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Rabbi Trusts

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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