Overview and Purpose
A rabbi trust is a trust established by an employer to provide a source
of funds which may be used to satisfy the employer's obligation to executives
under a nonqualified benefit plan. The trust is referred to as a rabbi
trust because the first IRS letter ruling with respect to this type of
trust involved a rabbi whose congregation had made contributions to such
a trust for his benefit. The ruling stated that the rabbi would not be
taxed on the funds in the trust until the funds were distributed to the
rabbi (or his beneficiary) upon his death, disability, retirement, or
termination of employment.
Typically, the rabbi trust is set up
as an irrevocable trust - the employer must
give up all rights to the assets and may not terminate the trust.
The trust is also usually considered a grantor trust, with income being
taxed to the grantor or employer.
The main purpose of establishing a rabbi trust is to offer
some level of security to the employee with respect to their
nonqualified benefits. This is especially true for a Nonqualified Deferral
Plan (NQDP), where the employee defers compensation with
only a contractual promise of the employer to pay the
benefits. Employee deferrals will be placed in the trust as
deferrals are made. In the event a "locked" Rabbi Trust is
established, once funds are placed in the trust, they may not
revert to the employer until all benefit obligations are fully
discharged. Trust assets must be used to pay benefits under
the plan. An "unlocked" Rabbi Trust allows the corporation to
access asset values as it sees fit.
How much security is provided? A key feature of a rabbi trust is that
the assets must be subject to the claims of the employer's creditors at
all times. If the employer becomes insolvent, all trust assets become
available to the employer's creditors, including NQDP participants. In
other words, if insolvency or bankruptcy occurs, the plan participants
stand in line with other employer creditors. So the security given is
protection against:
- Change of heart:
The employer cannot access assets in the trust,
once committed.
- Change of control: An
unfriendly takeover will not affect the assets in the trust.
Rabbi Trusts are frequently written with a trigger that requires full
funding of designated nonqualified benefit
programs upon a change of control, as defined within the document. This
mechanism protects participating executives from a change of heart due to a
hostile takeover, for example.
Rabbi Trusts and ERISA
The Department of Labor (DOL) has ruled that the establishment of a Rabbi
Trust would not in itself cause a plan to be considered funded
for ERISA purposes. Nor would the transfer of assets cause the plan to
be considered funded. The consequences of a plan being considered
funded for ERISA
purposes are that the plan would have to satisfy the
requirements of Title I of ERISA
which covers participation, vesting,
funding, fiduciary requirements, and enforcement requirements.
Rabbi Trusts and the IRS
The IRS has ruled that the establishment of a rabbi trust would not in
itself cause a plan to be considered funded for tax purposes, since
plan assets are subject to the claims of creditors, and are not set aside
solely for the benefit of participants. The consequences of a plan being
funded for tax purposes are that the plan participants would be
immediately taxed on accumulated funds as soon as the participant balances
become vested. For more on funded plans, please
view the Constructive
Receipt and the Economic
Benefit Doctrine
sections of Deferral.com.
IRS Positions on Rabbi Trusts
In Rev Proc 92-64, the IRS stated specific criteria
that are necessary to obtain a favorable ruling on a rabbi trust used
in connection with nonqualified plans. The Revenue Procedure contains
a model rabbi trust that is intended to serve as a safe harbor for taxpayers who adopt
and maintain the model trust in connection with nonqualified
plans. The Revenue Procedure goes on to state that if the
model trust is used, a plan participant will not be in constructive receipt or
incur an economic benefit,
solely on account of the adoption of the model trust.
This does not mean that a plan could
violate the constructive receipt doctrine or the economic
benefit doctrine due to other issues. In fact the IRS has
issued two Revenue Procedures, Rev.
Proc. 71-19, and Rev. Proc.
92-65, which state the guidelines used when reviewing
the underlying plan with respect to constructive receipt.
Excerpts of these Revenue Procedures may be found in the Constructive Receipt section of Deferral.com.
The IRS will continue to rule on plans that do not use a trust, or plans
that use the model trust. However, they will not rule on plans that use
a trust other than the model trust, except in rare and unusual circumstances.
Selected Provisions of the Model Trust
Below you will find a few of the
provisions in the model trust. More detailed
information and a sample copy of the model trust may be
found in Rev. Proc. 92-64.
- The trust must conform to the model
language provided in Section 5 of Revenue Procedure 92-64.
These provisions must be adopted verbatim, except where
substitute language is expressly permitted.
- The trust must provide that it is
the intention of the parties that the trust constitute an
unfunded plan, and that the trust will not affect the status
of the underlying plan, for purposes of ERISA.
- Trust must provide that the assets
are subject to the claims of creditors, in the event of
employer insolvency.
- Benefit payments to participants
must be suspended if the trustee is notified or otherwise
advised of the employer's insolvency.
- In the event of insolvency, the
trust must provide for the distribution of trust assets as
directed by the court to settle creditor claims.
- The participant must be prohibited
from assigning his benefits, prior to a distributable event
under the plan.
- The trustee of the trust must be an
independent third party.
- No assets may revert to the
employer until all benefits are paid.
- The trust must indicate how and when the employer will make contributions
to the trust.
Taxation of Rabbi Trusts
A rabbi trust is considered a grantor trust for income tax purposes, resulting
in trust income taxed to the employer. The trustee is required to file
a fiduciary tax return. Contributions to the trust are not tax deductible
by the employer. However, the employer may deduct the full amount of the
benefit payment as the trust makes payments to plan participants.
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