CLEVELAND -- Parker-Hannifin Corp. might have created a VEBA trust to reap a one-time tax savings, according to a federal court ruling.
The court ruled the company cannot claim an income tax deduction for most of the $42 million it put into the VEBA for medical benefits -- including post-retirement benefits -- more than a decade ago.
Industry experts and legal sources say the case does not establish any legal precedents regarding pre-funding of such benefits.
But, they claim, the case provides a warning about when a legal deduction can be taken when using a voluntary employees beneficiary association 501c(9) trust to fund benefit payments.
Parker-Hannifin established the VEBA in June 1987 to serve as a funding vehicle for health, disability, life and other benefits to its members. Parker-Hannifin contributed $42 million to the VEBA in June 1987. The company never notified any of its labor unions of the existence of the VEBA, nor did it disclose its existence to shareholders or the public, according to court documents.
In August 1988, the company filed an application for exemption from federal income taxes for the VEBA for the $42 million contribution, according to court documents. The exemption was granted and the company then deducted the entire $42 million for the 1987 tax year, when the federal tax rate was 46%. In July 1987 the tax rate was lowered to 34%.
The IRS disallowed all but $9.5 million of the deduction, saying the deduction was improper because it was taken in a year in which the company did not incur expenses for the benefit payments.
Parker-Hannifin appealed to the U.S. Tax Court, which upheld the IRS determination. The decision then was appealed to the Sixth Circuit Court of Appeals in Cincinnati.
The appellate court supported the Tax Court's decision, ruling the company could not claim a deduction for such contributions in the year in which they were made, but should take the deductions when benefits are paid.
The appellate court also said the timing of the tax rate decrease to 34% from 46% for the 1987 taxable year compounded the case.
"Thus, Parker was able to increase significantly the value of its income tax deduction by claiming it in a year in which a higher federal income tax rate was applicable. One may infer that Parker's motivation for the creation of the VEBA Trust was to maximize what it perceived to be a one-time, tax-saving opportunity," the appellate court said.
However, the appellate court overturned the Tax Court's decision to disallow a $2.5 million deduction by Parker-Hannifin for its contribution for long-term disability benefits.
Of its $42 million contribution in 1987, the company included $10.8 million for post-retirement benefits for retirees and $16.2 million for post-retirement benefits for active employees. The rest covered medical, dental, disability and administrative expenses. Both were disallowed by the IRS and the Tax Court, which concluded these amounts of the 1987 contribution did not qualify as a "reserve funded over the working lives of covered employees" as required by statute.
Not only did Parker-Hannifin not accumulate assets for the payment of post-retirement benefits, the appellate court said, "the entire amount of Parker's 1987 contribution had been depleted by the second month of Parker's 1989 taxable year."
The company argued the law does not require that assets actually be set aside or accumulated, but that the phrase "reserve funded over the working lives of the covered employees" is only a "mathematical computation, which serves to limit the amount of the deduction an employer can take." Nor, the company maintained, does the provision require the establishment of a funded reserve.
The appellate court rejected the company's argument, ruling "the plain meaning of the term 'reserve' supports the (IRS) interpretation . . . that assets must be set aside and accumulated for the payment of post-retirement medical and life insurance benefits."
According to the court, "neither the plain language of the statute nor the legislative history supports Parker's contention that the term 'reserve' refers only to a mathematical computation of the reserve liability. . . . A reserve without funds, quite obviously, is a mere fiction."
Henry Saveth, principal and attorney in the Resource Group of William M. Mercer, Washington, said the appellate court ruling "follows previous case law in that you have to accumulate assets in reserve and fund the benefits over the working lives to claim a deduction."
Mr. Saveth said legal limitations on deductions involving VEBA trusts have been implemented to ensure employers do not overdeduct and "apparently the court felt in this case they overdeducted."
The key issue in the appellate court ruling is that tax deductions for VEBA contributions should not be taken as a single amount in the year in which they are made, said Barry Barnett, principal at the Kwasha Lipton Group of Coopers & Lybrand, Fort Lee, N.J. But, he said, the deductions should be taken as benefit payments are made in subsequent years.
"When they put in the $42 million, they were pre-funding for a year beyond the year" the contribution was made, he said. "So essentially they were putting in a big chunk of cash and paying it out over a number of years and took the deduction in the year they made the contribution. And the law specifically states you cannot pre-fund and take the deduction in the year you put the money in. You must take it in the years the benefits are paid. That's the key issue here."