Jun 11, 2019
Employers that sponsor non-qualified deferred compensation plans may choose to set aside funds in order to create a pool of assets that can be used to pay benefits that have been promised to executives. Setting aside funds not only provides a source of liquidity to help meet benefit obligations, but may also protect plan participants from an employer’s unwillingness to pay promised benefits, whether due to the employer’s change of heart or due to a successor employer’s recalcitrance following a merger or acquisition. Those protections are particularly attractive to participants who make voluntary deferrals of compensation to the plan, as they provide participants a measure of comfort that their deferrals will be segregated from other corporate assets and used only to pay the promised benefits.
Although setting aside assets can provide a ready source of funds to pay promised benefits and provide security to plan participants, any set-asides will result in current income to plan participants, and will subject the plan to the substantive provisions of the Employee Retirement Income Security Act (“ERISA”), if the set-asides cause the non-qualified plan to become a “funded” plan. One way to avoid funded status is to contribute the assets to a rabbi trust.
Rabbi trusts have been maintained to support non-qualified plans since the early 1980s. A rabbi trust is a grantor trust (typically with an independent financial institution serving as trustee) that is used by employers in order to accumulate assets to defray benefit obligations under a non-qualified plan. The rabbi trust is usually irrevocable, although it can be designed to be revocable until the happening of certain events such as a change in control.
Internal Revenue Code
A rabbi trust preserves the favorable income tax characteristics of the non-qualified plan in large part because it contains provisions mandating that its assets remain subject to the claims of the employer’s general creditors in the event of the employer’s insolvency or bankruptcy. The Internal Revenue Service (“IRS”) has repeatedly found that such trusts do not cause the plan to be considered “funded” for income tax purposes. In fact, the name “rabbi trust” derives from one of the first Private Letter Rulings to be issued on such trusts, PLR 8113017, which was provided to a congregation that maintained a non-qualified plan for its rabbi. In that PLR the IRS found that the rabbi was not in constructive receipt of income set aside in the trust, nor did the existence of the trust provide the rabbi with an economic benefit that would be includable in income.
After a period in the mid-1980s during which the IRS refused to issue other private letter rulings on rabbi trusts, the IRS began issuing favorable rulings in 1986. Then, in 1992, the IRS issued Revenue Procedure 92-64 in which it provided a “model rabbi trust” intended to serve as a safe harbor for employers wanting to maintain such trusts. If the model trust language is used in accordance with the revenue procedure, the participants can be assured that the plan would not be considered a funded plan that would cause them to include plan benefits in income solely on account of the adoption of the trust.
The model language of Rev. Proc 92-64 must be adopted verbatim except where substitute language is expressly permitted. Additional provisions not inconsistent with the model language may be added. The trust must be valid and its terms enforceable under state law, and the trustee must be an independent third party granted corporate trustee powers under state law, such as a bank trust department. The trustee must be given some investment discretion, such as the authority to invest within broad guidelines established by the parties or the authority to approve company-directed investments.
Additional requirements under Rev. Proc. 92-64 include:
- The rights of plan participants to trust assets must be merely the rights of unsecured creditors
- Participants’ rights cannot be alienable or assignable;
- The assets of the trust must remain subject to the claims of the employer’s general creditors in the event of insolvency or bankruptcy; the board of directors and highest ranking officer of the plan sponsor/grantor must be required to notify the trustee of the employer’s insolvency or bankruptcy, and the trust must be required to cease benefit payments upon the company’s insolvency or bankruptcy;
- If life insurance is held by the trust, the trustee may have no power to name any entity other than the trust as beneficiary, assign the policy to any entity other than a successor trustee, or to loan to any entity the proceeds of any borrowing against the policy.
Subsequent to Rev. Proc. 92-64, the IRS issued Notice 2000-56. IRS Notice 2000-56 permits a model rabbi trust to include additional language in situations where a parent company contributes stock to a rabbi trust for the benefit of a subsidiary’s employees.
The IRS has required that, in order to receive a favorable ruling on a rabbi trust, the creation of the trust must not cause the plan to be “other than unfunded” for ERISA purposes, and that trust provisions requiring the assets of the trust to be available to satisfy claims of general creditors in the event of insolvency are enforceable under state and federal law. The Department of Labor’s (“DOL”) position seems to be that, at least with respect to rabbi trusts maintained in support of “excess benefit plans” or “top hat plans,” the maintenance of the rabbi trust will not cause the underlying plans to be funded for ERISA purposes (see DOL Adv. Op. 94-31A, fn. 3; DOL Adv. Op. 93-13A).
Internal Revenue Code Section 409A
The American Jobs Creation Act added Section 409A to the Internal Revenue Code (Code). Code Section 409A does not alter the favorable tax treatment for nonqualified deferred compensation plans that utilize mainstream rabbi trusts. However, it does provide that setting aside assets in an offshore trust to directly or indirectly fund deferred compensation unacceptably secures the payment of the promised benefits. The use of an offshore rabbi trust will thus cause the deferred compensation secured thereby to be immediately subject to inclusion in income and subject to a 20% additional tax. Interest on the underpayment of taxes is also due at the normal underpayment rate plus an additional 1%.
Code Section 409A also provides that if a plan provides that assets will become restricted to the provision of benefits under the Plan (i.e., no longer subject to claims of general creditors) in connection with a change in the employer’s financial health, the assets so set aside will become immediately subject to inclusion in income by participants, and subject to the 20% additional tax and the increased underpayment rate for past due taxes. This provision is designed to prohibit devices that would increase the security provided under a rabbi trust in instances where the financial health of the plan sponsor is deteriorating (but prior to insolvency or bankruptcy). The premise of such devices was that it was better to subject assets set aside to taxation rather than risk losing them to other general creditors if the plan sponsor’s financial condition worsened. The provision precludes the use of hybrid rabbi/secular trust arrangements that distribute assets from nominal rabbi trusts to secular trusts on the occurrence of triggering events indicating the employer’s financial difficulty.
Read more about Rabbi Trusts and changes in control situations.
Newport Group and its affiliates do not provide tax, legal or accounting advice. The material has been prepared for information purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before making any decisions. 20190510-843744-2550488