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CCH® PENSION — 03/23/10

VEBA barred from allocating investment income to payment of benefits to avoid tax on UBTI

A voluntary employees' beneficiary association (VEBAs) may not allocate investment income to the payment of member benefits in order to avoid the limit on "exempt function" income, and thus avoid the tax on unrelated business income, the U.S. Court of Appeals for the Federal Circuit (CA-FC) has ruled in CNG Transmission Management VEBA v. United States.

Exempt function income

Under Code Sec. 512(a)(3), there are two classes of exempt function income: (1) member contributions to the VEBA and (2) income "set aside" for payment of benefits. The amount of income set aside may not exceed a statutory account limit for the taxable year. Although the VEBA conceded that its year-end account balance exceeded that limit, it contended that it owed no UBI tax on its investment income because it had spent that income on member benefits during the year.

The appellate court affirmed the lower court's rejection of that argument. Under Reg. §1.512(a)-5T, a VEBA must pay tax on the lesser of (1) its investment income, or (2) the amount by which its "set aside" exceeds the statutory account limit. This formula does not provide for the allocation of income from a particular source to a particular expense. Thus, a VEBA may not avoid taxation on its investment income by allocating that income to the payment of member benefits during the tax year.

In addition, the court rejected the VEBA's argument that the rule in Code Sec. 419 treating a VEBA's investment income as the first source of funds to pay current member benefits extends to Code Sec. 512(a)(3).

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer's Benefits Reports.

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