefit Plan?
A welfare benefit plan is an employer-sponsored benefit plan in which all employees-including the ownfers of the business-can receive a wide range of “welfare” benefits. A welfare benefit plan is defined under U.S. Internal Revenue Code (IRC) Section 419(e) (thus, the name “419(e) Plan”), and allows benefits during the working years (such as college tuition payments, supplemental disability pay, severance pay, and in-home care); benefits to pay medical expenses after retirement; and death benefits for family and estate preservation. Any type of closely-held business (LLC, LLP, C-Corp, S-Corp, FLP) that is not taxed as a sole-proprietorship may participate in a 419 plan.[2]
Although a welfare benefit plan can be structured to be discriminatory among employees, there are at least two situations where an employer must follow the non-discrimination rules that apply to other benefit plans.[3] The first situation is when the welfare benefit plan is structured as a Voluntary Employees Benefit Association (VEBA).
Unlike a single-employer or a multiple-employer plan, a VEBA is non-discriminatory and is a tax-exempt trust. In addition, the benefit formula in a VEBA is based on a participant’s compensation, and the benefit contribution is limited to $200,000. The second situation is when the 419 Plan provides for post-retirement benefits. When a plan provides for post-retirement benefits, IRC Section 419A(e)(1) requires the benefits offered to be on a non-discriminatory basis. Therefore, if a 419 plan is non-VEBA and does not provide for any post-retirement benefits, it may be discriminatory.
A qualified plan (retirement plan) must meet the minimum coverage test set forth in IRC Section 410(b) and regulations thereunder. However, there are no clear guidelines as to what non discrimination rules apply to a 419(e) Single Employer Welfare Benefit Plan.[4] The DBO Plan should not have to deal with the enormous restrictions set forth in ERISA.
Nonetheless, we do believe the U.S. Internal Revenue Service (IRS) views all Plans, qualified and non-qualified, as generally not favoring the Highly Compensated Employee (HCE). With that premise in mind we have to look at two issues, one is coverage and the other is benefits provided to the covered employees.
How is the Investment Held?
Since any investment income inside a non-VEBA welfare benefit plan is currently taxable to the trust, most trustees choose to invest their plan assets in life insurance as any growth of cash value in a life insurance policy is tax-deferred. This creates a potential double-benefit. If a plan participant enjoys a long life, the tax-deferred build-up of value within the life insurance policy can help pay an array of welfare benefits, including supplemental disability, severance pay, education expenses, in-home care, medical expenses and more. Should the plan participant die, a tax-free death benefit will be paid to his or her beneficiaries.
Additionally, a 419 plan allows an employer to provide those benefits while receiving a substantial current-year tax deduction for providing them. Even better, a 1997 tax court case, Booth v. Commissioner, 108 TC 524 (1997), decided in the face of an IRS challenge that there is no tax to the 419 trust or to its participants, so that the value of the benefit the employee receives will not be added to his or her W-2 income-the benefits are non-taxable.
Who Gets What
The Employee. Companies looking to reward and retain their most important employees-usually highly compensated owners and executives with incomes over $100,000-are often limited in the amount they can contribute to most plans, particularly qualified retirement plans.
As of January 1, 2007, the annual contribution limit for defined contribution plans such as 401(k) plans will be only $45,000. The annual retirement benefit limitation under a defined contribution plan will be $180,000. For a high-income taxpayer, that contribution is not large enough to sustain the lifestyles of these highly compensated individuals over a prolonged retirement. In addition, as these employees near retirement, rising medical, prescription drug costs, and long-term care can potentially threaten the retirement lifestyle that the highly compensated employee has become accustomed to.
A welfare benefit plan can help to alleviate many of these issues by providing such benefits as severance, supplemental unemployment benefits (SUB), post-retirement medical, long-term care, sickness, accident, disability, medical, educational, vacation, dismissal wages, recreational or similar benefits. This helps to preserve the employees’ retirement savings and provides peace of mind that they are covered both in their working years and in retirement by a welfare benefit plan.
The Company. In today’s competitive economy, employee turnover is a major concern for businesses. It can be devastating when a key person leaves an organization. The reasons employees leave are as varied as the employees who leave, but most experts agree there are concrete ways to give employees incentive to stay.
For small- to mid-size companies, a welfare benefit plan offers an advantage in retaining and attracting employees by allowing the business to provide a unique, flexible benefit plan which ultimately rewards and retains the firm’s employees.
In planning for an employee-participant termination, the plan can be structured to act as “golden handcuffs,”[5] or it can be designed as a “portable” benefit plan to allow the employee to take the benefits with them to assume any additional costs of the benefits. No matter how the benefits are structured, the contributions to the plan can be fully tax-deductible to the company.
The Owner. A welfare benefit plan addresses some additional needs of the owner-employee of the company. Since, like pension plans, the plan participant has no incidence of ownership of the plan assets, the plan assets are creditor protected.[6] In addition, the death benefits of a welfare benefit plan can assist in providing a tax-deductible method of funding business and estate planning needs.
Sample Case 1: Presidio Animal Clinic
Presidio Animal Clinic is a five-year old veterinary hospital with six full-time veterinary doctors and three full-time assistants. Two of the doctors, Jane and Julie, are 50/50 owners of the hospital. They wanted to reward the non-owner doctors for growing the practice and provide them with additional incentive to stay with the hospital. In addition, Jane and Julie wanted to create a business succession plan that would protect the practice should something happen to them unexpectedly. Of course, providing the benefits using a tax-deductible method would mitigate a majority of the expected large tax burden from the very profitable hospital over next five years. They had $200,000 they could contribute to a plan annually. However, they did not want to be locked in to that amount in future years.
Jane and Julie decided to use a 419(e) welfare benefit plan for the benefits offered and its flexibility, as well as the selective participation capability. They chose to include the six doctors, who each received a permanent life insurance policy ranging from $1.2 million to $1.8 million in coverage, depending on age. Each of the non-owners named their spouses as beneficiaries of the death benefits provided by the plan. Jane and Julie named each other as beneficiaries of their death benefit provided by the welfare benefit plan in order to provide the cash needed to buy the other person’s share of the practice from their family should one of them die unexpectedly.
All six doctors completed a life insurance application and took an insurance physical examination. Jane and Julie signed the plan adoption agreement. Presidio Animal Clinic wrote a check for $200,000 for the initial contribution and another check for $2,500 for the annual administration fee. The plan was effective once the plan administrator received the adoption agreement and administration fee. Upon the next tax filing, the hospital deducted 100 percent of the $200,000 contribution amount and the $2,500 administration fee.
The hospital has continued to grow and all of the doctors are still with the hospital. Jane and Julie are looking to hire two more doctors and three more staff people in the next six months. Needless to say, all of the doctors know that they are taken care of in the future and are appreciated by their employer. Moreover, Jane and Julie breathe a bit easier knowing that they are protected as owners and that they have provided additional incentive for their employees to stay with the hospital.
Sample Case 2: Monarch Plumbing
Monarch Plumbing is a general contracting firm that has been in business for 20 years. The owners, John and Steve, are father and son. John, age 54, is 75 percent owner and Steve, age 28, owns 25 percent. Also employed by Monarch are two full-time office managers who have been with the company for over 10 years.
John and Steve want to reward the office managers with additional benefits, fund an estate plan with life insurance for John, and provide additional life insurance protection for Steve’s growing family. Due to Monarch’s expected growth, funding a tax-deductible benefit plan would help reduce Monarch’s growing tax burden. They expect to be able to contribute approximately $250,000 annually over the next five to seven years.
John and Steve chose the 419(e) plan for the tax-advantaged contributions and the admintrative simplicity of the plan. They designed the plan to provide a six million dollar life insurance policy for John’s estate plan requirements and a three million dollar life insurance policy for Steve. The office managers each received a $500,000 life insurance policy.
John, Steve, and the two office assistants each completed a life insurance application and an insurance physical examination. John and Steve signed the adoption agreement and Monarch submitted a check to the plan administrator for $250,000 for the initial contribution and a check for $2,500 for the annual administration fee. Upon the next tax filing, Monarch deducted 100 percent of the entire $252,500.
Monarch has continued to grow as expected. They have added two office assistants and have moved into a larger office. The office managers feel appreciated for their dedication to the company. John is more content knowing that his estate will remain intact for his children and grandchildren. Steve is relieved to know that his family is financially protected.
Summary
Running a business is a tough job made somewhat easier by having the right employees in place. A 419 plan provides the opportunity to recruit and retain employees using tax-deductible contributions. An additional, important benefit is that owners can provide themselves large benefits using a 419 plan.
Aside from the tax deduction that an employer is eligible to take for a contribution to a welfare benefit plan, there are several non-tax benefits that are inherent in a properly structured welfare benefit plan. Company dollars rather than personal dollars are used to purchase benefits. There is no limit on the amount of the contribution that an employer may make to a welfare benefit plan. There is no taxation to the employee for funds contributed to the welfare benefit plan since employees have no constructive receipt of the contributions to the plan.
A plan that is not a VEBA nor provides for post-retirement benefits can be totally selective in who it provides benefits for-plans can even provide benefits for just one person.
All funds in the plan are secure from the hands of creditors, personal as well as business, and all proceeds can go the next generation without the payment of income, estate, or gift taxes. These plans even avoid the Generation Skipping Tax.
Perhaps the most attractive benefit of a 419 plan is that there is no limit on the amount of the contribution that an employer may make to a 419(e) welfare benefit plan. The only thing that is limited by IRC Sections 419 and 419A is the amount of the deduction that an employer is eligible to take. This amount is referred to as the “qualified cost.” If an employer contributes an amount in excess of the “qualified cost,” the non-deductible portion is automatically carried over to the next tax year and may be deductible then, as allowed for under IRC Section 419(d). So regardless of the amount of the employer’s contribution, it all eventually will be deductible because of the unlimited carryover provision of 419(d).
Because maintaining a healthy work environment for its employees is critical for a company’s success, a company may choose to provide additional benefits that cater to the key employees in the organization. A 419 plan can be designed to provide special fringe benefits to these employees to enhance both their working years as well as their retirement years. The costs of the benefits are tax-deductible to the company! What could be better for a firm: Happy employees and happy owners, with the costs of their extra benefits partially subsidized by the government!
[1] The authors would like to thank an anonymous reviewer who, in addition to his or her other excellent comments, provided a citation to “The Depths of IRC 419,” http://www.irs.gov/pub/irs-tege/eotopicj92.pdf. That document covers IRC 419 at a level of depth that an accountant or attorney would love. We hope this article provides the appropriate depth for most GBR readers, who will defer to their professionals for actual implementation of employee benefit plans.
[2] The reason that a business that is ultimately taxed as a sole-proprietorship is not eligible to participate in a welfare benefit plan is that the employer and the employee are the same taxpayer.
[3] Under U.S. Internal Revenue Code section 505(b), employers are required to provide benefits to employees in such a way that a “favored group,” generally highly compensated employees, do not get the lion’s share of the benefits. The tests for whether discrimination has occurred are beyond the scope of this article, but generally, benefits must treat different classes of employees equally.
[4] Numerous tests can apply and satisfy discrimination issues, including Minimum Coverage Test, Ratio Percentage Test, Average Benefit Test and Average Benefit Percentage Test. Those tests will give assurance that discrimination issues are being met, and are commonly used in testing other employee benefit plans.
[5] “Golden handcuffs” definition: “Rewards and penalties designed to discourage key employees from leaving a company,” according to Investorwords.com at http://www.investorwords.com/2199/golden_handcuffs.html.
[6] The beneficiary of the plan is entitled to the plan benefits, as specified. He does not, however, own the underlying assets of the plan-he only gets the benefits he is entitled to. Therefore, the assets are not subject to attachment by creditors.
