Home > Insights > Publications > Rabbi trusts: Taxation basics and drafting beyond the model language
A version of this article originally appeared in the Spring 2020 issue of Employee Relations Law Journal.
A “rabbi trust” is so called because the first such trust was established by a Jewish congregation for its rabbi. The congregation applied for and obtained a private letter ruling (PLR) from the Internal Revenue Service (IRS) which clarified the tax consequences of the establishment of the trust to the rabbi.[1] To avoid immediate taxation to the rabbi, careful navigation between two key tax doctrines was required.
Tax consequences of rabbi trusts
Constructive receipt doctrine
In the context of the employer-employee relationship, the constructive receipt doctrine provides that income is included in the gross income of an employee in the tax year in which it is actually or constructively received by the employee.[2] Income is treated as “constructively” received in the tax year during which it is credited to the employee’s account, set apart, or otherwise made available so the employee can draw upon it at any time.[3]
Economic benefit doctrine
The economic benefit doctrine provides that, if in connection with the performance of services property is transferred to an employee, the employee will be taxed on the fair market value of the transferred property in the earlier of the tax year during which (i) the employee’s rights in such property can be transferred, or (ii) the employee’s rights in the property is no longer subject to a substantial risk of forfeiture, i.e., when the employee is vested in his or her rights to the property.[4]
Applying these tax doctrines, an employee will be subject to immediate taxation with respect to nonqualified deferred compensation[5] if (i) the employee can assign or transfer his or her rights to the deferred compensation, or (ii) the deferred compensation is “funded,” i.e., assets have been set aside for the exclusive benefit of the employee.
The terms of the original rabbi trust provided that assets irrevocably contributed to the trust would not be paid to the rabbi or his beneficiaries until the rabbi’s death, disability, retirement or termination of employment. Pending one of these events, the rabbi could not assign or pledge the trust assets which remained subject to the creditors of the congregation. The IRS ruled that the funding of the trust did not result in immediate taxation to the rabbi because the assets could not be assigned or transferred by the rabbi, the rabbi did not have access to the trust assets, and such assets remained subject to the congregation’s general creditors.
Rabbi trust is a grantor trust
Because the assets of a rabbi trust are subject to an employer’s creditors, the trust will be treated as a “grantor trust.”[6] This means that the assets of the trust are treated as assets of the employer for tax purposes. As a result, no deduction is allowed when the employer contributes funds to the trust and the employer is taxed currently on any earnings on trust assets. The employer is not allowed a deduction until the year in which a participant or beneficiary recognizes income due to a distribution from the trust.
IRS model rabbi trust language
Since taxpayers are not allowed to rely on PLRs issued to other taxpayers, many employers applied for PLRs with respect to their draft trusts after the issuance of the initial rabbi trust PLR. Eventually, the IRS decided to limit the issuance of these PLRs. Instead, in Revenue Procedure 92-64,[7] the IRS issued model rabbi trust language. The Revenue Procedure also set forth restrictions on future PLR applications. The IRS indicated that a future PLR will be issued only if an employer represents that the trust conforms to the model rabbi trust language and that the trust does not include any language inconsistent with the model provisions. Only in unusual circumstances will a PLR be issued with respect to a trust that does not comply with these requirements. For that reason, few employers applied for PLRs after issuance of the model rabbi trust language.
- The model rabbi trust includes numerous mandatory provisions which include, but are not limited to, the following.
- The trust must state the intention of the parties that the trust constitute an unfunded arrangement.
- The trust must be designated as revocable, irrevocable or irrevocable upon the occurrence of a designated event, such as a change in control.
- The trust requires an employer to specify the level of funding (immediate and ongoing as benefits accrue, funding at the discretion of the employer, or funding based on a designated event, such as a change in control).
- The trust provides that the assets are subject to the claims of creditors in the event of the employer’s insolvency.
- The trust describes the investment powers.
- The trust provides either that all income, net of expenses and taxes, will be accumulated and reinvested, or returned to the employer.
- The trust provides that benefits payable from the trust may not be assigned or pledged by participants or beneficiaries.
Deviations from the model rabbi trust language
Because the IRS generally declines to issue PLRs for rabbi trusts, it is difficult to predict with certainty whether the IRS will accept trust provisions that deviate from the model language in Revenue Procedure 92-64. Following are atypical provisions that are sometimes included in rabbi trusts.
Reimbursement of direct benefit payments by employer
The model rabbi trust requires an employer to deliver to the trustee a payment schedule and to make benefit payments to participants and beneficiaries in accordance with the payment schedule.[8] Generally, the model rabbi trust provides that once a trust becomes irrevocable, an employer has no right to direct the trustee to return trust assets to it or divert to trust assets to others before all payments of benefits have been made to participants and beneficiaries pursuant to the terms of the plan.[9] The model rabbi trust includes an exception to the general rule for the remittance of federal, state, and local taxes to the appropriate taxing authorities with respect to payments the trustee makes to participants or beneficiaries pursuant to the payment schedule under the plan.[10] The model rabbi trust also permits payments to the employer’s creditors if the employer becomes insolvent.
Arguably, there are additional situations in which the trustee should be able to make payments directly to the employer from trust assets. For example, for a variety of legitimate reasons, an employer may make benefit payments directly to plan participants or beneficiaries. In that case, the employer should be able to request reimbursement from the trust assets, in a form and manner acceptable to the trustee.
In addition, if plan benefits are taxed upon vesting (prior to actual payment of the benefits), the regulations under Internal Revenue Code Section 409A permit a plan to accelerate benefit payments to the extent necessary to satisfy federal, state and local income and payroll tax withholding. This might occur if there is a violation of Section 409A or a plan is subject to the tax rules under Internal Revenue Code Section 457(f).[11] In that case, a good argument can be made that a rabbi trust should permit payment to the employer for remittance of such taxes even though no benefit payment has been made by the trustee pursuant to the payment schedule.
Forfeiture of benefits
The general rule in the model rabbi trust, prohibiting reversion to the employer if assets are irrevocably contributed to the trust, applies even if benefits are forfeited by a participant who terminates employment prior to satisfying the plan’s vesting schedule. The result is that assets attributable to the forfeited benefits are inaccessible until plan benefits are paid to all plan participants and beneficiaries. This can be a particularly harsh result in the case of an account-based plan in which a participant’s benefit is equal to his or her account balance at the time of distribution. Except for forfeitures, there is typically no excess or deficit funding in a rabbi trust for an account-based plan. The safest course in this circumstance is to apply the “forfeited” trust assets against future employer contributions to the rabbi trust. However, depending on the number of participants and the amount of the forfeited benefits, this process could take years.
Arguably, a rabbi trust for an account-based plan could be drafted so that, in the event of a forfeiture due to a participant’s failure to satisfy the plan’s vesting schedule, an employer can direct the trust to pay to it the “excess assets” in the rabbi trust, i.e., the amount by which the total value of the trust assets exceed the total dollar value of benefits payable to all remaining participants and beneficiaries as of a specified determination date. Because rabbi trust assets must remain subject to the creditors of an employer in the event of insolvency, application of a reversion provision should be prohibited if an employer is at or near insolvency. Such a provision should only be relied upon if the employer is fiscally sound.
Application of a reversion provision in the case of a nonaccount-based plan is more problematic since the funding level of the trust varies depending on fluctuations in the stock market. For this reason, an employer may decide to forego a reversion provision in a rabbi trust for a non-account based plan. Should an employer desire such a provision, it is advisable to require a specified level of overfunding of plan benefits, e.g., 125% of the benefits due under the plan as of the determination date, before a reversion to the employer is permitted. Again, the employer should not be at or near insolvency at the time of the reversion.
Termination of the trust
The model rabbi trust generally provides that the trust will not terminate until the date on which all participants and beneficiaries are no longer entitled to benefits under the plan. An optional provision permits termination of the trust upon approval of all participants or beneficiaries entitled to benefits under the plan. Depending on the circumstances, it may be difficult to find and secure the approval of all plan participants and beneficiaries. Arguably, it should be permissible to substitute a trust provision permitting termination of the trust with the approval of 100% of the participants and beneficiaries who vote with respect to the trust termination. The trust could additionally require a threshold of voting participation by participants and beneficiaries, e.g., 80%.
Additional provisions
There are several other provisions that employers should consider when drafting rabbi trusts. These include a Section 409A savings clause (the plan and trust are intended to comply with Section 409A and will be interpreted accordingly), a provision that the trust does not create any third party rights or responsibilities, a provision that the trust agreement will be binding on successors, and indemnification provisions.
Conclusion
It is important to understand the underlying rules of taxation when drafting rabbi trusts, particularly if the rabbi trust will contain provisions not included in the IRS model trust. As noted above, there is no guarantee that, in the event of an audit, the IRS will sanction variations on, and additions to, the model rabbi trust provisions. However, such provisions are more likely to be acceptable if they do not run afoul of the underlying tax doctrines that defer taxation of employees. Prior to adopting one or more of the provisions described above, it is advisable to consult with legal counsel and document the rationale for such provisions.
Lori Jones is the chair of Thompson Coburn’s Employee Benefits practice.
[1] Private Letter Ruling 8113107.
[2] Treasury Regulation §1.451-1(a).
[3] Treasury Regulation §1.451-2(a).
[4] Internal Revenue Code §83.
[5] These rules do not apply to deferred compensation plans that are “qualified” under Section 401(a) of the Internal Revenue Code.
[6] Internal Revenue Code §§671-677.
[8] Revenue Procedure 92-64, 1992-2 C.B. 422, §4.
[11] Internal Revenue Code §457(f) provides that benefits under a nonqualified deferred compensation plan maintained by a tax-exempt entity are taxed at vesting, regardless of the timing of benefit payments.