Secure compensation and benefits programs with a rabbi trust

A rabbi trust is a grantor trust established by an employer to fund and secure compensation and benefits programs for highly-compensated employees.

Rabbi trusts are referred to as such because the first IRS letter ruling involved a rabbi whose congregation made contributions to such a trust for his benefit. The ruling stated that the employees would not be taxed on the funds in the trust until the distribution of the funds to the employee or their beneficiary.

As a grantor trust, all assets within the trust become consolidated into the employer’s balance sheet, and income within the trust flows through the employer’s P&L. Thus, there is usually no P&L or balance sheet expense for establishing the rabbi trust.

Uses and Protections

The most prevalent use of a rabbi trust is to provide security for executive benefits under a nonqualified deferred compensation plan (NQDP) where the employee defers compensation to a future date. The employer is then under contractual obligation to pay benefits. Employee deferrals are contributed to the trust and can be utilized only to satisfy obligations to employees, and the funds may not revert to the employer until all benefit obligations become fully discharged.

Rabbi trusts protect the assets within against:

  • Change-in-control
  • Change-in-management
  • Change-of-heart

By IRS definition, rabbi trust assets are subject to corporate creditors in the event of bankruptcy.

Level of Security

A key feature of rabbi trusts is that the assets are subject to the claims of the employer’s creditors at all times. In the event of an insolvency, the employer’s creditors will have access to all trust assets, including NQDP participants. If insolvency or bankruptcy occurs, plan participants will have to stand in line with other employer creditors.

A hostile takeover does not affect the assets in the trust. Rabbi trusts often include a trigger requiring full funding of designated non-qualified benefit programs when there is a change of control, as defined within the document. This mechanism protects participating executives from a change of heart due to a hostile takeover.

Usually, before a change-in-control (CIC), the trustee is “directed” by the company as far as all decisions on investments and distributions. However, after a CIC, the trustee should have total discretion on all aspects of the trust to protect the interest of trust beneficiaries. This is one of the weaknesses of many rabbi trusts in that plan sponsors have not adequately planned for a CIC event or prepared for what will happen to trust operations.

What are the Problems with Rabbi Trusts?

If you have a “Rabbi Trust” to fund your executive plans:

  • Have you taken a critical look at it lately?
  • Have you put your Execs at risk?

Many employers implemented their rabbi trust years or even decades ago and have never again reviewed it. The problem is that there have been many significant regulatory, legislative, best-practice, and trustee changes that may have your executives, your company, or both at risk.

What Employers Should Ask

Here are the critical questions employers should be able to answer:

  • Does our rabbi trust have best-practice provisions?
  • What exactly will happen in a Change-in Control (CIC)? Do we really know?
  • After a CIC, will our trustee resign, act as a discretionary trustee, or both?
  • Is our rabbi trust out of compliance with §409A? Many are!
  • Are our trustee fees competitive with recent market fee reductions?
  • Is our trust investment policy written and cost effective?

Alliance Trust Company of Nevada is happy to assist you in gaining more information on rabbi trusts and referring you to attorneys in our network to get you started. Contact us for more information.

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