Northrop Corp. v. U.S., (Ct Fed Cl 6/28/2011) 107 AFTR 2d ¶ 2011-998
The U.S. Court of Federal Claims, following the precedent in the Federal Circuit, has held that a voluntary employees' beneficiary association (VEBA) couldn't avoid the limitation on exempt function income in Code Sec. 512(a)(3)(E)(i) by allocating investment income to the payment of member benefits.
Background. A Code Sec. 501(c)(9) VEBA providing for the payment of life, sick, accident or other benefits is exempt if no part of net earnings inures to the private benefit of any person. Under Code Sec. 512(a)(3)(E)(i), the amount of income that may be set aside to provide benefits under a VEBA and treated as exempt function income can't exceed the qualified asset account limit under Code Sec. 419A(c) for the tax year (without taking into account any reserve for post-retirement medical benefits). The Code Sec. 419A(c) account limit for any qualified asset account for any year is the amount reasonably and actuarially necessary to fund the claims for account benefits incurred but unpaid as of the close of the year, and the related administrative costs. Accordingly, a VEBA's income is exempt from tax only to the extent that it does not result in a year-end account balance in excess of the amount necessary to satisfy incurred but unpaid member claims.
Under Reg. §1.512(a)-5T, Q&A-3, a VEBA will owe tax on the lesser of its investment income or the amount by which its year-end account balance exceeds this statutory account limit.
Under Code Sec. 419, an employer's contribution to a welfare benefit fund is deductible only for the tax year paid, and only to the extent the contribution doesn't exceed the qualified cost of the plan for its tax year that relates to (ends with or within) the employer's tax year. Qualified cost generally equals amounts expended on benefits plus any addition to the VEBA for the year, to the extent that the addition doesn't result in an account balance in excess of the account limit specified in Code Sec. 419A. A VEBA's qualified cost is then reduced by its after-tax income.
In late 2009, the U.S. Court of Appeals for the Federal Circuit, affirming the Court of Federal Claims, held that a VEBA couldn't avoid the limitation on exempt function income by allocating investment income to the payment of member benefits. (CNG Transmission Management VEBA, (CA Fed Cir 12/14/2009) 104 AFTR 2d 2009-7699) The Federal Circuit concluded that because CNG's investment income caused its total fund balances to exceed the statutory account limit, that investment income couldn't be classified as exempt function income. It rejected CNG's contention that its investment income didn't result in any account overage because it spent that income during the year on member benefits.
The Court also found that Code Sec. 419 limits the extent to which an employer can deduct contributions to a VEBA by limiting the deduction to the VEBA's qualified cost for the year; it does not indicate that in determining the amount of tax-exempt set-aside available under Code Sec. 512(a)(3)(E)(i), investment income must be the first source used to pay member benefits.
The Court similarly rejected CNG's reliance on Sherwin-Williams Co. Employee Health Plan Trust v. Comm., (CA 6, 2003) 91 AFTR 2d 2003-2302, which it found was clearly distinguishable on its facts. In addition, the Court disagreed with the Sixth Circuit's conclusion in that case that Code Sec. 512(a)(3)(E)(i) imposes a limit on a VEBA's accumulated funds, rather than its set-aside funds.
Issue before Court of Federal Claims. Northrop argued, as did CNG, that Code Sec. 512(a)(3)(E)(i) allowed a VEBA to allocate its investment income to the payment of member benefits and to avoid taxes on that investment income. It was undisputed that at the end of each relevant tax year, Northrop's assets exceeded the account limit under Code Sec. 419A by an amount greater than the investment income for the year.
Observation: The Court of Claims noted that Northrop (which was represented by the counsel that represented CNG) apparently wished to present a full record to the Court of Claims and Federal Circuit, so that the U.S. Supreme Court could eventually consider any and all of taxpayer's arguments against the Federal Circuit's interpretation of Code Sec. 512(a)(3). The Court noted that the taxpayer intended to seek a writ of certiorari if that becomes appropriate.
Court's conclusion. The Court of Federal Claims, concluding that it was bound by the precedent of the CNG decision, determined that a VEBA can't avoid the limitation on exempt function income in Code Sec. 512(a)(3)(E)(i) merely by allocating, or purporting to allocate, investment income toward the payment of welfare benefits during the course of the tax year. The Court granted IRS summary judgment and held that Northrop wasn't entitled to the tax refunds it sought.
The Court found that because it was bound by the Federal Circuit's decision in CNG, it specifically couldn't adopt a conflicting interpretation of Code Sec. 512(a)(3)(E)(i), adopt the reasoning in Sherwin-Williams that was rejected by the Federal Circuit, or consider Reg. §1.512(a)-5T to be other than a reasonable interpretation of Code Sec. 512(a)(3)(E)(i).
The Court further reasoned that since it was bound by the Federal Circuit's holding that because Code Sec. 512(a)(3)(E)(i) was unambiguous, the status of Reg. §1.512(a)-5T as invalid or arbitrary was immaterial to the resolution of Northrop's case. Because Code Sec. 512(a)(3)(E)(i) was clear and unambiguous under precedent binding on the Circuit, the reg's status, however firm or unfirm, wouldn't alter the analysis.
References: For VEBAs, see FTC 2d/FIN ¶D-4400; United States Tax Reporter ¶5014.18; TaxDesk ¶672,001; TG ¶20777.