What Is Rabbi trust?
A Rabbi trust is a type of irrevocable, non-qualified deferred compensation arrangement used by employers to set aside funds for future payments to select employees, typically executives. It falls under the broader category of deferred compensation plans within corporate finance. The defining characteristic of a Rabbi trust is that, while the assets are held in trust for the beneficiaries, they remain subject to the claims of the employer's general creditors in the event of insolvency or bankruptcy. This critical feature ensures that employees do not have immediate access to the funds, thus preventing current taxation under the constructive receipt and economic benefit doctrine principles. Contributions made to a Rabbi trust are not taxable to the employee until the funds are actually distributed, offering a valuable form of tax deferral.
History and Origin
The concept of a Rabbi trust originated from a private letter ruling issued by the Internal Revenue Service (IRS) in 1980. The ruling involved a Jewish congregation that sought to provide deferred compensation to its rabbi, ensuring that funds set aside for his future benefit would not be immediately taxable to him. The IRS ruled that because the assets placed in the trust remained subject to the congregation's general creditors, the rabbi did not have immediate access or control over the funds, and therefore, was not subject to current taxation22, 23. This initial ruling set a precedent, and similar arrangements became popularly known as "Rabbi trusts." In 1992, the IRS provided further clarification and a model trust document through Revenue Procedure 92-64, offering a "safe harbor" for employers establishing such trusts20, 21.
Key Takeaways
- A Rabbi trust is an irrevocable arrangement used by employers for non-qualified deferred compensation plans.
- It allows for tax deferral for the employee until the deferred compensation is paid.
- The assets held within a Rabbi trust are subject to the claims of the employer's general creditors in the event of insolvency or bankruptcy.
- A Rabbi trust provides employees with a degree of security against a "change of heart" by the employer or new management, as the employer generally cannot reclaim the funds.
- It does not protect the deferred compensation from the employer's creditors.
Interpreting the Rabbi trust
A Rabbi trust is primarily interpreted as a mechanism to provide a measure of security for deferred compensation without triggering immediate taxation for the employee. For the arrangement to qualify as a Rabbi trust and maintain its tax-deferred status, the deferred funds must not be beyond the reach of the employer's general creditors. This condition means that the employee effectively remains an unsecured creditor of the employer for the deferred amounts. The use of a Rabbi trust signifies the employer's commitment to setting aside funds for future obligations, offering psychological comfort to the beneficiary, and protecting the funds from potential mismanagement or diversion by the employer for other business purposes19.
Hypothetical Example
Consider an executive, Sarah, who works for Tech Innovations Inc. and participates in their non-qualified deferred compensation plan, which uses a Rabbi trust. Sarah defers $50,000 of her annual bonus into this plan. Tech Innovations places these funds into an irrevocable Rabbi trust, managed by an independent trustee. The trust invests the money, and it grows over time.
While these funds are set aside for Sarah, they are legally considered assets of Tech Innovations Inc. and could be claimed by the company's general creditors if Tech Innovations were to face severe financial distress and file for bankruptcy. However, Sarah knows that the company itself cannot simply decide to take the money back or use it for day-to-day operations. When Sarah retires in 10 years, the funds, including investment gains, will be distributed to her, and she will pay income tax on the full amount at that time.
Practical Applications
Rabbi trusts are widely used in executive compensation packages as part of non-qualified deferred compensation plans. They are particularly attractive for highly compensated employees who have already maximized contributions to qualified retirement plans like 401(k)s. By utilizing a Rabbi trust, companies can attract and retain key talent by offering additional tax deferral opportunities on deferred salary, bonuses, or other forms of compensation17, 18.
These trusts function as a funding vehicle to ensure the employer has set aside assets to meet its future obligations under the deferred compensation plan, even if those assets are not protected from the employer's creditors. The setup often involves an agreement that the trust will become irrevocable upon a certain event, such as a change of control in the company, further protecting the employee's deferred benefits from a new management's potential change of mind16. However, it is crucial to understand that while a Rabbi trust provides protection against the employer's discretion, it offers no protection against the employer's financial distress, meaning the deferred funds could be lost if the company becomes insolvent15.
Limitations and Criticisms
Despite their benefits, Rabbi trusts have significant limitations, primarily the lack of creditor protection. The assets held in a Rabbi trust, by design, must remain subject to the claims of the employer's general creditors. This means that in the event of the employer's insolvency or bankruptcy, the deferred compensation held in the trust can be seized by the company's creditors to satisfy outstanding debts13, 14. This inherent risk is a major drawback, as it exposes the employee to the financial health of the employer.
Another point of criticism revolves around the timing of FICA taxes. While income tax is deferred until distribution, FICA taxes (Social Security and Medicare taxes) on the deferred compensation are generally due and withheld when the compensation is earned or vested, even if the income has not yet been received by the employee10, 11, 12. This "special timing rule" means that employees may pay Social Security and Medicare taxes years before they actually receive the deferred income9. Additionally, strict adherence to IRS guidelines, particularly Revenue Procedure 92-64, is required to maintain the favorable tax treatment. Failure to comply, such as structuring the trust to protect assets from creditors based on the employer's deteriorating financial health (known as "springing trusts"), can lead to immediate taxation of the deferred amounts7, 8.
Rabbi trust vs. Secular trust
The primary distinction between a Rabbi trust and a Secular trust lies in the creditor protection of the deferred assets and the timing of taxation. A Rabbi trust, as discussed, makes the deferred assets subject to the employer's general creditors. This feature allows for the deferral of income tax for the employee until actual distribution.
In contrast, a Secular trust provides greater security for the employee because the assets placed in the trust are irrevocably set aside and are not subject to the employer's creditors. However, this enhanced security comes at a cost: the employee is generally taxed on contributions to a Secular trust when they are made or when they vest, rather than when they are distributed. This is because the assets are considered funded and beyond the reach of the employer, triggering immediate taxation under the economic benefit doctrine. Therefore, while a Secular trust offers superior asset protection, it forfeits the tax deferral benefits that are the hallmark of a Rabbi trust.
FAQs
Q: Why is it called a "Rabbi trust"?
A: The name "Rabbi trust" originated from the first private letter ruling issued by the Internal Revenue Service (IRS) in 1980, which involved a trust set up by a congregation to provide deferred compensation for its rabbi.6
Q: Does a Rabbi trust protect my money from my employer's bankruptcy?
A: No, a Rabbi trust does not protect your deferred compensation from your employer's creditors in the event of insolvency or bankruptcy. The assets in a Rabbi trust are still considered part of the employer's general assets and can be claimed by creditors.4, 5
Q: What are the tax implications for employees with a Rabbi trust?
A: Employees benefit from tax deferral on the deferred compensation itself and its earnings; they do not pay federal or state income tax until the funds are distributed. However, FICA taxes (Social Security and Medicare) are generally due when the compensation is earned or vested, even if not yet received.2, 3
Q: Can an employer reclaim funds from a Rabbi trust?
A: Generally, no. Once an employer contributes assets to an irrevocable Rabbi trust, they cannot retrieve those funds. This feature provides a level of security for employees against the employer's discretion or a change in management, even if it doesn't protect against creditors.1