Rabbi Trusts

A popular method of deferring compensation for executives is the use of a rabbi trust (so named because it was first used to provide deferred compensation for a rabbi). The rabbi trust is a type of nonqualified deferred compensation arrangement in which amounts are transferred to an irrevocable trust to be held for the benefit of executive employees, similar to a vested trust. The trust is designed to provide some assurance that future benefit obligations will be satisfied.

The IRS will find a valid rabbi trust exists if all three of these conditions are met:

• the trust's assets must be available to all the general creditors of the employer if the employer files for bankruptcy
• there are no insolvency triggers that hasten payments to employees when the employer's net worth falls below a certain point, thereby bypassing creditors before insolvency is declared
• there is a procedure to provide notice to the trustee of the bankruptcy of the employer or financial hardship of the employer

Because a rabbi trust is subject to the claims of the employer's general creditors, the employer is considered the owner of the trust and the executive is not subject to tax on the deferred amounts until payments are actually received. When payments are actually received and the executive is taxed, the employer may take a corresponding deduction.

The most common reasons why employers use rabbi trusts are:

• to offset IRS limits on qualified plans (as an excess benefit plan)
• to supplement an executive's retirement plan
• to provide a voluntary deferred compensation plan

Planning Tools A Model Rabbi Trust Form has been issued by the IRS. As long as it is used, the model trust form provides a safe harbor for taxpayers that adopt and maintain grantor trusts in connection with unfunded deferred compensation arrangements.

Less frequently, rabbi trusts are used for executive incentive plans, director retirement plans, golden parachute plans and termination arrangements.

Work Smart The IRS has approved an arrangement under which key employees who contribute the maximum amount to a 401(k) plan can make excess deductible contributions to an employer's nonqualified supplemental savings plan funded by a rabbi trust. Contributions to the trust are not available to the employees and would not be currently taxable to plan participants. Amounts distributed under the nonqualified plan would not be taxable to the employees until paid or otherwise made available.