Nonqualified deferred compensation plans backed by rabbi trusts are gaining popularity.

• Author: Knight, Ray A.

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...