Key Takeaways
- Trust defers employee taxes until distribution.
- Assets subject to employer creditors' claims.
- Used for non-qualified deferred compensation plans.
What is Rabbi Trust?
A rabbi trust is a non-qualified deferred compensation arrangement where an employer sets aside assets in a trust to fund future employee benefits, such as executive retirement or incentives, while allowing tax deferral for the employee until distribution. Unlike fully secured plans, these assets remain subject to the employer's creditors, preserving the employee’s tax deferral by avoiding constructive receipt of income.
The concept originated from an IRS ruling involving a synagogue’s deferred compensation plan for its rabbi, but today rabbi trusts are widely used in corporate settings for C-suite executives and other key employees.
Key Characteristics
Rabbi trusts combine flexibility and tax advantages with specific structural requirements. Key features include:
- Non-qualified plan: Used for deferred compensation beyond qualified retirement plans, often for executives.
- Grantor trust status: The employer is taxed on earnings, with no deduction until employee payout.
- Asset earmarking: Funds are set aside but remain accessible to employer creditors, ensuring no employee constructive receipt.
- Irrevocable until triggered: Trusts may be revocable initially, becoming irrevocable upon events like change of control.
- Restricted access: Employees cannot assign or pledge interests, protecting against premature distribution.
- Independent trustee: Often manages assets such as cash or securities, including stocks like JPMorgan Chase or Visa.
How It Works
Employers establish a rabbi trust by funding it with cash or securities intended for select employees, typically in the executive ranks. The assets grow tax-deferred for the employee but remain subject to claims by the employer’s creditors, maintaining the plan’s non-qualified status.
Distributions occur only upon defined triggering events such as retirement, death, disability, or a change in corporate control. At payout, the employee recognizes income and pays taxes accordingly, including potential payroll taxes. The trust’s irrevocable nature after triggers, combined with an onerous contract provision, helps ensure commitment to future payments.
Examples and Use Cases
Rabbi trusts are commonly used by companies to retain and reward high-level employees through deferred incentives.
- Financial sector: JPMorgan Chase may use rabbi trusts to secure executive deferred compensation while managing tax exposure.
- Technology and payment processing: Firms like Visa set aside shares or cash in rabbi trusts as part of executive retirement or performance plans.
- Investment funds: Some companies within the SPDR S&P 500 ETF Trust may utilize rabbi trusts to offer flexible compensation to key personnel.
Important Considerations
While offering tax deferral and informal funding protection, rabbi trusts do not shield assets from employer creditors or bankruptcy proceedings, unlike ERISA-qualified plans. This exposes employees to risk if the company becomes insolvent.
Employers and executives should carefully navigate tax implications due to the grantor trust status and consult advisors before implementation. Proper drafting aligned with IRS guidelines ensures compliance and helps avoid unintended tax consequences or disputes during corporate changes.
Final Words
A rabbi trust offers a strategic way to defer taxes on executive compensation while protecting assets from immediate employee access. To optimize its benefits, consult with a financial or tax advisor to align the trust’s terms with your long-term compensation goals.
Frequently Asked Questions
A rabbi trust is a non-qualified deferred compensation trust set up by employers to hold assets for future employee benefits like executive retirement. It allows employees to defer taxes until they receive distributions while keeping the assets accessible to employer creditors.
The term 'rabbi trust' originated from a 1980 IRS ruling approving a synagogue's deferred compensation plan for its rabbi. This arrangement placed funds in a trust subject to the synagogue's creditors, which avoided immediate taxation for the rabbi.
Employers fund the trust with assets for select employees, which grow tax-deferred for the employee but are taxed currently to the employer. Employees cannot access the funds until certain events like retirement, and the assets remain available to employer creditors.
Employees defer income tax on the assets until distribution, which often occurs at retirement. Employers deduct contributions only when payouts are made, and since the trust is a grantor trust, the income and assets are attributed to the employer for tax purposes.
No, assets in a rabbi trust remain subject to the employer's creditors, meaning if the employer goes bankrupt, those assets can be claimed by creditors. This lack of protection is a key difference from ERISA-qualified plans.
Rabbi trusts are commonly used by employers to provide deferred compensation or retirement benefits to key executives and select employees. They offer more security than unfunded plans but are not limited to religious organizations.
No, employees cannot access, assign, or pledge funds in a rabbi trust until specific triggering events like retirement, death, disability, or termination occur, ensuring the funds are reserved for future benefits.
Advantages include tax deferral for employees and reduced employer risk of changing benefit commitments, with added oversight from an independent trustee. Disadvantages include lack of protection from employer creditors and potential exposure to employer bankruptcy.
