Rabbi Trusts

One of the most popular strategies for protecting non-qualified deferred compensation is the Rabbi Trust. A rabbi trust is an irrevocable trust used to fund deferred compensation benefits for key employees. It is often used to hold certain amounts of an employee's pay until an agreed upon date gives the employee the right to the funds and as a vehicle for providing long-term stock ownership incentives to motivate and retain key executives as well as a means for deferring taxable income. As a non-qualified deferred compensation plan, rabbi trusts avoid many of the complex and administratively burdensome requirements that govern qualified plans under ERISA and the Internal Revenue Code. In addition, they can be tailored with great flexibility to fit precise objectives and be targeted for a specific employee or groups of employees.

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 upon his disability, retirement, or termination of employment; or to his beneficiaries upon his death. 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 purpose of establishing a rabbi trust is to offer some level of security to the employee with respect to their non-qualified benefits. This is especially true for a Non-qualified Deferred Compensation (NQDC) Plan, in which the employee defers compensation with only a promise of the employer to pay the benefits. Employee deferrals will be placed in the trust as deferrals are made. In a "locked" Rabbi Trust, 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. In an "unlocked" Rabbi Trust, the corporation to access asset values as it sees fit.

In a rabbi trust, the company can choose to place assets inside the trust as additional liquidity to provide benefits reserved under the non-qualified deferred compensation plan. The trust is an entity of the corporation and takes direction from the plan committee that governs the non-qualified deferred compensation plan. Because the trust is an entity of the corporation, any asset held in trust is taxable to the corporation based on the corporation's tax bracket. The trustee has responsibility to provide payouts, if necessary, only to pay executive benefits. The corporation cannot access the trust for its working capital.

Vesting can occur over seven years, or longer if the employee is considered "top-hat". The employer records an expense based on the value of the award spread over the vesting period. Distributions can be made in cash or stock. Employees defer all income taxes until distribution and the employer receives a corresponding deduction at the time of distribution.

ERISA's requirements do not apply to two types of non-qualified deferred compensation plans: "top hat" plans and "excess benefit" plans are given special exemptions from most of ERISA's substantive requirements. Like other "top-hat" plans, a rabbi trust must be both "unfunded" and benefit a select group of management or highly compensated employees. To be considered "unfunded", plan assets must remain unsecured and may not unconditionally vest in or be transferable by the employee beneficiary. Any "unfunded" plan must clearly provide that participants have the status of general unsecured creditors. Employees included in such a plan must also be limited not only in number, so that the plan will be select, but also in rank. The plan's assets are subject to the claims of general creditors but are inaccessible to the company for discretionary use until benefit obligations are met.

An "excess benefit" plan is an unfunded plan that provides benefits to employees in excess of the limits imposed by Internal Revenue Code Section 415. In other words, it provides benefits to highly paid employees under a defined benefit plan in excess of $100,000 in 2006, or provides contributions under a defined contribution plan in excess of $44,000 per year. Both top hat and excess benefit plans are unfunded. Thus, employers cannot set aside amounts on behalf of employees participating in the non-qualified deferred compensation plan. Unlike the assets held in a qualified retirement trust, assets used to provide non-qualified deferred compensation promises are subject to the creditors of the employer sponsoring the non-qualified deferred compensation plan.

Thus, Rabbi trusts are exempt from the participation, vesting, funding and fiduciary requirements of ERISA, but are subject to limited reporting and disclosure requirements, the most significant of which is that the employer must file a brief, one-time disclosure statement within 120 days of plan inception and be prepared to provide plan documents upon request. Congress exempted top hat plans from most of ERISA's protections because it believed that this select group of employees had the sophistication to adequately protect its own retirement benefits.

The promise to pay the deferred amount must be a mere contractual obligation of the employer, not evidenced by notes or secured in any way. The election to defer must be made before the beginning of the period of service for which the compensation is payable, unless the non-qualified deferred compensation plan imposes a substantial forfeiture provision that remains in effect throughout the entire period of deferral. The plan must also define the time and method of payment for each event that entitles a participant to receive benefits and must state clearly that participants have the status of general unsecured creditors of the company and that the non-qualified deferred compensation plan constitutes a mere promise to make payments in the future. The Non-qualified deferred compensation plan must specifically prohibit the transfer or alienation of a participant's interest and must state that it is the intention of the parties that the arrangement be unfunded for tax purposes and for purposes of Title I of ERISA. Rabbi trusts must take the form of the model rabbi trust described in IRS Revenue Procedure 92-64 except in rare and unusual circumstances. Employers should always request a letter ruling from the IRS regarding any proposed rabbi trust.

The Rabbi Trust will protect an employee's investments from many company hazards, but not all dangers. If insolvency or bankruptcy occurs, the plan participants stand in line with other employer creditors.

Accounting and Rabbi Trusts

In regard to accounting treatment, compensation received through a rabbi trust must be expensed on the company's books in the year the compensation is deferred if it is 100% vested when deferred. If vesting is used, the expense is booked over the vesting period. When company stock is used in a rabbi trust, the company is only required to book an expense and liability based on the value of the stock at the time of grant. Additional increases in the value of stock would not be booked as an expense.

Rabbi Trusts and ERISA

The Department of Labor has ruled that the establishment of a Rabbi Trust would not in itself cause a non-qualified deferred compensation plan to be considered funded for ERISA purposes. Nor would the transfer of assets cause the non-qualified deferred compensation plan to be considered funded. The consequences of a non-qualified deferred compensation 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 non-qualified deferred compensation plan to be considered funded for tax purposes, since non-qualified deferred compensation plan assets are subject to the claims of creditors, and are not set aside solely for the benefit of participants. The consequences of a non-qualified deferred compensation plan being funded for tax purposes are that the non-qualified deferred compensation plan participants would be immediately taxed on accumulated funds as soon as the participant balances become vested. The Economic Benefit Doctrine sets forth that the promise to pay deferred compensation, in order to avoid taxation, must be subject to substantial risk of forfeiture, e.g., not beyond the reach of the employer's creditors. In addition, the Doctrine of Constructive Receipt refers to how the compensation is set aside for the employee, including the use of trust mechanisms as with the rabbi trust. Rabbi Trusts are not operable under the laws of some states.

In Revenue Procedure 92-64, the IRS stated specific criteria that are necessary to obtain a favorable ruling on a rabbi trust used in connection with non-qualified deferred compensation 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 non-qualified deferred compensation plans. The Revenue Procedure goes on to state that if the model trust is used, a non-qualified deferred compensation 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 non-qualified deferred compensation 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 non-qualified deferred compensation plan with respect to constructive receipt.

The employer receives no tax deduction for payments of compensation to the trust, but it does receive a tax deduction when the trust pays the funds to the employee. When collected, the income of the trust is taxable to the employer. However, because the employee has no vested interest in the trust until payment, the Rabbi Trust is considered unfunded for ERISA purposes.

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 IRS Revenue Procedure 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 non-qualified deferred compensation plan, and that the trust will not affect the status of the underlying non-qualified deferred compensation 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 non-qualified deferred compensation 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 non-qualified deferred compensation plan participants.

Secular Trusts

Some employers have sought to allay employee fears about default in the event of bankruptcy by funding the non-qualified deferred compensation plan with a secular trust. A secular trust is an irrevocable trust created to fund non-qualified deferred compensation liabilities. Unlike a rabbi trust, a secular trust places funds outside the reach of creditors. Therefore, unless provisions are inserted creating a substantial risk of forfeiture, the employee is currently taxable as a result of contributions to the trust. Correspondingly, the employer is able to deduct contributions to the trust as they are made. Because the employee is taxed immediately on deferred amounts, future payouts of the principal amounts will be tax-free.

Since the employee has an interest in the trust, the secular trust is considered "funded" for ERISA purposes. In addition, because the employee has a vested interest in the trust, it will not become property of the company's creditors during a bankruptcy situation. This protects employees from an employer's bankruptcy because the secular trust represents an irrevocable transfer of assets that cannot be reached by an employer's creditors. Unfortunately, because of that stipulation, amounts set aside in a secular trust are taxable to the employees in the year the amounts are placed in the trust. Thus, employees must pay current taxes on amounts set aside in a secular trust, even though they do not receive this money until retirement.

A secular trust can be beneficial to the employee who objects to risking forfeiture of deferred amounts. These amounts are, after all, part of the employee's current compensation. It may make little sense to defer that compensation if its ultimate receipt is subject to new risks. To take care of the tax cost, the plan may provide for immediate distribution from the trust of sufficient funds to cover the employee's tax costs. Some companies gross up the deferred amounts to cover all or part of the tax costs.

Secular trusts have been more often talked about than implemented. While the benefit security aspects of a secular trust are attractive, the cost is substantial. To offset to the effects of adverse taxation, many companies make "gross up" payments to their executives. These costs are often material, and may need to be disclosed in the company's proxy report. For that reason, they tend not to be popular with shareholders. The trust's earnings are potentially subject to double taxation: once at the trust level, and again when distributed to the employee.

Springing Trusts

Another method to protect employee interests is a springing trust. A springing trust is the consequence of an unfunded non-qualified deferred compensation plan containing a provision that, if some event such as a change in ownership or effective control of the company occurs, the company is required to establish a rabbi trust to hold the deferred amounts. A variation of the springing trust is the "rabbicular trust".

Rabbicular Trusts

More sophisticated planners seeking the best of both worlds have developed a hybrid, the "rabbicular trust," under which a rabbi trust converts to a secular trust (and becomes taxable) upon the occurrence of an event signaling financial difficulty for the employer (short of bankruptcy), such as a stipulated decline in debt-equity ratios, net worth, gross sales, earnings per share, etc., and when the event occurs, the trust becomes a Secular trust and the executive is given the right to withdraw benefits.

The rabbicular trust can protect against:

• Change of control or management: 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 non-qualified benefit programs upon a change of control, as defined within the document. This protects participating executives from a change of heart due to a hostile takeover, for instance.
• Change of heart: management's reluctance to pay benefits. The employer cannot access assets in the trust, once committed.
• Change of financial condition: may include situations such as a change in the corporate net worth, net income or price per share. Other conditions might include a specified change in financial ratios or the loss of a particular client or customer.

In addition to these changes, a "call" is another tool that executives might wish to consider in order to help protect their investments. A call allows the employee to receive their investments at any time. For example, if you, as the investor, feel that your non-qualified deferred compensation is at risk, you may than collect your compensation immediately. However, there is a downside to a call. Typically, the executive will incur a penalty upon exercising a call of a benefit. The penalty may be a percentage of the total compensation withdrawn.

The objective is to protect the assets from the claims of the employer's creditors if events occur which make insolvency likely, and to take advantage of the tax deferral and ERISA exemptions until that time. However, federal bankruptcy laws permit the bankruptcy Trustee to reclaim any transfer made within ninety (90) days of the employer's bankruptcy (or within one (1) year for transfers to insiders). A rabbicular trust must be designed very carefully to ensure that it accomplishes the desired tax deferral without compromising the security of the benefit.

Haircuts

Another mechanism for avoiding loss of deferred amounts on bankruptcy is called a "haircut provision". Here the executive is given the right to an immediate payout of the deferred amounts, subject to forfeiture of part of the deferrals. It is generally recommended that the "haircut" involve a forfeiture of at least ten percent of the executive's deferred account. (The Internal Revenue Service has not issued any rulings on the effect of "haircut provisions".) Frequently, non-qualified deferred compensation plans that include "haircuts" also provide that the executive cannot participate in the non-qualified deferred compensation plan in the future, once a "haircut" withdrawal has occurred.

"Haircuts" have a built-in public relations disadvantage. If key executives start to exercise withdrawal privileges at a time when the company is under siege, other employees as well as shareholders and suppliers may assume that the prospects for its survival are slim.

Bankruptcy Insurance

Bankruptcy insurance policies offer employees an effective means of protecting their non-qualified deferred compensation plan benefits. When used in conjunction with a rabbi trust, it minimizes the risks associated with a non-qualified deferred compensation plan. Unfortunately, such policies are not the ideal solution for all employees. Those in financially weak or private companies or employees who plan to continue working for 10 to 20 years may find that the cost of bankruptcy insurance policies outweigh the benefits. These policies tend to be expensive, and there is a risk of nonrenewal if the employer's fortunes take a turn for the worse.Click here for More on Bankruptcy Insurance

Inclusion of any security measures in a non-qualified deferred compensation plan should be analyzed thoroughly to meet the needs of both the corporations and its executives. In doing so, risks can be minimized, while maximizing the potential benefits to both parties.