I am Glad You Asked! Using Welfare Benefit Trusts to Solve Post-Retirement Medical Planning Needs

by Gerald Nowotny
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Part I

Overview

Scott Peck’s bestseller the Road less Traveled begins with the understatement of understatements – “Life is difficult”.  Trouble in life comes from so many different directions. For the small business owner, it is a combination of challenges – the economic environment, taxes and government regulation. For the corporate middle manager that has a high paying job, it is age discrimination under the guise of corporate restructuring along with high taxes.

In either case, trouble seems to find you right at the time when your kids are still in college, your parents have moved in with you because your Mother has Alzheimer’s and your spouse is threatening to leave because they aren’t personally fulfilled.

I can’t solve all of those problems but I can propose an interesting solution to the problem of post-retirement medical benefits. What exactly are post-retirement medical benefits? For most of us, our only connection with post-retirement medical benefits seems to be through media coverage dealing with the problem that most large corporation and state and municipal governments have regarding under-funding.

In a nutshell, the companies made a number of promises regarding post-retirement medical benefits, and the money that they have set aside is a lot less than the cost of medical benefits that they promised to pay for retirees.  The problem with large corporations is the accounting treatment and adverse impact on earnings. The problem for retirees is different. Retirees have to decide how to finance Mama’s nursing home costs because she has Alzheimer’s and Dad wants to avoid spending his children’s future inheritance that he worked fifty years to accumulate.

The other side of the side is also one that does not immediately jump to the surface when you hear the term “post-retirement medical benefits.” What is going to happen to Junior who is on the Autism Spectrum when his parents are no longer around? Junior’s parents worry about Junior not becoming a burden on the siblings and attempting to provide the best financial support and healthcare for Junior with or without government support.

This article suggests the use of a single employer welfare benefit trust that is funded on a pre-tax basis. The welfare benefit trust is a taxable trust and may be funded using permanent life insurance or using an investment strategy that does not generate a lot of current investment income taxed at ordinary rates. The welfare benefit trust provides a pre-retirement death benefit and post-retirement medical benefits. The range of medical expenses for the business owner, spouse and dependents is wide ranging. This article is the first of several installments introducing the single welfare benefit trusts and a tax efficient mechanism to finance future medical costs in retirement.

Legal Background

A Single Employer Welfare Benefit Plan under IRC Sec. 419(e) is an employee benefit plan established by an employer for the benefit of its employees. The plan generally provides for the payment of sickness, accident, life or other benefits to its members or their dependents or designated beneficiaries.

The purpose of a Single Employer Plan is to furnish a method by which employers may provide certain specified health and welfare benefits to a group of its employees, as defined by the employer. The employer makes tax-deductible contributions to the Plan to pay for the selected benefits selected.

The investment earnings of the Plan derived from its investments are taxable to the trust during the funding period.  The employee is not taxed on the contribution made on his behalf, except for the amount of imputed income (relating to the economic benefit of any life insurance on his life using the lesser of the life insurer’s term insurance cost or Table 2001.

A Single Employer Plan may be formed as a trust or a corporation, generally having as its trustee, a bank or trust company, and is administered by a common plan administrator. A Plan should only be considered by an employer who offers or will provide a qualified retirement plan. Let’s not give the IRS a reason to believe that the Plan is a retirement plan in disguise. It’s not! However, the single employer welfare benefit trust is not subject to the qualified retirement plan rules of IRC Sec. 401(a). Nevertheless, the single employer welfare benefit trust is subject to the provisions of ERISA.

A Plan that receives employer contributions is subject to Title I of ERISA in particular those rules that apply to ERISA reporting and fiduciary requirements for employee welfare benefit plans. The employer must prepare a Summary Plan Description, to be filed with the Department of Labor and distributed to the plan participants.  

Additionally, the trustee must file IRS Forms 5500 annually, to report on the financial aspects of the Plan. The trustee of the Plan is subject to all of the fiduciary, disclosure and reporting rules of ERISA.

As long as the participants do not make any contributions to the Plan, the plan is exempt from the vesting and funding requirements of ERISA. The participant must be employed through the specified retirement age and satisfy all plan requirements to receive post-retirement medical benefits.

The Single Employer Welfare Benefit Trust versus Multi-Employer Welfare Benefit Trusts

Most clients run for the door these days as soon as you mention the numbers – 419. Multi-employer welfare benefit trusts were heavily audited in the last 1-12 years. Bloodstains are still visible on the Streets! In some cases, every client of a 419 promoter underwent an IRS audit and ended up paying taxes, interest and penalties. However, at the same time that these plans were being bludgeoned by the Service, a few single employer benefit plans remained unscathed. How did they manage this with the IRS who was on a “search and destroy” mission with respect to 419 plans?

A Multiple Employer Welfare Benefit Plan, is a welfare benefit plan that is part of a 10-or-more employer plan and that qualifies for special treatment under IRC Sec. 419A (f)(6). In many cases, these programs were marketed and sold to business owners as a form of tax-deductible non-qualified deferred compensation or at least the IRS thought so!

Contributions to welfare benefit plans are deductible by an employer when paid if they qualify as ordinary and necessary business expenses. Most 419A (f)(6) multi-employer cases ended badly for the taxpayer. The Single Employer Welfare Benefit Trust funding pre-retirement death benefits and post-retirement medical benefits is not that Plan.

Time after time in scheme after scheme, promoters have claimed their plans satisfy section 419A(f)(6) and generate deductions for the insurance benefits provided under the plans yet are also tax-free to plan participants. Each and every time, the taxpayer has lost!

Single Employer Welfare Benefit Trust Tax Considerations

The Single Employer Plans relies on a series of tax provisions for its favorable tax treatment.  IRC Sec. 419(e) provides the operating rules and definitions for a Welfare Benefit Plan. IRC Sec 62 allows a deduction for the annual employer contributions to the plan as an ordinary and necessary business expense.

IRC Sec. 419(c)(1) defines the deductible contribution as being the “qualified cost” of the benefits provided and additions to the qualified asset account. IRC Sec. 419(a) defines the deductible contribution as being the “qualified cost” of the benefits provided and additions to the qualified asset account.

The employer’s contributions to the Plan are made on a tax-deductible basis. Employees covered under the plan are only taxed on the economic benefit costs under Table 2001 for any pre-retirement death benefit provided by the plan. At retirement, Plan disbursements to retirees, their spouses and dependents are received on a tax-free basis for payment of post-retirement medical benefits.

No part of the Plan’s net earning can inure to the benefit of any private shareholder or individual, except through benefit payment(s). At termination, the benefits do not revert back to the Employer. This is a key technical point, which hurt so many multi-employer trust arrangements.

Upon termination of its participation in a Plan by an Employer, the prohibited inurement rule is not be violated if any assets remaining after satisfaction of all liabilities are used to provide life, sickness, accident or other benefits to employees, using criteria that avoid disproportionate benefits to officers, shareholders or highly compensated employees of the employer.

The Plan may be selective on participation in pre-retirement life benefits. However, the Plan’s post-retirement medical benefit must be offered to all employees on a non-discriminatory basis. The employer does have the option to exclude several categories of employees for post-retirement medical benefits.  These are:

  1. Employees with less than 3 years of service;
  2. Employees under age 21.
  3. Seasonal, temporary or part-time (less than 1000 hours worked per year) employees;
  4. Employees covered by collective bargaining;
  5. Nonresident aliens.

In a typical closely held business, it is unusual for an employee to remain with the Employer for an entire career. The Plan does not have a vesting schedule. On the other hand, why shouldn’t an employee that has worked for the business owner loyally for thirty years be entitled to some security in old age?

The Calculation of Plan Funding Under a Single Welfare Benefit Trust

The Funding of future benefit obligations (death and post-retirement medical expenses) is provided utilizing cash deposits. Alternatively, permanent life insurance may be utilized to fund the Plan on a tax-free basis utilizing the policy cash value and accrued insurance proceeds to pay post-retirement medical expense(s).

Reasonable actuarial assumptions and certifications as per IRS Notice 2007-84 are utilized to calculate the maximum funding amount to be made during the employer’s working years. The employer makes contributions on an annual basis in order to meet the targeted funding amount.

The insurance contracts may be set up so that the annual premiums will constitute “qualified costs”, as defined in IRC Sec. 419(c)(1). In many respects, the funding for post-retirement medical benefits is similar to the funding of a defined benefit plan obligation.  A future article will outline the actuarial factors involved in the funding level of the Plan.

Thinking Outside of the Box When it comes to Post-Retirement Medical Benefits

  1. Alzheimer’s and Dementia

The term post-retirement medical benefit is nebulous. One item that ominously stalks any retiree is the possibility of Alzheimer’s or another form of dementia. According to the Alzheimer’s Organization, one in three seniors dies with Alzheimer’s or some other form of dementia.

In 2013, the direct costs of caring for those with Alzheimer's to American society totaled an estimated $203 billion. Total payments for health care, long-term care and hospice for people with Alzheimer's and other dementias are projected to increase from $203 billion in 2013 to $1.2 trillion in 2050 (in current dollars).

This dramatic rise in costs includes a 500% increase in combined Medicare and Medicaid spending. The federal and state governments simply can’t afford this. How much more can you be taxed?

The affluent business owner’s likelihood of qualification for Medicaid benefits is “slim to none”. The “spend down” requirements would require the retiree to have $2,000 of assets left and about $50 of income per month. The community spouse or non-impaired spouse would be left with some exempt assets like a home and a car and a monthly income of about $2,750 per month.  The sixty month look back on asset transfers is designed to prevent “gaming the system” in order to qualify for Medicaid.

The Plan provides a method to pre-fund future medical expenses on a tax-deductible basis. The payment of future medical expenses in retirement to a nursing home or health healthcare services will receive tax-free treatment. Trust assets may accumulate towards these future needs with little or no taxation. The point is this – There is no need to spend yourself into poverty in order to provide medical benefits for a spouse.

  1. Autism Spectrum Disorder

Autism and related illnesses on the spectrum have reached epidemic levels. As of 2008 the incidence of Autism is 1 in 88 children. In 2000 these same numbers were 1 in 160. The medical costs for a child with autism are 6-9 times greater than a child without this illness. Additionally, the average cost for behavioral counseling services and care on top of medical costs is an additional $40,000 - 60,000. Many parents rightfully worry about the future care of their autistic child.

This concern is heightened at a time with large federal and state budget deficits and likely cutbacks in government benefits in the future. Taxes continue to increase making it harder to finance future healthcare benefits on an after-tax basis. Parents are also concerned about not imposing additional financial and economic burdens on siblings and other family members.

The Plan can provide important funding for these special needs situations on a pre-tax basis. Life insurance funding within the Plan can provide a “self-completion” component in the event of the parents’ death.

Summary

The Single Welfare Benefit Trust under IRC Sec. 419(e) offers great utility when it comes to funding post-retirement medical benefits which are at least $250,000 - 500,000 for the average retiree depending on the statistics that you use. These numbers do not contemplate long term nursing costs, which may be $100,000 - 125,000 per year in an average nursing home.  Seniors on Medicare only have about 50 percent of the cost of medical services and prescriptions covered by Medicare and definitely no coverage for nursing home requirements.

Several points come to mind. First, with income tax rates rising, the Plan provides a meaningful current reduction in taxes. Second, the issue of post-retirement medical costs is real and always presents itself when you least expect it. The Single Employer Welfare provides a strategic method for pre-funding these needs with large and meaningful tax deductions. In many respects, the level of funding may be similar to a defined benefit plan. Funds can accumulate with little or no taxation to make payments on a tax-free basis for the business owner, employees, spouses and dependents.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Gerald Nowotny, Law Office of Gerald R. Nowotny | Attorney Advertising

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