Rabbi Trust Plan & Its Taxation Basics

It is critical to understand what a rabbi trust is and the underlying taxation regulations when drafting these trusts.

In the United States, the Rabbi Trust is a popular non-qualified deferred compensation plan. The first IRS letter approving this sort of trust involved a Rabbi, hence the name Rabbi Trust. The employer’s contribution to the trust is tax-deductible, and the employee does not have to pay tax on that sum until he/she receives it from the trust. Also, the trust is irrevocable and uncontrollable. Employers cannot get their money back after they contribute to this trust. We will discuss more about the Rabbi trust and its features to help you understand it better.

Rabbi Trust Plan and Taxation

It is critical to understand what a rabbi trust is and the underlying taxation regulations when drafting these trusts, especially if the rabbi trust has features not included in the IRS model trust. Let’s have a look at what they actually signify.

What is Rabbi Trust?

A rabbi trust is a type of trust that was established to help employers meet their non-qualified benefit responsibilities to their employees. It was a rabbi and his congregation who were the first to use this sort of trust after an Internal Revenue Service (IRS) private letter ruling permitted its use; this type of trust has since been referred to as a “rabbi trust”. To put it simply, it is a non-qualified employee trust that has been established for the mutual benefit of both a company and an employee.

How Does Rabbi Trust Work?

A rabbi trust enhances an employee’s financial security since the assets held inside it are not under the employer’s authority and are often set up to be irrevocable. Therefore, once an employer makes contributions to a Rabbi Trust, they will be unable to recover those funds. Also, employees are not required to pay taxes on the amount of money that their employer contributes to the trust because it is not considered a component of their wages. This means that until the employee actually receives the money from the trust, they will not be required to pay any tax on that amount.

For instance, an employee is paid $60,000 per year. A $500 monthly contribution is made by the employer to the employees’ trust fund. The yearly taxable income for the employee is $60,000.00.

In order for the additional $6,000 to be taxable, the employee must either take the money or get an actual check from the trust. Using this method, the employee’s assets can grow tax-free in the trust.

Workers can’t revoke the trust, and it’s completely out of their hands. It’s illegal for an employer to obtain the money back after they donate to a trust.

Non-qualified Deferred Compensation Plans

A non-qualified deferred compensation plan is an example of a Rabbi trust application where an employee receives tax-deferred compensation, which is therefore not taxable. An employer places assets in a separate trust for a future employee. Due to the economic benefit principle, the money is included in gross income even though the employer hasn’t reduced it.

If the trust assets were available to the employers general creditors, funds deposited in such a plan would not be considered income under Section 83(a). Because the employee is in danger of forfeiture under Section 83(a) and the accompanying rules 1.83-1, the compensation is not subject to current inclusion in the employee gross income.

The risk of forfeiture or other techniques of avoiding constructive receipt must be high in all non-qualified deferred compensation programs. The Trust is unique in that the money invested in it is shielded from employer changes of mind. The money in the trust cannot be withdrawn by the employer. Money in a trust is regarded as safe as long as the employer’s finances are strong. If an employer declares bankruptcy, the funds may be susceptible to general unsecured creditors’ claims.

Acquisition of a Business

When one company buys another, it may desire to set aside a portion of the purchase price and pay the payee after certain conditions are met. A Rabbi trust can be used to defer the tax liability of the deferred purchase price payments to the payee.

For the trust to work, there must be a real risk of forfeiture if the payee does not meet the agreed-upon criteria. If the condition is unbreakable, a constructive receipt may override the Rabbi’s trust.

How does Rabbi Trust Taxation Protect Employees?

In contrast to traditional trusts, rabbi trusts allow employees’ assets to grow without them having to pay tax on any capital gains until they remove their funds. In this way, a rabbi trust is equivalent to a qualified retirement plan in terms of tax benefits. Also, in times of financial difficulty, this trust shields employees from a company’s desire to take some of the trust’s assets to pay its other obligations. For example, it is illegal for a business to take $50,000 out of a rabbi trust in order to cover staff salaries. The employer cannot modify the structure of a rabbi trust once it has been established, providing further protection for the beneficiaries.

Importance of rabbi trust

Rabbi trust is considered important for many reason, a few of those are:

Importance of rabbi trust

  • In a rabbi trust, the assets of employees can grow tax-free until they decide to take the money out.
  • The basic goal of a rabbi trust is to protect the employee’s nonqualified perks. Many firms create trusts to improve executive promises.
  • The shareholder and financial communities recognize the use of rabbi trusts as a legal and even beneficial corporate practice.
  • There are no tax advantages for firms who limit their use of a rabbi trust, unlike other forms of trusts.

Rabbi Trust Taxation

Historically, the term “rabbi trust” refers to a trust formed by a Jewish community for the benefit of the rabbi of that congregation. The IRS sent a private letter ruling (PLR) to the congregation clarifying the tax consequences of the rabbi’s trust.

Tax Implications of a Rabbi Trust

It was necessary to navigate between two important tax concepts in order to prevent immediate taxation of the rabbi’s income.

  • Constructive receipt doctrine – Constructive reception concept is a tax doctrine that applies to the employer-employee relationship and states that money is included in an employee’s gross income in the tax year in which the employee receives it, whether it is actually received or constructively received. The income is classified as “constructive” received in the tax year in which it is credited to the employee’s account, set aside, or otherwise made available so that the employee can draw upon it at any time.
  • Economic benefit doctrine – Under the economic benefit doctrine, an employee is taxed on the fair market value of the property transferred to him or her in connection with the performance of services, whichever is earlier. According to these tax rules, an employee’s nonqualified deferred remuneration is immediately taxable if (i) the employee can assign or transfer his or her rights to it, or (ii) it is “funded”, i.e., assets are set aside for the employee’s sole benefit. By law, assets irrevocably given to the trust could not be paid to the rabbi or his beneficiaries until death, disability, retirement, or termination. The rabbi could not assign or pledge the trust assets until one of these situations occurred. For example, the rabbi couldn’t assign or transfer the assets, didn’t have access to them, and was subject to the congregation’s general creditors.
  • Rabbi trust as a grantor trust – A rabbi trust is classified as a “grantor trust” because its assets are susceptible to an employer’s creditors. For tax reasons, the trust’s assets are classified as employer assets. As a result, the employer cannot deduct contributions to the trust and is currently taxed on trust earnings. The employer cannot deduct until a participant or beneficiary receives money from the trust.
  • IRS model for rabbi trust – Since taxpayers cannot depend on other taxpayers’ PLRs (Private Letter Ruling), many employers submitted PLRs for their drafting trusts after the initial rabbi trust PLR was granted. The IRS eventually decided to limit PLR issuance. To avoid this, the IRS published Revenue Procedure 92-64 which limits future PLR applications. The IRS stated that a future PLR will only be provided if an employer certifies that the trust is consistent with the model rabbi trust language. A PLR will be awarded only in exceptional situations for a trust that does not meet these criteria. So few employers applied for PLRs after the model rabbi trust language was issued.

Provisions of a rabbi trust

We can’t foresee whether the IRS will accept trust terms that depart from the typical wording in Revenue Procedure 92-64 because the IRS rarely issues PLRs for rabbi trusts. Here are some rare rabbi trust provisions:

Reimbursement of direct benefit payments by the employer

The model rabbi trust requires an employer to provide a payment schedule to the trustee and to pay participants and beneficiaries on time. To the extent permitted by law, employers may not ask the trustee to return or redirect funds to them until all benefits have been paid out to participants and beneficiaries. There is an exception to the general norm in the model rabbi trust for payments made to participants or beneficiaries under the plan’s payment schedule. In the event of insolvency, the model rabbi trust allows payments to creditors.

There may be other occasions where the trustee should be permitted to pay the employer directly from trust funds. For example, an employer may pay benefits directly to plan participants or beneficiaries for lawful reasons. A request for reimbursement from the trust funds should be acceptable to the trustee in that situation.

A plan may also enhance benefit payments to meet federal, state, and local income and payroll tax withholding requirements if benefits are taxed upon vesting (prior to actual payment). This may occur if Section 409A is violated or if a plan is subject to IRS Section 457(f) tax restrictions. In that instance, a rabbi trust should allow the employer to repay such taxes even if the trustee has not made a benefit payment per the payment schedule.

Forfeiture of benefits

Although benefits are forfeited when a participant leaves work before the plan’s vesting schedule is completed, the general rule under the model rabbi trust prohibits reversion to the employer. As a result, forfeited benefit assets are inaccessible until all participants and beneficiaries are reimbursed. This is especially true in account-based plans where a participant’s benefit is equal to their account balance at the time of distribution. This trust for an account-based plan has no excess or deficit money except for forfeitures. In this case, the “forfeited” trust funds should be applied to future employer contributions to the rabbi trust. If the number of participants and lost benefits is large, this process could take years.

A rabbi trust for an account-based plan could theoretically be drafted so that, in the event of forfeiture due to a participant failing to meet the plan’s vesting schedule, the employer receives the “excess assets”, i.e. the amount by which the total dollar value of benefits payable to all remaining participants and beneficiaries exceeds the total dollar value of trust assets. Because rabbi trust assets are liable to an employer’s creditors in the event of insolvency, reversion should be forbidden. This provision should only be used if the employer is solvent.

A non-account-based plan’s reversion provision is more difficult to apply because the trust’s funding level varies with market swings. A non-account-based plan may allow an employer to avoid the trust reversion provision. If an employer wants such a provision, it should require a certain degree of overfunding of plan benefits, e.g., 125% of the plan’s benefits payable as of the determination date, before allowing reversion to the employer. A second condition is that the employer is not insolvent.

Termination of the trust

The model rabbi trust normally states that it will not end until all participants and beneficiaries have stopped to be eligible for benefits. An optional provision allows the trust to be terminated with the consent of all members or beneficiaries. Obtaining the consent of all plan members and beneficiaries may be difficult. Possibly, a trust provision allowing termination of the trust with the approval of 100% of the participants and beneficiaries voting on the termination should be allowed. The trust may also require a certain percentage of members and beneficiaries to vote.

Additional provisions

When drafting rabbi trusts, there are a number of important considerations that employers should keep in mind. Section 409A savings provisions (the plan and trust are intended to comply with Section 409A and will be read appropriately), a provision that the trust does not generate any third party rights or liabilities, a provision that the trust agreement will be binding on successors, and indemnity provisions are some examples of these.

Rules of rabbi trust distribution

Understand your options and liabilities for distributions made before or after January 1, 2005, or after December 31, 2004.

The age at which a person becomes eligible for a benefit.65 and retired65 and retired
Age limit for distributionEven if you are still working, you must start by April 1 of the following year you turn 70½.Even if you are still working, you must start by April 1 of the following year you turn 70½.
Annual Minimum Distribution$25,000 or your account balance, whichever is less.$25,000 or your account balance, whichever is less.
Payout Period by Default5 years (subject to an annual minimum)5 years (subject to an annual minimum)
Other Options for PaymentYou have the option of changing the default payout period to one in which you receive your money in annual installments over a time span ranging from 2 to 15 years (subject to an annual minimum).

After turning 65, you can begin receiving payments. However, the payments must begin by April 1 in the year following your 70½-year anniversary.

It's necessary to fill out a distribution election form.
As an alternative to the default payout period, you can request and be able to defer payments for at least five years from the time you first become eligible for distributions and April 1 of the year after you reach the age of 70½ by requesting and being able to receive your money in one lump sum or annually over 2 to 15 years (subject to an annual minimum).

It's necessary to fill out a distribution election form.
Distribution Election Form DeadlineYou must submit a Distribution Election Form before you turn 65 or, if later, before your retirement (if you retire after 65).If you want to defer payments for five years, you must complete a Distribution Election Form at least 12 months before the payment date.

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As stated previously, there is no guarantee that the IRS will approve alterations or additions to the model rabbi trust plan requirements. These clauses are more likely to be acceptable if they do not conflict with the underlying tax concepts that defer employee taxation.

It is advised to seek legal advice and establish the rationale for any of the measures mentioned above before implementing them; get in touch with Eqvista. Our experts here will efficiently manage your company equity and guide you through.

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