Rabbi trusts: a security blanket for corporate executives.

Corporate executives wanting to defer compensation are in a dilemma. Many tax-saving techniques were eliminated by the Tax Reform Act of 1986 and subsequent legislation and the benefits available to key employees under qualified deferred compensation plans have been limited. Moreover the Revenue Reconciliation Act of 1993 reduced the compensation limit from $235,840 to $150,000 for purposes of calculating qualified plan contributions or benefits for highly compensated employees (HCEs).

As a result, employers are being forced to devise new ways to reward and keep their key employees. Thus, a greater proportion of HCEs' retirement income will come from nonqualified top-hat plans, which are more flexible. Nonqualified plans allow corporate employers to provide extra rewards for "top hats" (key corporate executives and top producers), without increasing benefits for everyone. Furthermore, nonqualified plans afford top-level executives protection in the event of termination, by allowing them to defer a portion of otherwise current income. The arrangement is structured to avoid income taxation to the executive until he receives plan payments from the employer. This article discusses one kind of nonqualified funding arrangement, the "rabbi trust," named for the type of taxpayer for whom a letter ruling was first requested approving deferral of compensation.

Background

In Letter Ruling 8113107,(1) the Service ruled that the funding of an irrevocable trust by a congregation for its rabbi was not a taxable event. The trust agreement provided that, upon the death, disability, retirement or termination of services of the rabbi, the trustees would make distributions of principal and income to the rabbi or his beneficiary. The trust could not be altered, amended, revoked, changed or annulled by the congregation; however, the trust's assets remained subject to the claims of the congregation's creditors as if they were the general assets of the congregation. The rabbi's interest in the trust was not subject to attachment, alienation, assignment, pledge or claims of the rabbi's creditors, and could not be otherwise alienated or encumbered by him.

This structure permits an employer to establish a nonqualified deferred compensation plan by periodically placing sufficient assets to fund the deferred payments into an independent trust for the future benefit of an HCE. The employee receives an unsecured promise from the employer that he will receive certain benefits on retirement or death. The trust cannot be altered, amended or revoked, and the employee's interest cannot be assigned, pledged or otherwise encumbered. The trust's property comes from the employer's general assets and must always remain subject to the general claims of the employer's creditors. The employee's only rights in the amounts set aside are those of an unsecured general creditor. The rabbi trust has developed into an extremely flexible device for tax planning or takeover protection.

Tax Treatment

For an employee to receive favorable tax treatment, his rights must be no greater than those of a general creditor. If the employer in any way secures the promise to pay in the future, the employee may be subject to immediate taxation.

For Federal tax purposes, the employer is assumed to be the owner of the rabbi trust, because the trust's assets are subject to the claims of creditors as if the trust were a general asset of the company. The trust is treated as a grantor trust (under Secs. 671 and 677(a)) for income tax purposes because trust assets may be used to discharge the employer's obligations. Thus, the employer (the grantor) must include all trust income, deductions and credits in computing its taxable income.(2)

Contributions to the trust will not be taxable to the employee if (1) the income was not constructively received (Sec. 451); (2) no economic benefit was realized; (3) no taxable transfer of property for the performance of services occurred (Sec. 83); and (4) no vesting took place (Sec. 402(b)). The employee will be taxed only when he receives (or has the unrestricted right to receive) a distribution from the trust. According to Sec. 404(a)(5) and Regs. Sec. 1.404(a)-12(b)(2), the employer is allowed an offsetting deduction only for amounts withdrawn, distributed or made available. Since funds are not actually paid out, set aside or made available for the employee's use, the employee is not required to include in gross income employer contributions. Although the employee hopes to defer income until retirement years (when he will likely be in a lower tax bracket), the value of the tax deferral to the employee may be diminished if the income tax rates when the trust distributes its assets are higher than when they were first contributed.

Although it may seem that the employee receives all of the benefits from a rabbi trust, it is also financially advantageous to the employer. After establishing a rabbi trust, the employer generally is not obligated to set aside funds each year, as in a defined contribution plan. This requires advance planning on the employer's part. For example, assume the company promises an after-tax lump-sum distribution of $100,000 to an employee who is in the 36% tax bracket. Because the employee is taxed on distribution, there will need to be $156,250 in the trust for distribution. Overfunding is not a problem to the employer, because extra funds revert back after distribution. Another advantage to the employer is that non-qualified plans, unlike qualified plans, are not subject to the nondiscrimination and reporting requirements.(3) Moreover, since the assets in a rabbi trust remain subject to creditors' claims, the employer's creditworthiness is enhanced.

Funding Arrangement

For HCEs to qualify for tax deferral, the plan must be unfunded. This is not inconsistent with assets placed in a rabbi trust to pay benefits under the plan. A rabbi trust is unfunded for purposes of the Code and Title I of ERISA as long as the provision that trust assets may be used to satisfy creditor claims due to a change of financial condition (i.e., insolvency or bankruptcy) is enforceable under Federal and state law.

Objectives

The objectives of rabbi trusts are simple: to provide participating employees with benefits to be taxed at a later date, while providing security for the promise to pay deferred compensation. No income is recognized by the employee until payments are received, since the trust assets remain subject to the claims of the employer's general creditors. However, if the employer "funds" the deferred compensation agreement (i.e., violates the condition that assets are subject to claims of general creditors), the employee might be subject to Federal income taxation in the year the contributions are made, even if fund distributions are not received until many years later, pursuant to the economic benefit doctrine or Secs. 83 and 402(b).(4) As a result, the executive possibly would not have the cash to pay the tax. If a rabbi trust is properly structured, however, it affords an HCE the ability to have a "funded" deferred compensation arrangement that is taxed only in years distributions are received.

Model Trust Language

In Rev. Proc. 92-64,(5)q the IRS issued model rabbi trust language as a safe harbor for taxpayers who use grantor trusts in connection with unfunded deferred compensation arrangements. By adhering to the model trust provisions, an employee will not be in constructive receipt of income or incur an economic benefit due solely to the adoption or maintenance of the trust. The model language must be followed verbatim, except for provision labeled as "optional" or "alternative." Some of the more important provisions address:

* Irrevocability of the trust.

* That the trust is intended to be a grantor trust.

* That plan participants and their beneficiaries have no preferred claim on, or any beneficial ownership interest in, the trust assets.

* That any rights created under the plan and the trust agreement are unsecured contractual right of plan participants and their beneficiaries against the company.

* That any trust assets will be subject to the claims of the company's general creditors under Federal and state law in the event of insolvency.

* That the company will deliver to the trustee a schedule indicating the amounts payable in respect of each plan participant (and his beneficiaries), with a formula or other instructions acceptable to the trustee in determining the amounts so payable, the form in which such amount is to be paid and the time of commencement for payment of such amounts.

* That the trustee will cease payment of benefits to plan participants and their beneficiaries if the company is insolvent.

* That the board of directors and the chief executive officer (CEO) have the duty to inform the trustee in writing of the company's insolvency.

* That benefits payable to plan participants and their beneficiaries under the trust agreement may not be anticipated, assigned, alienated, pledged, encumbered or subjected to attachment, garnishment, levy, execution or other legal or equitable process.

The Service will continue to issue rulings on unfunded deferred compensation plans that do not use a trust, and on unfunded deferred compensation plans that use the model trust language. However, only in rare and unusual circumstances will rulings be issued on unfunded deferred compensation arrangements that use trust language other than that contained in Rev. Proc. 92-64.

In Rev. Proc. 92-65,6 the IRS amplified Rev.. Proc. 71-19(7) by addressing the circumstances under which the Service will issue advance rulings on the application of the constructive receipt doctrine to unfunded deferred compensation arrangements (whether or not they involve rabbi trusts):

* If the plan provides for an election to defer payment of compensation, such election must be made before the beginning of the period of service (i.e., the employee's tax year) for which the compensation is payable, regardless of the existence in the plan of forfeiture provisions. Special rules are provided for new plans and newly eligible participants.

* The plan must define the time and method for payment of deferred compensation for each event (e.g., termination of employment, retirement, disability or death) that entitles a participant to receive benefits. The plan may specify the date of payment or provide that payments will begin within 30 days after the occurrence of a stated event.

* The plan may provide for payment of benefits in the case of an "unforeseeable emergency."

* The plan must provide that participants have the status of general unsecured creditors of the employer and that the plan constitutes a mere promise by the employer to make benefit payments in the future.

* The plan must provide that a participant's rights to benefit payments under the plan are not subject in any manner to anticipation, alienation, sale, transfer, assignment, pledge, encumbrance, attachment or garnishment by creditors of the participant, or the participant's beneficiary.

Risks

Rabbi trust participants and their employers may be concerned about the quality of the promise behind the benefits in a nonqualified deferred compensation plan. Three elements of risk need to be considered: (1) change of control; (2) the employer's decision to terminate the trust; and (3) change in financial condition.

If a company is taken over after the establishment of a rabbi trust, what happens if the new management does not want the plan? This is the primary reason why the rabbi trust agreement must be irrevocable. If the trust were revocable, and all of the trust assets reverted back to general assets of the business, the agreement would mean little.

Second, what if the company decides to terminate the trust? The rabbi trust provides security for participants in the event of a change of control or a change of heart by management by being irrevocable.

What if the company becomes insolvent? In general, trust assets are insulated from the claims of the employer's creditors, except in the case of insolvency or bankruptcy. Since the assets of a rabbi trust remain subject to the claims of the company's general creditors, the trust does not protect against insolvency or bankruptcy. In fact, during insolvency or bankruptcy, the IRS does not take the employee's side. The agreement that the trust assets will be subject to the claims of the company's general creditors is meant to protect creditors from the possibility that the employee will invade the trust and leave with whatever assets remain. The Service used to allow "insolvency triggers" - provisions in the trust "requiring or authorizing the trustee to accelerate distributions in the event that the employer becomes insolvent."(8) These provisions, however, put employees in a superior position when compared to all other general creditors, implying an economic benefit that would require the imposition of a Federal income tax. With a rabbi trust, participants have only some degree of assurance that trust assets will be available when it is time for the promised payments. Because the trust assets remain subject to the claims of the employer's general creditors, an executive's benefits could be substantially diminished on the bankruptcy or insolvency of the employer. For this reason, it is important for an employee to examine carefully the company's financial stability before entering into such an arrangement.

Insuring Deferred Compensation Payments

The risk associated with a change of financial condition was mitigated when the IRS approved a novel plan in which an executive secured a rabbi trust with an insurance policy. The Service concluded in Letter Ruling 9344038(9) that deferred compensation payable under a rabbi trust arrangement would not be includible in the executive's income, before it was paid or made available to him, when the employee purchased insurance to pay the promised amount in the event the employer failed to honor its commitment.(10) Although the executive had to independently negotiate the policy terms with the insurer (without the employer's involvement or participation) and was responsible for paying the premiums, the employer could reimburse the employee for payments. The reimbursement, however, represented additional compensation that had to be included in the executive's taxable income under Sec. 61. In addition, there was no contractual relationship between the employer and the insurer, and the employer provided the insurance company only with information otherwise publicly available.

Current Applications of Rabbi Trusts

The creativity in drafting nonqualified deferred compensation arrangements funded with rabbi trusts appears to be almost endless. Although the basic foundation on which these arrangements are built remains constant (i.e., the employer promises to pay compensation in the future, funds are subject to the claims of the employer's creditors, employee benefits are nontransferable and nonassignable, etc.), the ways in which companies use them continue to expand.

Discussed below are recent letter rulings involving the creation of rabbi trusts that have been approved by the IRS. The rulings cover a wide array of nonqualified deferred compensation arrangements, including "excess" plans, which measure what highly paid participants would have received from their pension plan, assuming no limitations were imposed by the Code, and supplemental executive retirement plans. The focus of each discussion will be on the unique formulas the employer devised to measure the deferred compensation benefits available to key employees.

* Nonqualified plan integrated with Social Security

In Letter Ruling 9205003,(11) a company established a rabbi trust to provide nonqualified supplemental benefits for certain executives selected by the firm's board of directors. Although there were four payment options available to the executive, the normal form of distribution was monthly lifetime benefit terminating on the death of the employee. The executive received the supplemental benefit at retirement or permanent disability.

The formula the company used to calculate the supplemental benefit was 65% of the executive's highest average compensation for three consecutive years, less the executive's Social Security primary benefit. The interesting variable in this formula is the company's integration of the executive's Social Security benefit into its nonqualified plan. Although integration is commonly found in qualified retirement plans, it is rarely part of a nonqualified plan. Also, the payments to be received by the executive were to be reduced by payments from the company's regular qualified plan.

* Lump-sum cash payment reduced by severance pay 

In Letter Ruling 9203018,(12) a company established a plan along with a rabbi trust to provide nonqualified deferred compensation benefits to its key employees. Under the plan, the key employee was entitled to receive a supplemental benefit in the form of a lump-sum cash settlement. Unlike Letter Ruling 9205003, no other payment options were available. To determine the amount of the supplemental benefit, the company used a formula that each year accrued a benefit based on the lesser of a fixed sum (which would change through the years) or 5% of the company's net profits for the year. The total payable under the plan was to be reduced by 50% of any amount the employee received under his severance agreement with the company. The supplemental benefit was payable on the earliest of any of the following: 1. Termination of employment due to the employee's permanent disability. 2. The employee's death (benefit then payable to employee's beneficiary). 3. The employee's termination of employment following a change in control of the company. 4. The first day of the month following or coinciding with the employee's sixty-fifth birthday.

* Protecting key people with three plans In Letter Ruling 9151010,(13) a company set up three separate, interrelated plans (A, B and C) and rabbi trusts to provide nonqualified deferred compensation benefits to selected executives and key employees. Each plan had its own unique guidelines for determining which key people were entitled to benefits and the dollar amount of such benefits.

Plan A provided an "excess pension benefit" to each employee whose pension benefit under the company's qualified retirement plan was reduced due to Sec. 415 limitations on benefits. The excess pension benefit was payable to HCEs in a single lump sum on termination of employment for any reason other than death (i.e., a form of severance pay). If an employee died before retirement, Plan A provided for a payment to the employee's surviving spouse.

Plan B made available a "supplemental pension" (payable annually) to the company's executive officers if they stayed with the firm until their normal retirement dates. The officers included in Plan B were the chairman of the board and CEO, the president, three vice chairmen and the executive vice president. As with Plan A, if certain conditions were satisfied, Plan B provided for a surviving spouse benefit if an officer died while still employed by the company.

Under Plan C, a participant whose employment was involuntarily terminated within two years following a "change in control" was entitled to receive a single lump-sum cash payment immediately on his involuntary termination. The payment was equal to (1) twice the employee's annual base salary plus 2) twice the average award paid to him under the company's annual incentive plan minus (3) the total amount paid under all other severance arrangements.

* Credit formula provides excess benefits Under the rather creative terms of the nonqualified deferred compensation plan in Letter Ruling 9121022,(14) a participant was entitled to a benefit equal to the difference between the participant's (1) normal retirement benefit under the employer's qualified defined benefit pension plan and (2) benefits under the qualified plan if credited with additional years of service.

Each participant was to receive a credit for an additional seven or 10 years of service, to be determined by a committee that monitored the plan. The only employees eligible for the nonqualified deferred compensation benefits were those advised specifically by letter from the company's CEO or secretary and approved by the board of directors. On entry into the plan, each participant was required to make a binding election concerning the form of the excess benefit payment. Payments from the rabbi trust (established to accumulate assets to pay the company's obligations to participants) had to begin within 30 days of the date the participant's employment with the company ceased.

* Supplemental benefits tied to a Sec. 401(k) plan Letter Ruling 911905615 focused on a company that provided nonqualified deferred compensation benefits as an inducement for the recruitment or continued services of certain key employees. Under the rabbi trust, highly compensated participants make an election before performing services to defer base salary and/or incentive compensation (i.e., a cash or deferred arrangement-style nonqualified plan). The company was to make matching contributions using a formula identical to the one contained in the firm's qualified Sec. 401 (k) plan.(16) The agreement provided that the company would make matching contributions only if, for the year in question, the employee had made the maximum elective deferrals and contributions allowed under the regular qualified plan.(17) Further, to make certain that matching contributions occurred only on an "excess" basis, the matching contributions were to be reduced dollar-for-dollar by the amount of matching contributions made under the company's regular qualified plan.

Due to the limitations placed on elective deferral contributions to a Sec. 401(k) plan ($9,240 for 1995), the above arrangement would be very attractive to HCEs.

* Hypothetical investment in company's common stock In Letter Ruling 9112023,(18) the IRS approved a novel plan involving phantom investments. The company implemented a plan under which a key employee could elect, for any calendar year, to receive in cash none, 25%, 50%, 75% or 100% of his incentive award for the year. The amount not taken in cash was deferred and, of this amount, the employee could elect to have none, 25%, 50%, 75% or 100% treated as if invested in the company's common stock. The purchase of the common stock was only fictional (i.e., the assets of the rabbi trust were not invested in company securities).

Although not specifically stated in the letter ruling, presumably, when participants terminated their employment with the company, they were able to cash in their phantom stock at its then current fair market value.

In Letter Rulings 9119056 and 9112023, the deferral election was to be made annually. Consequently, if the executive was concerned about the financial stability of the company, he could simply forgo the election to defer compensation. Alternatively, if the plan so provides, the participant could defer income for a short period of time rather than wait until retirement.

* Hostile takeover rabbi trusts Takeovers of one company by another have become commonplace in today's business environment. As a result, top-level executives find themselves at risk of not only losing their position, but their deferred compensation as well. In 1990, the Service approved anti-takeover features as part of the provisions included in a rabbi trust.

In Letter Ruling 9037018,(19) two plans were created by a company in an attempt to discourage a hostile takeover. Plan one was restricted to "senior officers" (as defined in the plan). Under this plan, each officer was entitled to receive a benefit following early, normal or disability retirement. Although payments were to begin on the first day of the month following retirement, benefits were also payable to an executive who terminated employment within three years following a change in control of the company. Plan two was maintained for the benefit of "outside directors," providing for benefit payments to begin after retirement or following the termination within three years after a change of control.

A "change in control" occurred under both plans if (1) more than 30% of the company's voting stock was acquired in a transaction not arranged or approved by the board of directors or (2) during any two-year period, individuals who comprised the board of directors at the start of such period ceased to thereafter represent a majority.

In Letter Ruling 9040067,(20) a company established a nonqualified deferred compensation plan for certain executives. Under the plan, each participant was entitled to payment of deferred compensation on termination, retirement or death before age 65. Although a plan participant vested in his deferred compensation benefits ratably over a five-year period, participants were to become fully vested in their deferred benefits if a "change of control" occurred. A change of control occurred if more than 50% of the corporation's voting stock was sold to outsiders.

In both letter rulings, plan participants were entitled to a significant portion of the corporation's assets in the event of a takeover. Clearly, the presence of an anti-takeover rabbi trust (also included in Plan C of Letter Ruling 9151010, discussed earlier) is an obstacle the acquiring company cannot ignore.

* Deferred compensation for professional athletes A rabbi trust may also be set up to provide deferred benefits for professional athletes. In Letter Ruling 9119068,(21) a professional sports league received IRS approval to adopt a nonqualified retirement plan to provide benefits to league members who were professional participants in the league's sport and who met the plan's eligibility requirements. Payments from the plan to eligible participants (or their beneficiaries) were due following the earliest of (1) normal retirement age (as established in the plan), (2) permanent disability or 13) death.

The plan allowed participants to withdraw limited amounts due to unexpected emergencies. Except for smaller amounts payable in a lump-qsum distribution, benefits were to be paid out in the form of an annuity.

Conclusion

Rabbi trusts have become a common "security device" to protect participants' benefits in nonqualified deferred compensation plans. One IRS Branch Chief estimates that as much as "seventy percent of top executives' deferred compensation at large public companies comes in nonqualified form, usually rabbi trusts."(22) The results of a 1992 survey of 191 firms showed that 94% offered one or more nonqualified supplemental retirement plans.(23) The trusts provide executives with some comfort that deferred compensation amounts will ultimately be paid notwithstanding their employers' short-term business reversals.

Rabbi trusts are not perfect, however. Availability, of trust assets to creditors, lack of insolvency accelerators or irrevocable rights to the trust, as well as fluctuating tax rates, are concerns that must be taken into account when considering a deferred compensation arrangement. Nevertheless, rabbi trusts provide incentives for key employees (as do other nonqualified deferred compensation plans), since their stake lies in the success of the company. Also, the use of rabbi trusts may improve a company's creditworthiness, since the assets are subject to creditors' claims. Most importantly, rabbi trusts enable a company to secure and retain well-qualified employees, as well as selectively fund benefits for them.

The IRS continues to issue favorable rulings in this area and shows no signs of stopping. Thus, the types of nonqualified deferred compensation arrangements using rabbi trusts that are available to key employees appear to be limited only by the creativity of their drafters.

(1) IRS Letter Ruling 8113107 (2/31/80). (2) See Regs. Sec. 1.61-13(b). (3) The Department of Labor requires a one-time registration statement filing for top-hat plans. If not filed, From 5500, Annual Return/Report of Employee Benefit Plan (With 100 or more participants), is required. (4) See Klueger, "The `Rabbi' Trust: A unique Way to Defer Compensation," 16 Colorado Lawyer 614 (Apr. 1987). (5) Rev. Proc. 92-64 1992-2 CB 422. (6) Rev. Proc. 92-65, 1992-2 CB 428. (7) Rev. Proc. 71-19, 1979 CB 698. (8) See Klueger, note 4. (9) IRS Letter Ruling 9344038 (8/2/93). (10) Two earlier letter rulings concluded that a guarantee of deferred compensation by an employer's parent does not cause any portion of the amount transferred to the rabbi trust by the employer to be currently taxable to the employee. IRS Letter Rulings 8741078 (7/17/87) and 8906022 (11/10/88). (11) IRS Letter Ruling 9205003 (10/29/91). (12) IRS Letter Ruling 9203018 (10/18/91). (13) IRS Letter Ruling 9151010 (9/18/91). (14) IRS Letter Ruling 9121922 (2/22/91). (15) IRS Letter Ruling 9119056 (2/13/91). (16) The company was to contribute 25% of the first 6% of compensation a participant elected to defer, up to a maximum of 1 1/2 of compensation. (17) Regs. Sec. 1.40(k)-1(e)(6)(iii) provides that such a provision will not disqualify the Sec. 401(k) plan. (18) IRS Letter Ruling 9112023 (12/21/90). (19) IRS Letter Ruling 9037018 (6/15/90). (20) IRS Letter Ruling 9040067 (7/12/90). (21) IRS Letter Ruling 9119068 92/14/91). (22) See Sheppard, "Brisendine Provides Rabbi Trust Update," The Exempt Organization Tax Review 13 (Jan. 1994). (23) "More-Equal Benefits Go To Some Top Executive," The Wall Street Journal, 5/25/93, at C1.