Code section 512(a)(3)(E) and Treas. Reg. §1.512(a)-5T address the computation of the unrelated business taxable income of voluntary employees’ beneficiary associations (VEBAs) described in §501(c)(9). The provisions also apply to supplemental unemployment compensation benefit trusts (SUBs) described in §501(c)(17).

 §512(a)(3)(E). Unrelated business taxable income for social clubs, VEBAs, and SUBs is calculated differently than for most other exempt organizations. The special rules are contained in §512(a)(3). All income of a social club, VEBA, or SUB is taxable except exempt function income. Exempt function income has two components.  First, member contributions to a social club, VEBA, or SUB are exempt function income. The second component of exempt function income includes is income set aside for charitable purposes. For VEBAs and SUBs, the second component also includes amounts set aside to provide for the payment of life, sick, accident, or other benefits; provided, however, that the amount set aside for payment of benefits is exempt function income only to the extent that the amount does not exceed the qualified asset account limit under §419A. The qualified asset account limit is the amount reasonably and actuarially necessary to fund claims incurred but unpaid at the close of the taxable year for member benefits, plus administrative costs with respect to such claims.

 Comment: The difference between the two components of exempt function income is noteworthy. The first component is income in the traditional sense in that it is received from members and employers to pay for benefits and administration. The second component pertains to other income, such as investment income, but the amount included as exempt function is determined not with reference to the amount received but rather is limited to amounts set aside for the specified purposes, subject to the §419A limit (not taking into account any permitted reserve to fund post-retirement medical benefits).

 Prior to the Deficit Reduction Act of 1984, exempt function income of a VEBA or SUB included all amounts set aside for charitable purposes and for the payment of benefits. The 1984 Act added §512(a)(3)(E), which is the §419A limitation, to prevent VEBAs and SUBs from accumulating excessive non-taxed investment income in a set aside account.

 Treas. Reg. §1.512(a)-5T, issued in 1986, explains the application of §512(a)(3)(E). According to the regulation, UBTI of a VEBA or SUB is generally the lesser of:

•  the income of the VEBA or SUB for the taxable year (excluding member contributions); or
• the excess of the total amount set aside as of the close of the taxable year (including member contributions) over the qualified asset account limit (calculated without regard to the otherwise permitted reserve for post-retirement medical benefits) for the taxable year.

 Case Law. The computation of UBTI for VEBAs was the subject of recent litigation. Three VEBAs argued that the §419A limit applies to amounts accumulated in a set aside account at year’s end and not to amounts expended on benefits during the year. The VEBAs claimed that they used investment income, rather than member contributions, to pay benefits during the taxable year. Under their arguments, investment income would not be taxable if it was used by a VEBA during the taxable year to provide benefits. The VEBA prevailed in Sherwin-Williams Co. Employee Health Plan Trust v. Commissioner, 330 F.3d 449 (6^th Cir. 2003), nonacq., AOD 2005-02. VEBAs in two other cases lost similar arguments. In CNG Transmission Mgmt. VEBA v. United States, 588 F.3d 1376 (Fed. Cir. 2009), a VEBA argued that its investment income was used first to provide member benefits, leaving member income which is expressly included in exempt function income. The Federal Circuit Court of Appeals in CNG Transmission distinguished in part and rejected in part Sherwin-Williams, holding the §419A limitation applies to all amounts set aside for member benefits, whether or not actually expended during a taxable year. In Northrop Corp. Employeee. Ins. Benefit Plans Master Trust v. United States, 99 Fed. Cl. 1 (Cl. Ct. 2011), the federal claims court followed the Federal Circuit in rejecting the VEBA’s attempt to avoid UBIT on its investment income.

 Particularly given that the Congressional intent for enacting §512(a)(3)(E) was to limit the ability of VEBAs and SUBs to collect untaxed investment income in set aside accounts, the CNG Transmission and Northrop cases properly construe §512(a)(3)(E). As the IRS pointed out in its nonacquiescence to Sherwin-Williams:

 We disagree with the Sixth Circuit’s conclusion that investment income can be set aside and used separately before the end of a taxable year to pay the reasonable costs of administering health care benefits and thereby avoid the limits imposed by 512(a)(3)(E) on exempt function income. As discussed above, the statutory provisions are not dependent upon a determination as to whether particular sources of income were used to pay the costs of administration in any particular year.

 Treas. Reg. §1.512(a)-5T. In Sherwin-Williams, the Sixth Circuit referred to Treas. Reg. §1.512(a)-5T as supporting its conclusion that the §419A limitation applies to the amount of investment income remaining at the close of the taxable year. The court quoted the statement in Treas. Reg. §1.512(a)-5T, A-3(a) that the limitation applies to amounts set aside to pay benefits “as of the close of the taxable year.”

 In contrast, in CNG Transmission and Northrop, the VEBAs argued that Treas. Reg. 1.512(a)-5T was invalid. The Tax Court in CNG Transmission held that §512(a)(3)(E) was ambiguous and that Treas. Reg. §1.512(a)-5T was a reasonable interpretation of the statute that supports the government’s position. On appeal, the Federal Circuit concluded that the statutory language in §512(a)(3)(E) was not ambiguous; but even if §513(a)(3)(E) were ambiguous, Treas. Reg. §1.512(a)-5T was a reasonable interpretation of the statute entitled to deference.  As to the validity of the regulation, the Federal Circuit in CNG Transmission declined to consider the issue because it was not timely raised by the VEBA at trial.

 The Northrop court declared itself bound by the conclusion of the Federal Circuit in CNG Transmission that §512(a)(3)(E) was clear and unambiguous. Thus, any arguments that the temporary regulation is invalid or arbitrary were immaterial to the analysis in Northrop. The claims court acknowledged the VEBA’s arguments against the validity of Treas. Reg. §1.512(a)-5T, but declined to “indulge in an analysis of the status of” the temporary regulation that would be pure “dicta.”

  Section 512(a)(3)(E)  does not contain a reference to ”the close of the taxable year.” According to §512(a)(3)(E)(i), a VEBA or SUB may treat a set aside to pay benefits to members as exempt function income only to the extent that the set aside does not result in an amount of assets set aside for such purpose in excess of the account limit determined under §419A for the taxable year. Given the language of §512(a)(3)(E)(i), it seems that the phrase “as of the close of the taxable year” in Treas. Reg. §1.512(a)-5T refers to the time frame for applying §512(a)(3)(E) rather than to the balance existing at the close of the taxable year.

 To clarify the point, the final regulation could either replace the reference to the close of the taxable year with the wording of §512(a)(3)(E) or state that the limitation applies to amounts “used or set aside” by a VEBA or SUB as of the close of the taxable year.

 In its 2011-2012 Priority Guidance Plan, the IRS includes regulations under §512 explaining how to compute the UBTI of a VEBA as a priority under Employee Plans – Executive Compensation, Health Care, and Other Benefits, and Employment Taxes. Given the support for the regulation in CNG Transmission and Northrop, it is unlikely that the final regulation will differ significantly from its temporary predecessor.