Employee risk; rabbi trusts and other risk reduction devices

AuthorMarla J. Aspinwall - Michael G. Goldstein
Pages217-236
177
CHAPTER VII
EMPLOYEE RISK; RABBI TRUSTS AND OTHER RISK REDUCTION DEVICES
I. EMPLOYEE RISKS
A major incentive for retirement planning is to reduce risks — the risk that economic
conditions will change, the risk that future earnings will diminish, the risk that illness will strike,
and all the other risks that can prevent an employee from enjoying a reasonably comfortable
retirement. Accordingly, employees want to be able to rely on the sources of their retirement
income.
One of the major advantages of tax-qualified plans is that the employer must set aside
assets in a separate trust to fund the payments,1 and those funds cannot be reached by the
employer’s general creditors.2 Thus, an employer could go bankrupt, but its retirees still could
receive their qualified plan benefits.3
Two factors can make NQDC a risky proposition for the employee. First, the payments
under the NQDC plan are “deferred,” usually until after the employee attains normal retirement
age. Second, to achieve the desired income tax and ERISA treatment, the employee’s benefits
under a NQDC plan must be “unsecured and unfunded.” The desired income tax result —
escaping current income tax (so that the employee is only taxed on the amounts when
received) — can only be achieved if the employer’s agreement to pay the benefits is an
unfunded and unsecured promise to pay money or property in the future.4 Also, the desired
ERISA result — avoiding the more burdensome requirements of ERISA such as funding and
participation — will only be achieved if the NQDC plan is a “top hat plan.”5 In order to be a top
hat plan, the plan must be “unfunded.”6
There are at least four separate types of risks for the employee relying on NQDC benefits.
First, there is the risk of a “change in control.”7 When the employee retires, different individuals
1 29 U.S.C. § 1103(a), ERISA § 403(a).
2 See Patterson v. Shumate, 504 U.S. 753 (1992), 119 L.Ed.2d 519, 528 (1992) (“The anti-alienation
provision required for ERISA qualification . . . constitutes an enforceable transfer restriction for purposes
of § 541(c)(2)’s exclusion of property from the bankruptcy estate”).
3 Id. 11 U.S.C. § 541(0)(2).
4 Treas. Reg. § 1.83-3(e) (emphasis added). See Chapter III, “Income Tax Consequences of NQDC for
the Employee” for a discussion of Section 83.
5 See ERISA §§ 201(2) (participation and vesting), 301(a)(3) (funding), 401(a)(1) (fiduciary
responsibilities); 29 U.S.C. §§ 1051(2), 1081(0)(3), 1101(a)(1).
6 Id.
7 IRC § 409A includes a fairly typical definition of “change in control” which is discussed in Chapter III,
“Income Tax Consequences of NQDC for the
Employee.” The IRS model rabbi trust also includes a
definition of a “change of control.” Rev. Proc. 92-64,1992-2 C.B. 422, 427, § 13(d). The “golden
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may be in control of the employer. If new owners do not want to pay the benefits, the employee
may need to sue the employer to collect the benefits, which can be costly and time consuming.
Second, there is the risk of a “change of heart.” When the NQDC plan is established, the
employer is willing to make the payments for the benefit of the employee, and makes a legal
obligation to pay those benefits. However, many years later, when the employee has attained
retirement age, the company may decide not to pay the benefits. The employee can sue to
enforce the employer’s legal obligation to pay the benefits, but again that can be costly and time
consuming.
Third, there is a risk that the employer will have a change in financial condition (short of
bankruptcy or insolvency). If the employer has too many bills to pay, the employer may decide
that the retirees entitled to payments under the NQDC plan will be the last paid. Again, the
employee may need to sue to receive benefits.
Fourth, there is the risk that the employer will become insolvent or bankrupt. As
discussed in Chapter III, “Income Tax Consequences of NQDC for the Employee,” the employee
can have only the rights of an unsecured general creditor of the employer in order for the
employee to defer the income tax liability on the NQDC benefits.8 Like all other unsecured
general creditors, the employees may receive only pennies on the dollar, or nothing, in the
bankruptcy proceeding.9
In light of the importance of NQDC benefits in an employee’s retirement planning, many
employees and employers have searched for ways to reduce the risks.
II. RABBI TRUSTS
One frequently used approach is the rabbi trust, which can address three of the risks
described above (the change of control risk, the change of heart risk, and the change in financial
condition (short of insolvency or bankruptcy) risk), but cannot address the fourth risk (the
bankruptcy risk).
A.
Taxes and Rabbi Trusts.
1.
Original Rabbi Trust Ruling. A description of a rabbi trust, and the
explanation for its name, can be found in the first IRS Private Letter Ruling (“PLR”) approving a
rabbi trust arrangement. In IRS PLR 8113107 (Dec. 31, 1980), a congregation established a trust
parachute rules” discussed in Chapter III, “Income Tax Consequences of NQDC for the Employee,”
should also be considered in connection with this type of provision.
8 IRC § 83(a); Rev. Rul. 60-31, 1960-1 C.B. 174, 177; see also Goodman v. Resolution Trust Corp., 7 F.3d
1123 (4th Cir. 1993).
9 Assuming that NQDC benefits could be characterized as wages for services performed in the
90-day period
immediately before the bankruptcy, the employee’s claim for benefits might be entitled to the “third
priority” level among the
unsecured creditors, up to a maximum of $4,000. 11 U.S.C. § 507(a)(3).
However, since even this
amount would only be paid after all secured creditors have been paid, it would be
of little comfort to the employee in most cases.

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