Is a single-employer welfare benefit plan appropriate for a small business?

• Author: Walker, Deborah

In an era in which tax-deferral transactions are subject to intensified scrutiny, businesses are challenged to bring ever-greater discipline to the design and implementation of legitimate employee benefit arrangements that offer tax advantages. This is particularly true for businesses with very few employees.

However, a small business often has an even more acute need than its larger competitors for the nontax advantages a well-designed benefit plan offers. A small business's need to attract and retain quality workers can often be met if it can offer prospective employees a superior benefits package. Yet, this important recruiting and retention tool can be a challenge for smaller businesses that may not have the in-house benefits and tax expertise needed to assess these plans. Consequently, many of these employers would welcome a benefits plan governed by dear rules.

Congress and the IRS have provided specific rules for certain arrangements, which, if followed, allow employers comfortably to take advantage of the favorable tax treatments such arrangements offer, and make use of the recruitment and retention advantages they provide.

A good example of this type of plan is a single-employer welfare benefit plan (WBP) funded by a trust. Sec. 419 governs deductions for contributions to such trusts. While some WBPs use tax-exempt trusts, some opt for a taxable trust. Generally, rules on the types of benefits permitted, the funding limits and the deductibility of contributions are the same whether or not the trust is taxable.

The law on welfare benefit arrangements may be overwhelming for advisers to closely held businesses. However, there are some guidelines that can help an employer decide whether and how to implement a WBP.

In General

A WBP provides welfare benefits (e.g., health benefits) for active and retired employees; life insurance; disability income insurance or payments; severance pay; supplemental unemployment benefits; long-term care benefits; and post-retirement medical or life insurance benefits. Under Sec. 419(e)(2), a WBP cannot provide disguised deferred compensation and is not a qualified retirement plan. Hence, a trust funding a WBP cannot be a source of retirement income or deferred compensation benefits.

Payments from a WBP will be made only if the specific benefit being funded becomes payable to plan participants. Thus, if a WBP is funding postretirement medical benefits, amounts will be paid only if the medical expenses are incurred in retirement. Assets related to funded post-retirement benefits that are not paid because an employee terminates before being entitled to benefits stay in the trust and are used to pay benefits to other employees.

WBPs can be part of an arrangement under which an employee has a choice between current compensation and current benefits; however, the choice cannot be between current compensation and deferred (retiree) benefits. Such an arrangement does not meet the Sec. 125(d)(2) cafeteria plan rules that prohibit salary reduction amounts from being used to purchase deferred benefits. Thus, to the extent that retiree benefits are funded, contributions must be employer contributions, not salary-reduction contributions.

ERISA Rules

A full understanding of the rules applicable to WBP funds requires focusing on Employee Retirement Income Security Act of 1974 (ERISA), as well as tax, requirements. The trust document funding a WBP will specify when and how benefits can be paid. A trustee must be responsible for investing assets until such amounts are paid to plan participants and beneficiaries. Trust assets can be used to pay benefits only as directed by the trust document.

The WBP trust's assets are owned by the trust, not by the employer; any use of the...