RABBI TRUST: Definition, Administration, and Taxation

Rabbi trust

The Rabbi Trust is a non-qualified deferred compensation plan that invests money in an irrevocable trust and holds it for the benefit of employees for retirement purposes. While the funds, like your 403(b) account, are designed for your retirement, there are critical differences, particularly regarding distributions, that RPB is here to assist you to understand. As you evaluate how to incorporate a Rabbi Trust balance into your retirement savings plan, we recommend that you consult with a tax advisor about distribution alternatives and taxation to ensure that you fully understand the impact on your finances when you retire.

What is a Rabbi Trust?

The rabbi trust is a non-qualified, deferred payment scheme established by companies for their employees in the United States. Because the first Internal Revenue Service Letter ruling approving the use of this sort of trust concerned a Rabbi, it is known as the Rabbi Trust.

The sum given to the rabbi trust by the employer is not considered part of the employee’s compensation and is tax-deferred. This means that the employee does not have to pay any tax on that sum until she receives it from the trust.

For example, an employee may be paid $60,000 a year. Every month, the employer gives $500 to the employee rabbi trust. The taxable income of the employee is $60,000 per year.

The additional $6,000 is not taxable income until the employee withdraws the funds or receives a cheque from the trust. This permits the employee’s assets to grow tax-free inside the trust.

The trust is irrevocable and beyond the employers’ control. Once an employer contributes to a rabbi’s trust, he or she is not permitted to withdraw the funds.

How Does a Rabbi Trust Work?

The Rabbi trust does not provide any tax benefits to the employer until the employee receives benefits from the trust. At that point, the employer can deduct the amount of the trust fund distribution to the employee from taxable income. As a result, its application is limited in comparison to other forms of trust.

Typically, an employer will use a rabbi trust to provide a source of cash to satisfy the employer’s commitment to executives under a non-qualified benefit plan. In the event of insolvency, the general creditors of a corporation may seek the assets held by the rabbi trust under federal and state legislation. If the employer goes bankrupt or the corporation becomes insolvent, the law gives creditors access to the trust’s assets.

Mergers and takeovers normally have no effect on the trust’s assets. Only the beneficiaries (or the trustee) have the authority to amend the terms of trust once it is established. Once established, an employer cannot change the structure or provisions of the trust. The corporation that takes over has no authority to alter the conditions of the trust.

Employers are not permitted to withdraw funds from the trust under any circumstances. Thus, the assets maintained by a rabbi trust are safe and dedicated to serving the employee’s interests. Unless the corporation goes bankrupt, the monies are safe in the trust.

Is a Rabbi Trust Safe?

Yes, for the most part. If your company is financially secure but you believe your employer may refuse to pay benefits, a rabbi trust can assist protect your deferred salary.

However, if your major concern is that your employer will go bankrupt, a rabbi trust will not help you. In that situation, you could be better off with a bankruptcy-protected secular trust.

How Do You Create a Rabbi Trust?

Companies are in charge of establishing a rabbi trust. They are referred to as the grantor. The trustee, who oversees and maintains the funds, could be a bank or trust company that assisted in the creation of the trust arrangement.

Why Should You Create A Rabbi Trust?

A rabbi’s trust is a significant step forward in giving plan participants benefit security. An irrevocable rabbi trust, together with the transfer of adequate assets into the trust, can effectively eliminate the danger of nonpayment for all reasons other than your bankruptcy or insolvency.

An irrevocable rabbi trust is an excellent method for employees who are concerned about nonpayment due to a hostile takeover or similar incident (“change in control”), or when the employer refuses to pay (“change of heart”). If your employees’ principal fear is nonpayment as a result of your insolvency or bankruptcy, you may want to consider formally supporting your NQDC plan with a secular trust or secular annuity.

Rabbi Trust Model

The IRS has developed safe harbor wording in the form of a model rabbi trust that explains how to build trust to achieve tax deferral of NQDC benefits. This model trust has mandatory provisions and language that must be followed, as well as optional provisions and language that can be changed as long as the modifications are not inconsistent with the suggested model trust language. The IRS will not provide positive rulings on any rabbi trust that does not follow the model trust language.

Tip: The establishment of the rabbi trust does not make the plan “financed” for the purposes of the Employee Retirement Income Security Act of 1974. (ERISA).

Tip: Follow the sample rabbi trust language to ensure that your trust arrangement successfully defers taxation for your employees. What if you don’t follow the model when establishing your rabbi’s trust? If you are challenged by the IRS, you may be required to demonstrate that your plan is not supported for tax reasons. You can set up and run an NQDC plan with a rabbi trust without seeking a favorable IRS judgment (this is common).

Tip: The model trust includes optional features that allow you to tailor the trust to the interests of you and your employees. For example, Revenue Procedure 92-64 allows “springing” rabbi trusts, which are trusts with few or no assets until a triggering event happens (for example, a change in control of the employer).

Rabbi Trusts and Federal Income Taxation

Employee

When your employee receives NQDC plan benefits, the money kept in a properly formed rabbi trust is generally includable in his or her gross income.

Caution: Under the doctrine of constructive receipt (which requires taxation when funds are available to the employee without substantial restrictions), the economic benefit doctrine, or if the NQDC plan fails to meet the requirements of IRC section 409A, the IRS may tax an employee on contributions made to an NQDC plan prior to the receipt of plan assets.

Employer

Because the rabbi trust is a grantor trust and you, as the grantor, are the grantor, the IRS considers you to be the trust’s owner for tax reasons. As a result, when calculating your tax liability, you must include the rabbi trust income, deductions, and credits.

Corporate-owned life insurance (COLI) is frequently utilized as a financing vehicle because cash values build tax-deferred (unless the alternative minimum tax (AMT) rules apply), and the life insurance proceeds are tax-free upon your employee’s death.

Rabbi trust contributions are deductible in the year benefits under the plan are included and the trust is includible in your workers’ gross income. In general, this means that you will be allowed to deduct when your employee receives NQDC plan benefits. Deductions are allowed only to the extent that they are usual and reasonable business expenses.

You can deduct the entire amount paid to a participant (contributions plus investment earnings).

Rabbi Trusts and Their Risks and Costs

Rabbi trusts are not without hazards and consequences. The establishment and upkeep of a rabbi trust frequently lead to an increase in legal and administrative expenses. The trust’s investment income is taxable to you (corporate-owned life insurance is often used as a rabbi trust investment to avoid current taxation). Furthermore, if the trust is irrevocable, you will not have access to the trust assets and will be unable to use the assets in the event of a company emergency or opportunity. Furthermore, the trust assets are unprotected in the event of your insolvency or bankruptcy.

Internal Revenue Service Code (IRC Section 409a)

Section 409A of the Internal Revenue Code, enacted as part of the American Jobs Creation Act of 2004, includes funding rules for rabbi trusts. If a rabbi trust invests in offshore assets, or if the trust becomes funded as a result of a trigger based on the employer’s financial condition, NQDC plan benefits are normally liable to federal income tax and penalties when they vest, according to Section 409A (i.e., when they are no longer subject to a substantial risk of forfeiture). Again, this could be before the employee is eligible to receive benefits from the plan. If you have or are thinking about starting an NQDC plan that is informally funded by a rabbi trust, you should consult a pension consultant about how to apply this crucial law.

The Benefits and Drawbacks of a Rabbi Trust

Pros

  • Employee tax advantages
  • Employees are protected in the event of a change of heart or a change in ownership.

Cons

  • Creditors have the right to seize assets.
  • Employers receive no tax breaks.

Pros Explained

  • Employee tax advantages: A rabbi trust allows CEOs to delay income tax on contributions until they take the money from the trust in retirement.
  • Employees are protected in the event of a change of heart or a change in ownership: Unlike stand-alone NQDC plans, which are effectively an employer commitment to pay out future benefits, rabbi trusts are normally irrevocable and will always be paid out to the employee until the firm becomes insolvent.

Cons Explained

  • Creditors can seize assets: If the company fails, the money in a rabbi trust may not be safe from creditors.
  • Employer tax benefits: Unlike other types of trusts, rabbi trusts do not provide employer tax benefits.

Rabbi Trust vs. Secular Trust

Rabbi TrustSecular Trust
Provides non-qualified benefits to key employeesProvides non-qualified benefits to key employees
Creditors can come after assets if company files for bankruptcyCreditors can’t come after assets if company files for bankruptcy
Not taxable until the employee takes withdrawalsTaxable as soon as an employee becomes fully vested

Rabbi and secular trusts function mostly in the same way. Both are irrevocable trusts that businesses create to provide non-qualified perks to essential employees. There are, nevertheless, some significant variances.

One significant distinction is that creditors cannot seize assets under a secular trust if the company goes bankrupt. The employee is better protected. Secular trusts, on the other hand, are taxable as soon as the employee is vested.

Rabbi trusts, on the other hand, are not taxable until the employee withdraws from the trust. When the trust incurs taxes, the trustee is responsible for them.

The disadvantage of rabbi trusts is that they are not immune from creditors.

The Rabbi Trust is a non-qualified deferred compensation plan that invests money in an irrevocable trust and holds it for the benefit of employees for retirement purposes. While the funds, like your 403(b) account, are designed for your retirement, there are critical differences, particularly regarding distributions, that RPB is here to assist you to understand.

Conclusion

When drafting rabbi trusts, it is critical to understand the underlying taxation rules, especially if the rabbi trust contains elements not contained in the IRS model trust. As previously stated, there is no guarantee that the IRS will sanction alterations and additions to the model rabbi trust provisions in the case of an audit. However, such rules are more likely to be approved if they do not conflict with the underlying tax concepts that defer employee taxation. It is advisable to contact legal counsel and establish the rationale for any of the requirements outlined above before implementing one or more of them.

Rabbi Trust FAQs

Who owns a rabbi trust?

Your employer is treated as the trust’s owner and is responsible for paying all taxes and reporting any trust revenue. Assume your annual salary is $150,000, and your employer contributes an additional $1,500 per month to a rabbi trust for you as a perk.

What is the benefit of a rabbi trust?

Rabbi trusts allow employees’ assets to grow tax-free until they withdraw their funds. A rabbi trust is similar to a qualified retirement plan in this regard. A rabbi trust does not provide any tax benefits to businesses, which limits its use in comparison to other types of trusts.

Can a rabbi trust be revocable?

The rabbi’s trust is typically irreversible, but it might be intended to be revocable until specific conditions occur, such as a change in control.

Why is it called a rabbi trust?

A “rabbi trust” got its name since the first one was established for a Jewish congregation’s rabbi. The congregation requested and received a private letter ruling (PLR) from the Internal Revenue Service (IRS) that addressed the tax implications of establishing the trust for the rabbi.

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