Secular Trusts

Secular trusts are named so as to distinguish them from rabbi trusts. A secular trust is a type of nonqualified deferred compensation arrangement funded to compensate executive and key employees. A major distinction between secular trusts and rabbi trusts is that the money held in a secular trust cannot be reached by an employer's bankruptcy creditors. In contrast, creditors can claim assets held in a rabbi trust after bankruptcy.

As a result, an employer's contributions to a secular trust and the trust's earnings are generally considered taxable income to the executive or key employee. However, the executive can still benefit from contributions to the trust to help pay the increased tax liability.

The employer is also allowed a current tax deduction for its contributions when they are taxed to the employee, or when the contributions become vested. Once taxed, later distributions to the employee (from already taxed contributions) are tax-free.

Warning Undistributed earnings of a secular trust are currently taxable to the executive-beneficiary. Because a secular trust is itself taxed on the earnings that it does not distribute, a double tax is essentially imposed. In other words, the secular trust pays income tax on its undistributed income and the executive-beneficiaries also pay income tax on the increased vested account balances that are attributable to the secular trust's undistributed income. Therefore, this should be factored into any arrangement made between an employer and employee when a secular trust is involved.

Most secular trusts are designed to secure supplemental retirement plans for executives. Employers usually hold secular trust assets in cash, bonds or treasury issues. In addition, most employers "gross up" (increase the amount of) vested secular trust benefits to cover the tax due on trust contributions.