Nonqualified deferred compensation plans backed by rabbi trusts are gaining popularity

Recent legislation has reduced the benefits available to executives under qualified employee benefit plans and, consequently, has made forms of nonqualified deferred compensation (NQDC) attractive to both public and closely held corporations. NQDC arrangements provide additional benefits to recruit and retain executives and supply the flexibility needed to counteract the qualified plan limitations under the Tax Reform Act of 1986. Judging from the steady stream of private letter rulings that the Internal Revenue Service has issued on the subject, NQDC plans backed by so-called rabbi trusts are extremely popular these days. Such plans enable an employer to provide rewards for key executives and top producers without increasing benefits for everyone. Plan participants are able to defer income recognition while attaining some assurance that funds will be available to make the promised payments.

Historically, benefits under nonqualified plans have been paid out of the general assets of the employer when they become due. The increasing incidence of takeovers and bankruptcies of overleveraged companies, however, have placed executives' unfunded benefits at risk because they are not guaranteed. From the employee's standpoint, a mere promise to pay may not be enough. Rather, the employee wants some assurance that funds will be available to make the agreed-on payments. A rabbi trust is a viable alternative to totally unfunded arrangements because it encompasses a protection mechanism providing a limited guarantee of the benefits to be paid under the unqualified plan.

In a NQDC arrangement employing a rabbi trust, the employer places assets sufficient to fund the deferred compensation payments in a trust that is managed by an independent trustee. To prevent constructive receipt by the plan participants of the deferred amounts, the funds in the trust remain subject to the claims of the employer's creditors and the employee's benefits under the trust are nontransferable and nonassignable. From the employer's standpoint, the rabbi trust is a grantor trust. Accordingly, income earned on trust assets is taxed currently to the employer. From the employee's standpoint, the tax (and the employer's related compensation deduction) is deferred until payment actually is made. This is because an employer's mere promise to pay at some future time does not result in constructive receipt to the employee.

After reviewing the initial rabbi trust ruling, this article discusses the tax issues involved, traces the evolution of the rabbi trust through a series of private letter rulings, and outlines key trust plan components. The article then analyzes the effect of ERISA upon rabbi trust rulings and concludes by discussing how the rabbi trust concept has evolved into an extremely flexible compensation planning device.

INITIAL RULING

The term "rabbi trust" was born when the IRS first approved a NQDC arrangement funded through a grantor trust in Letter Ruling No. 8113102 (December 31, 1980). In the private ruling, an irrevocable trust was established by a congregation to secure promised benefits to a rabbi. Under the trust agreement, benefits were to be paid to the rabbi upon his death, disability, retirement, or termination of service. Trust property was not subject to the claims or other attachments by the rabbi's creditors. Nevertheless, trust assets did remain subject to the claims of the congregation's general creditors. The arrangement further provided that amounts placed in the trust would be invested and managed by trustees. Under the trust terms, none of the provisions could be altered, amended, revoked, changed, or annulled by the employer.

The IRS favorably ruled that the amounts placed in the irrevocable trust for the rabbi would not be included in the rabbi's taxable income until actually received by or otherwise made available to him. This treatment enabled the rabbi to defer income, even though the funds were subject to forfeiture in the event the employer became insolvent. Likewise, the employer's contribution did not become deductible until the amounts were included in the rabbi's gross income. In addition, since the trust constituted a grantor trust under section 677(a) of the Internal Revenue code, the employer was required to pay taxes on the trust's earnings. Of course, since the rabbi's employer was a tax-exempt organization, deferring the employer's deduction and causing the taxation to it of the earnings was of no practical consequence.

TAX ISSUES INVOLVED

In the ruling, the IRS primarily addressed two relevant tax issues in resolving its conclusion -- the constructive receipt doctrine and the economic benefit doctrine.

Constructive Receipt Doctrine

Under the constructive receipt doctrine, income is deemed to be constructively received and therefore includible in income when it is available for withdrawal or disposition at the taxpayer's discretion. For example, when a credit union or bank adds interest to the balance of a savings or checking account, that interest income is constructively received by the account holder. Section 451 states that the amount of any item of gross income shall be included in gross income in the tax year of receipt unless, under the method of accounting used to determine taxable income, the amount is to be properly accounted for in a different period. Treas. Reg [section] 1.451-2 clarifies that income, although not actually in the possession of a taxpayer, is constructively received by him in the taxable year in which it is credited to his account, set apart from him, or otherwise made available so that he may draw upon it at any time if notice of intention to withdraw has been given.

Given the general rule for income inclusion under the constructive receipt doctrine, the establishment of a rabbi trust to fund a NQDC arrangement could arguably constitute a taxable event for the employee. Nevertheless, Treas. Reg. [section] 1.451-2 provides that income subject to substantial limitation or restriction will not be considered constructively received. Under the rabbi trust agreement, payment of funds placed into, or earned by, the trust is restricted in the case of corporate insolvency, because the general creditors, not the employee, would receive the assets if this situation arose. This restriction constitutes a "substantial limitation" on the payment of assets to an employee and hence the amounts paid to a rabbi trust on behalf of the employer (and the income earned on those funds) are not currently taxable to the employee.

In a rabbi trust agreement, no actual guarantee of payments is provided by the employer's promise. Thus, holding that a NQDC arrangement funded by a rabbi trust (but containing only an unsecured promise to pay) does not give rise to constructive receipt is thus consistent with Revenue Ruling 60-31, 1960-1 C.B. 174, which holds that such a promise will not trigger constructive receipt of income in a nonqualified deferred compensation arrangement.

Economic Benefit Doctrine

The economic benefit doctrine holds that benefits should be taxed to an employee when the are conferred. The doctrine was first judicially applied to deferred compensation in Sproull v. Commissioner, 16 T.C. 244 (1951), aff'd, 194 F.2d 541 (6th Cir. 1952). In Sproull, a trust was created in 1945 for the benefit of a company president. The trustee was to pay half of the money to the president in 1946 and the remainder in 1947. The Tax Court ruled that economic benefit had been conferred to the president upon creation of the trust in 1945 because no contingencies for payment were involved and no one other than the employer had any control or interest in the money in the trust.

With respect to a rabbi trust, the question arises whether an employer setting aside unsecured funds for the purpose of paying promised benefits constitutes a currently taxable conferment of benefits. Section 83 of the Code defines the term "property" and designates what transfers of property are taxable. In Treas. Reg. [section] 1.83-3(e), "property" is defined as real and personal property other than money or an unfunded and unsecured promise to pay money in the future. Section 83(a) provides that an income recognition event occurs in the first taxable year in which the property either (1) becomes transferrable or (2) is no longer subject to a substantial risk of forfeiture. The amount so recognized as compensation for services rendered is the excess of the fair market value of property transferred for services given over the amount actually paid for the property. When a rabbi trust is created, the promise to pay the money in the future is subject to the claims of the employer's general creditors. Consequently, no income inclusion by the employer is required by section 83.

EVOLUTION OF RABBI TRUSTS

Pre-Moratorium Ruling Period

The progression and continuing viability of the IRS's initial private letter ruling on rabbi trusts are illustrated by a series of subsequent rulings. In 1983, in Letter Ruling No. 8325100 (March 22, 1983), the IRS limited the class of creditors to whom the trust assets had to be available in order to prevent constructive receipt to only judgment creditors. In that same year, in Letter Ruling No. 8329070 (April 21, 1983), the IRS reversed ground and held that required trust assets had to be made available not only to judgment creditors but to all the contributing corporation's creditors, upon its insolvency. The IRS continues to hold, however, that all income, deductions, and credits attributable to the trust should be included in computing the taxable income of the grantor and designed such a trust a "grantor" trust. See Letter Ruling No. 8325100 (March 22, 1983); Letter Ruling No. 8429012 (June 22, 1984).

In Letter Ruling No. 8509023 (November 29, 1984), an escrow trust rather than an irrevocable trust found favor with the IRS, and the realm of the rabbi trust was expanded. Furthermore, in Minor v. United States, 772 F.2d 1472 (9th Cir. 1985), the court allowed a medical group to use an escrow trust to fund the NQDC arrangement as long as the trust's assets remained subject to the creditors' claims. Interestingly, the court stated that the plan "severely stretches the limits of a nonqualified deferred compensation plan." 772 F.2d at 1476.

Post-Moratorium Ruling Period

In early 1985, the IRS declared a temporary moratorium to reexamine its policy. The suspension of activity was lifted on May 18, 1986, but the new ruling policy is more restrictive than its predecessor and more protective of creditors' rights. Currently, the IRS will rule favorably on a rabbi trust only if the trust assets can be reached by the creditors of the employer upon its bankruptcy or insolvency. (Insolvency, in this case, means the inability to meet current obligations as they become due.) If employee beneficiaries have preferential rights to trust assets, constructive receipt will be deemed to have occurred and taxation will result.

KEY TRUST PLAN COMPONENTS

In the post-moratorium ruling period, a rabbi trust must contain several key trust plan components to enhance the probability of a favorable IRS ruling. These key components include:

* The employer should establish a rabbi trust program and transfer assets to the trust, report all income generated by the trust, and take into account all deductions and credits generated by the trust.

* The trust should be managed at all times by an independent corporate trustee. The trustee's duties must be to protect and conserve the trust's assets.

* The trust should be an irrevocable trust, but the assets must remain subject to the claims of all the employer's general creditors in the event of the employer's insolvency. The use of the trust's assets to satisfy claims of the employer's general creditors must be enforceable by the creditors under federal and state law.

* The employer may want to make the trust irrevocable within a specified time period (such as 30 days) after a favorable ruling on the legitimacy of the arrangement is received by the IRS. If the IRS issues an unfavorable ruling, the employer could revoke the trust, reclaim the assets in the trust, and employ them in other forms of nonqualified deferred compensation.

* A written procedure should be prepared on how the trust may be altered or amended. No amendments should be effective without the written consent of both the employee and the employer.

* No benefits received from the trust can be assigned by the employees to their survivors, nor can the benefits be attached by creditors of the survivors. (Attachment may occur, however, once payments begin.)

* The trust should specify that it will not terminate unless all benefits have been paid to the beneficiaries. If any assets remain, they revert to the employer.

* No trigger mechanisms in the event of the employer's insolvency should be included. According to Letter Ruling No. 8325100 (March 22, 1983), "[a]n insolvency trigger is any mechanism in a rabbi trust which directs the trustees to accelerate distribution of the funds in the trust." Such a trigger is unacceptable because it would prefer the participant over the creditors and may cause the plan to be "unfunded" for ERISA purposes.

* The promise to pay benefits should not be secured by notes or similar means. This might create the appearance of being funded.

* The trust instrument should specify the procedure by which the trustee is to be notified of the employer's insolvency. Such a procedure should address the following: (a) suspension of payments to beneficiaries, (b) holding of trust assets for employers' general creditors, and (c) resumption of payments to the beneficiary after employer is again solvent. (The first payment after suspension may include payments that were suspended, and interest may be credited to suspended payments.)

* The trust should designate how the trust principal and the investment income will be invested.

* The trust should remain "unfunded" for ERISA purposes.

ERISA AND "UNFUNDED" RABBI TRUSTS

An excess beenfit plan is a plan maintained by an employer only for the purpose of providing benefits for certain employees in excess of the limitations on contributions and benefits imposed by section 415 of the Code. Such excess benefit plans will be the subject of favorable IRS ruling only if they are considered "unfunded" for purposes of the Employer Retirement Income Security Act of 1974, in which case they will not be subject to the requirements of ERISA. In 1989, the Department of Labor issued Advisory Opinion No. 89-22A, which provides that a NQDC plan employing a rabbi trust that provides benefits in excess of those permitted by section 415 will be considered "unfunded." The advisory opinion also provides for the first time that "unfunded" for IRS purposes has the same meaning as "unfunded" for ERISA.

Generally, to satisfy the ERISA requirements for excess benefit plans, the plan must be maintained for the benefit of management and highly compensated employees. The deferred compensation must be backed by no more than a naked promise to pay the compensation at a later date. Specifically, a rabbi trust must comply with the designated requirements provided by the IRS. When the requirements are met, the trust will be treated as not providing "funding" for purposes of the rules governing nonqualified deferred compensation.

FLEXIBLE COMPENSATION

PLANNING DEVICE

Since being initially sanctioned by the IRS, the basic rabbi trust arrangement has evolved into an extremely flexible compensation planning device. Recent favorable rulings underscore how combining a NQDC plan with a rabbi trust can satisfy a wide variety of corporate needs and key employees' concerns.

Anti-Takeover Rabbi Trusts

A hostile takeover can not only put an end to a top manager's job, but it might also place his deferred compensation arrangements in jeopardy. In Letter Ruling No. 9037018 (June 15, 1990), the IRS approved a rabbi trust plan with built-in anti-takeover insurance.

Example. Corporation X, with sufficient assets, sets up a rabbi trust-backed nonqualified deferred pay plan for its senior officers and outside directors. The deferred compensation is payable on the participant's normal, early, or disability retirement, his death, or his termination of employment within three years of a change in control of Corporation X. The plan's definition of "change in control" is specifically designed to protect participants in the event of a hostile takeover. A change in control is deemed to occur if (1) more than 30 percent of Corporation X voting stock is purchased in a transaction not arranged or approved by Corporation X's board of directors, or (2) during any two-year period, persons who constitute Corporation X's board of directors at the beginning of the two-year period cease thereafter to constitute a majority.

Another anti-takeover feature received approval in Letter Ruling No. 9040067 (July 12, 1990). Under the approved plan, benefits were payable on death, retirement, or termination of employment, and participants vested in their benefits ratably over a five-year period. In the event of a takeover, however, the participant would become fully vested. Consequently, if a participant were forced out by the new owners, he or she would be entitled to a full payout. "Takeover" is defined as occurring if more than 50 percent of the employer's outstanding securities entitled to vote in directors' elections are sold to anyone other than a corporation under common control with the employer or its parent.

Second Rabbi Trust

In Letter Ruling No. 9029051 (April 24, 1990), the IRS approved a twin rabbi trust arrangement. Under the arrangement, the NQDC plan was funded with a conventional rabbi trust. In addition, a second rabbi trust was established to provide additional comfort to truly conservative employees worried that they may have to sue to enforce payment of the deferred compensation; this trust was set up to defray participants' legal fees and expenses in connection with lawsuits or proceedings brought to enforce their rights under the plan.

"Golden Handcuffs" Rabbi Trust Plan

Letter Ruling No. 9041053 (July 24, 1990) approved an "earnings participation plan" that ties deferred compensation levels to a corporation's annual net operating income and operating margin. Under the plan, participants were credited with units that are set up for bookkeeping purposes only. The corporation agreed, however, to set aside assets in a rabbi trust as a reserve against its payment obligations under the earnings participation plan. Payouts to participants were to be staggered over four years of continuous employment, starting January 1 after the year when units are allocated to participants. Full payment was to be made in the event of involuntary termination due to death, disability, retirement, or termination not for cause. Consequently, a key employee who quit early (or is terminated for cause) would lose part or all of the deferred compensation.

Life Insurance Transferred to Rabbi Trust

In Letter Ruling No. 9041052 (July 17, 1990), an employer set up a rabbi trust as a reserve for payments required under deferred compensation plans established five years previously. Among the assets transferred to the trust were insurance policies on the lives of employees. The employees had no rights or interests in the policies, which were owned by the company before the transfer. Following the transfer, the trust was the owner and beneficiary of the policies. The IRS ruled that the transfer of the policies to the trust did not constitute a transfer for valuable consideration within the meaning of section 101(a)(2). Consequently, amounts received on the death of a participant-insured were excludable from gross income. The IRS reasoned that since the rabbi trust is treated as a grantor trust, then for income tax purposes, the corporation owns the policies both before and after the transfer.

Hardship Payour Provision

In Letter Ruling No. 9037026 (June 15, 1990), a corporation set up a rabbi trust-backed deferred compensation plan that afford employees an opportunity to elect in advance to defer up to 20 percent of their compensation (including bonuses). The plan provided for payouts in the event of retirement, disability, death, termination of employment, or "hardship." The ruling, which approved the trust, does not disclose how "hardship" is defined by the plan. An earlier private ruling -- Letter Ruling No. 8844020 (August 5, 1990) -- approved a plan that allowed withdrawals to meet a "severe financial hardship." This term was defined as a hardship that could not "reasonably be relieved by reimbursement by insurance or otherwise, liquidation of the participant's assets to the extent that the liquidation would not in itself cause a financial hardship or cessation of deferrals under the plan."

CONCLUSION

Rabbi trusts afford employers the opportunity to attract top management into their companies with the incentive of tax-deferred compensation. Not only do rabbi trusts mitigate the threat that takeovers pose to NQDC arrangement, but they allow executives to postpone tax on deferred compensation. If employers comply with the key plan components outlined in this article, the IRS will likely issue a favorable ruling.

RAY A. KNIGHT is a professor of accounting at Middle Tennessee State University. He received a B.S. degree in accounting from the University of Houston, an M.A. degree in accounting from the University of Alabama, and a J.D. degree from Wake Forest University. He is a member of the American Institute of Certified Public Accountants, American Bar Association, American Taxation Association, and several other professional organizations. Mr. Knight has published articles in many professional journals, including The Tax Executive.

LEE G. KNIGHT is a professor of accounting at Middle Tennessee State University. She received a B.S. degree in accounting from Western Kentucky University, and M.A. and Ph.D. degrees from the University of Alabama. She is a member of the American Accounting Assocation and the American Taxation Association. Ms. Knight has published articles in many professional journals, including The Tax Executive.

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