Understanding Rabbi Trusts: A Comprehensive Guide for Chevron Employees

What Is It?

A rabbi trust is a trust that you create to cover your unofficial cost of benefit obligations under nonqualified deferred compensation (NQDC) plans for your workers. Because a rabbi benefited from the first trust of its kind to get a favorable IRS verdict, it was named after the religious leader. The main goals of setting up a rabbi trust are to provide your staff the peace of mind that assets will be accessible and that deferred compensation will be paid out when it's due in accordance with the NQDC plan. Because the trust keeps the plan assets separate from the company, it offers some security for your employees' deferred compensation. In addition to avoiding the potential financial strain of having to pay a sizable amount of deferred compensation when it's due, adequately segregating funds in a rabbi trust will obligate the trustee, who is typically impartial toward the employer, to pay the deferred compensation from the trust assets when it's due in accordance with the terms of the NQDC plan.

Caution: Despite being kept separate from the corporation's assets, the rabbi trust's holdings are nevertheless vulnerable to claims from the company's creditors, and benefits could be forfeited in the event that the employer files for bankruptcy or becomes insolvent.

Tip: A rabbi trust can be irrevocable or revocable (or revocable with the ability to be revoked with the occurrence of a certain event, such as a change in the employer's control). In the event that a rabbi trust is irreversible, the employer forfeits any and all right to use the NQDC plan assets until all benefit obligations are fulfilled. With the exception of bankruptcy or insolvency, the assets are there to give your employees the NQDC benefits. The assets held in the rabbi trust become available to your general creditors in the event of bankruptcy or insolvency.

How Do You Establish A Rabbi Trust?

By signing a trust agreement with a trustee (often a bank or trust company), you, the settler or grantor, create a rabbi trust. The NQDC plan contributions and investment gains are then held by the trustee.

Tip: Multiple employees can benefit from a single rabbi trust.

Why Should You Establish A Rabbi Trust?

When it comes to giving plan participants benefit security, a rabbi trust is a significant advancement. If you place enough assets into an irrevocable rabbi trust, you can almost remove the possibility of nonpayment for any cause other than bankruptcy or insolvency. An irreversible rabbi trust is a perfect tool for workers who are concerned about nonpayment mainly due to a hostile takeover or something similar (a "change in control"), or in situations where the employer declines to pay (a "change of heart"). However, if your employees' main issue is nonpayment due to your insolvency or bankruptcy, you might want to think about formally supporting your NQDC plan with a secular annuity or trust.

Model Rabbi Trust

The Internal Revenue Service (IRS) has created safe harbor language in the form of a model rabbi trust that demonstrates how to structure a trust in order to achieve tax deferral of NQDC benefits. This model trust contains certain language that must be adopted as is, as well as optional provisions and language that can be modified as long as the changes aren't inconsistent with the suggested model trust language. The IRS will not issue favorable rulings on any rabbi trust that doesn't conform to the model trust language. For more information on the model trust provisions, see Revenue Procedure 92-64.

Tip: The creation of the rabbi trust doesn't cause the plan to be considered 'funded' for the purposes of the Employee Retirement Income Security Act of 1974 (ERISA).

Tip: You may wish to follow the model rabbi trust language in order to be sure that your trust arrangement will effectively defer taxation for your employees. What happens if you don't follow the model in setting up your rabbi trust? If challenged by the IRS, you may have to prove to the IRS that your plan is not funded for tax purposes. You can establish and operate a NQDC plan with a rabbi trust without applying for a favorable IRS ruling (this is common).

Tip: The model trust contains optional provisions that allow you to customize the trust to meet your and your employees' needs. For example, Revenue Procedure 92-64 permits 'springing' rabbi trusts, that is, a rabbi trust that has little or no assets until a triggering event occurs (for example, a change in control of the employer).

Federal Income Tax Treatment of Rabbi Trusts

Employee

When your employee receives NQDC plan benefits, the money kept in a well-crafted rabbi trust is typically includable in their gross income.

Caution: However, under the economic benefit doctrine, the doctrine of constructive receipt (which requires taxation when funds are available to the employee without substantial restrictions), or in the event that the NQDC plan does not comply with IRC section 409A, the IRS may tax an employee on contributions made to a plan before the plan assets are received.

Employer

Because the rabbi trust is a grantor trust and you, the employer, are the grantor, the IRS treats you as the owner of the trust for tax purposes. As a result, you must include the rabbi trust income, deductions, and credits when you calculate your tax liability.

Because cash values of corporate-owned life insurance (COLI) build tax-deferred (unless the alternative minimum tax (AMT) regulations apply) and you receive the life insurance earnings tax-free upon your employee's death, COLI is frequently utilized as a financing mechanism.

Contributions to the Rabbi Trust are deductible in the year that the plan benefits and trust are included in your employees' gross income. This usually indicates that you can deduct the amount only when your employee starts to get benefits from the NQDC plan. Only the portion of such amounts that represent regular and necessary business expenses is eligible for deduction.

Tip: You can deduct the full amount paid to a participant (contributions plus investment earnings).

Risks and Costs Associated With Rabbi Trusts

Rabbi trusts are not without hazards and expenses. Legal and administrative expenses frequently go up when a rabbi trust is established and maintained. The income from the trust's investments is taxable to you (rabbi trust investments frequently use corporate-owned life insurance to avoid current taxation). Furthermore, in the event of a corporate emergency or opportunity, you will not be able to access or use the trust's assets if it is irreversible. Furthermore, in the event of your bankruptcy or insolvency, the trust assets are not safeguarded.

Internal Revenue Code (IRC Section 409a)

Funding regulations pertaining to rabbi trusts are found in IRC Section 409A, which was passed as part of the American Jobs Creation Act 2003. Under Section 409A, benefits under the NQDC plan are normally subject to federal income tax and penalties when they vest (i.e., when they are no longer subject to a substantial risk of forfeiture) if a rabbi trust invests in offshore assets or if the trust may become funded as a result of a trigger based on the employer's financial health. Once more, this can occur before the employee is qualified to receive plan benefits. If you currently have an informal NQDC plan funded by a rabbi trust, or are thinking about starting one, you should speak with a pension specialist about how this significant law may apply to you.

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