Employer stock rabbi trusts.

A nonqualified deferred compensation plan can be a valuable incentive tool for an employer wishing to reward officers and other top management. It can be used to supplement the benefits received from the employer's qualified plans or may be useful for the employer unable (or unwilling) to shoulder the expense and complexity associated with qualified retirement plans.

Through the use of a rabbi trust, an employer may provide an additional level of comfort to participants in unfunded plans by making contributions to a grantor trust. The trust is usually (but not always) irrevocable, and the employer is treated as the owner under the grantor trust rules of Secs. 671-678. The Department of Labor (DOL) does not consider a rabbi trust arrangement to be funded for ERISA purposes solely because of the establishment and operation of a trust (DOL Advisory Opinion 89-22A).

IRS Letter Ruling 9235006 illustrated how an employer may successfully use employer securities to fund such a trust and limit taxable income generated by trust earnings. An affiliated group of employers proposed to fund an irrevocable trust primarily with stock of the parent corporation, a publicly traded company. The trust had an independent trustee but provided that the parent had the sole discretion, subject to some timing restrictions, to substitute assets in the trust with assets of equal fair market value.

The IRS ruled that the parent was the owner of the trust for income tax purposes, and deductions for benefit payments under Sec. 404(a)(5) would be allowed when the amount was included in the participants' gross income. As long as the parent remained the trust's owner, the receipt of dividends paid on the parent's stock would not be includible in the parent's gross income in the year paid. Any substitution of assets for the employer stock likewise would not cause the parent to recognize any gain or loss from a sale or exchange of the assets. The result is a highly flexible deferred compensation plan in which trust taxable income is limited, benefits are backed by the value of employer stock set aside to pay the benefits, and the substitution of other property (including cash) at the time benefits become payable does not cause any adverse tax consequences.

In addition, the ruling provided that the contribution of property to the trust did not cause a transfer of property for services within the definition of Sec. 83 and Regs. Sec. 1.83-3(e). Participants using the cash method of accounting were taxed on benefits when received or made available for payment.

The trust specified that on a change in control of the parent all benefits due and payable would be paid to participants who separated from service. The IRS specifically expressed no opinion as to the applicability of the golden parachute payment provisions of Secs. 280G and 4999 to the plan.

When planning for the implementation of any rabbi trust, it is prudent to refer to Rev. Proc. 92-64. The model rabbi trust in this revenue procedure serves as a safe harbor for taxpayers adopting a grantor trust for unfunded deferred compensation plans. The use of this model trust provides assurance that participant employees will not be taxed under the doctrine of constructive receipt or incur an economic benefit solely due to the existence and maintenance of the grantor trust.

If an employer wishes to apply for a letter ruling on a rabbi trust, Rev. Proc. 71-19, as amended by Rev. Proc. 92-65, provides guidance on the Service's position relative to the doctrine of constructive receipt as applied to unfunded deferred compensation plans.